<PAGE>   1
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
 
                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                   FORM 10-K
 
               [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
 
                         FOR THE TRANSITION PERIOD FROM
                               --------------- TO
                                ---------------
 
                         COMMISSION FILE NUMBER 0-20083
 
                            SPACELABS MEDICAL, INC.
             (Exact name of registrant as specified in its charter)
                            ------------------------
 
<TABLE>
<S>                                               <C>
                    DELAWARE                                             91-1558809
         (State or other jurisdiction of                              (I.R.S. Employer
         incorporation or organization)                             Identification No.)
</TABLE>
 
               15220 N.E. 40TH STREET, REDMOND, WASHINGTON 98052
              (Address of principal executive offices) (Zip Code)
 
       Registrant's telephone number, including area code: (425) 882-3700
                            ------------------------
 
        Securities registered pursuant to Section 12(b) of the Act: NONE
 
          Securities registered pursuant to Section 12(g) of the Act:
                    COMMON STOCK, PAR VALUE $0.01 PER SHARE
 
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to 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 registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
 
  The aggregate market value of the common stock held by nonaffiliates of the
                                registrant as of
February 4, 1999 was $185.2 million (based on the closing sales price of $20.00
             per share on the NASDAQ National Market on such date).
 
  The number of shares outstanding of the registrant's common stock, $0.01 par
             value per share, as of February 4, 1999 was 9,414,202.
 
                      DOCUMENTS INCORPORATED BY REFERENCE.
 
Proxy Statement for the 1999 Annual General Meeting of Stockholders
Part III (Items 10-13)
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>   2
 
                               TABLE OF CONTENTS
 
<TABLE>
<S>             <C>                                                           <C>
PART I
 
     ITEM 1.    BUSINESS....................................................    1
                HISTORY.....................................................    1
                PRINCIPAL MARKETS...........................................    2
                SPACELABS MEDICAL'S PRODUCTS................................    3
                RESEARCH AND DEVELOPMENT....................................    6
                MANUFACTURING...............................................    6
                SALES AND MARKETING.........................................    6
                CUSTOMER SUPPORT AND WARRANTY...............................    7
                COMPETITION.................................................    8
                CHANGES IN HEALTHCARE.......................................    8
                EMPLOYEES...................................................    9
     ITEM 2.    PROPERTIES..................................................    9
     ITEM 3.    LEGAL PROCEEDINGS...........................................    9
     ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.........   10
                EXECUTIVE OFFICERS OF THE REGISTRANT........................   10
 
PART II
 
     ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
                SHAREHOLDER MATTERS.........................................   11
     ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA........................   12
     ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                AND RESULTS OF OPERATIONS...................................   13
     ITEM 7A    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK........................................................   24
     ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................   25
     ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                AND FINANCIAL DISCLOSURE....................................   51
 
PART III
 
     ITEMS 10-13.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.......   51
 
PART IV
 
     ITEM 14.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
                8-K.........................................................   51
</TABLE>
 
                                        i
<PAGE>   3
 
                                     PART I
 
                                ITEM 1. BUSINESS
 
Spacelabs Medical, Inc. and its wholly owned subsidiaries ("Spacelabs Medical",
"Spacelabs" or the "Company") develop, manufacture, market and service patient
monitoring, diagnostic cardiology and clinical information systems ("CIS")
products for use throughout the healthcare enterprise. Spacelabs Medical's
principal products are used for diagnosis, monitoring and information management
across the healthcare continuum. The Company also sells the disposable and
replaceable supplies to support these products.
 
Spacelabs Medical's strategy has three key elements: first, to continue its
transition into the emerging CIS market; second, to enhance its position in the
US healthcare market through the expansion of its medical device product line
and distribution channels; and third, to expand its presence in international
markets.
 
The first element of the Company's strategy is to continue its transition into
the emerging CIS market. One aspect of this is to capitalize on the Company's
large installed base of patient monitoring and diagnostic cardiology systems to
transition into the CIS market with its suite of point-of-care products. A
second aspect of this strategy is to broaden the Company's CIS offering through
acquisitions and joint ventures. The Company has acquired or entered into
relationships with a number of companies to enhance its CIS product line. The
acquisition of Ameritech Knowledge Data, Inc. ("AKD") added both a clinical data
repository ("CDR") and a master patient index system. A marketing agreement with
Tempus Software, Inc. ("Tempus") added a resource scheduling system, which is
being integrated with the Company's Caremaster(TM) system. The acquisition of a
CIS product developed by Orca Medical Systems, Inc. ("Orca") added a
departmental system for the emergency department. The acquisition of Burdick,
Inc. (renamed Spacelabs Burdick, Inc. on December 31, 1998 and referred to
herein as "Spacelabs Burdick") added an electrocardiographic ("ECG") management
system. The acquisition of Advanced Medical Systems ("AMS") provided an
obstetrical information system. These product lines helped the Company build a
CIS that supports management of the care process throughout the enterprise.
 
The second element of this strategy reflects the ongoing challenge to maintain
technological leadership in critical care monitoring and to expand the Company's
presence in the medical device marketplace. To maintain and enhance its
competitive position, the Company believes that it must provide products for
more areas of the device market through continued development of new and
clinically useful products as well as through strategic acquisitions and
alliances. During 1998, the Company introduced a new, technologically advanced
monitoring product line, the Ultraview Care Network(TM). In the last two years,
the Company has also significantly expanded its product line and, therefore, the
markets in which it competes, through acquisitions and agreements. The
acquisition of AMS and Spacelabs Burdick added fetal monitoring and a line of
diagnostic cardiology products. Medical Insight R & D, B.V. ("MI") provided a
line of anesthesiology delivery machines. An investment in Bunnell, Incorporated
("Bunnell") added the option of distributing a ventilator into the neonatal
market. In addition to these product initiatives, the Company also believes that
it must maintain strong sales, marketing and service organizations that compete
effectively.
 
The third element of the Company's strategy is to expand its efforts to
penetrate international markets. While there are many similarities among various
national markets, the Company believes that most national markets must be
approached on an individual basis. An individualized approach includes not only
investment in product-related requirements such as regulatory approvals, user
interfaces and documentation in the local language, but also requires investment
in the creation of distribution channels and in the establishment of a base of
satisfied customers.
 
HISTORY
 
Spacelabs Medical was founded in 1958 to collaborate with NASA in developing
technology to monitor the vital signs of astronauts in space. By the mid-1960s,
the Company was developing vital sign
                                        1
<PAGE>   4
 
monitoring systems for use in hospitals, and in 1968, it introduced its first
system for monitoring patients in intensive care units. Its technological
innovations include the first monitors using distributed microprocessors and the
first modular monitors. Between 1980 and 1992, Spacelabs Medical was a wholly
owned subsidiary, first of the Squibb Corporation ("Squibb") and then of a 1987
spin-off from Squibb, Westmark International Incorporated ("Westmark").
Effective June 26, 1992, Spacelabs Medical became a separate publicly traded
company pursuant to the distribution by Westmark of Spacelabs Medical common
stock to holders of Westmark common stock in a tax-free, one-for-one stock
dividend. In 1995, the Company sold the First Medic line of non-hospital
defibrillator products to Physio Control International Corporation. In 1996, the
Company acquired JRS Clinical Technologies, a clinical information company. In
1997, the Company acquired AMS, AKD, Spacelabs Burdick and a software product
developed by Orca. In November 1997, Spacelabs entered into a development and
supply alliance with Medical Insight Ltd. regarding MI's development and
manufacture of an anesthesia delivery system for the Company. In 1998, the
Company acquired all the rights to the anesthesia delivery system and certain
other technology, and commenced the pilot manufacture of the anesthesia delivery
system. In 1998, the Company obtained FDA 510(k) clearance to commercially
distribute anesthesia delivery systems in the United States. The Company is
currently working to meet CE mark requirements for distribution in Europe and to
obtain the approval of other regulatory bodies. These approvals are expected in
the first half of 1999 to coincide with the anticipated full-scale commercial
introduction of the device. While the Company remains optimistic regarding such
commercial introduction, there is risk that such regulatory approvals and
manufacturing scale-up may be delayed. In 1998, the Company continued to
integrate Spacelabs Burdick and Spacelabs Medical products and distribution
channels.
 
PRINCIPAL MARKETS
 
Critical Care Monitoring. The critical care monitoring market in hospitals and
elsewhere consists of adult intensive care units; neonatal and pediatric
intensive care units; and operating rooms and other associated interventional
areas such as recovery rooms, emergency departments, labor and delivery rooms,
cardiac catheterization labs, endoscopy rooms, and step-down units.
 
Adult critical care units such as coronary care units and surgical intensive
care units are characterized by, among other things, labor-intensive staffing,
sometimes with a one-to-one or often with a one-to-two nurse-to-patient ratio.
 
Over the last decade, hospitals have increasingly used telemetry step-down units
where patients at risk are still monitored but do not require the high level of
nursing care found in intensive care units. A more recent trend has been to use
portable monitors in other acute care areas of the hospital when they are
temporarily needed by individual patients. This temporary monitoring approach
may have cost advantages, and allows patients to be monitored without moving to
an intensive care unit.
 
Perinatal and pediatric intensive care requires monitors with specialized
functionality because of the differences between monitoring a critically ill
newborn or child and a critically ill adult. These differences are a major
factor in choosing a monitor for neonatal intensive care units ("NICUs") or
pediatric intensive care units.
 
Fetal and Labor and Delivery Monitoring. Specialized monitors are used for fetal
monitoring during pregnancy, labor and delivery. These monitors may also display
information about the mother. The information from these monitors may be sent to
a labor and delivery central station or be entered manually into the birth
record.
 
Perioperative and Emergency Monitoring. Perioperative and emergency monitoring
in operating rooms, recovery rooms or emergency departments has traditionally
used stand-alone or portable monitors but is turning to networked monitors as
information systems become more prominent. Surgery was once primarily an
inpatient procedure utilizing very sophisticated monitors in hospital operating
rooms. Now more than half of all surgeries are performed as outpatient
procedures, increasing the demand for simpler, noninvasive monitors.
 
                                        2
<PAGE>   5
 
Diagnostic Cardiology. Diagnostic cardiology products are marketed to both acute
care facilities (hospitals) as well as to the alternate and primary care markets
(all non-hospital facilities including physician's offices and clinics).
 
Typically, hospitals will have a cardiology or cardiopulmonary department that
performs diagnostic cardiology procedures using these types of products. The
test will be performed by trained technicians and the results of the test will
be read and interpreted by a cardiologist. The department may perform ECG
procedures for outpatient as well as inpatient needs. It is not uncommon for
departments other than cardiology, such as emergency or intensive care units, to
purchase an electrocardiograph to ensure rapid response time when there is a
requirement for an electrocardiogram.
 
In the primary care market, the traditional purchasers of diagnostic cardiology
products have been family, general and internal medicine practices as well as
cardiology practices.
 
Clinical Information Systems. Spacelabs Medical believes that the traditional
market for vital signs monitoring is evolving into one that integrates CIS into
the critical care monitoring system and that with the right design, patient
monitoring systems can be the architectural base for critical care CIS. In
addition, the Company believes that computerization of collected patient
information on an electronic patient chart allows a caregiver to better focus on
patient needs and that computerization of routine but essentially clerical tasks
enhances clarity and accuracy.
 
Developing an information management system to store, retrieve and interrelate
the information in clinically meaningful ways is a significant challenge.
Customer expectations have also evolved due to provider restructuring as the
result of managed care. One of the clearest needs emerging is for patient-
focused systems that permit caregivers to view and manage the patient care
process across the continuum of care. The Company believes that the market for
enterprise-wide CIS to schedule resources, automate data collection and
retrieval, and analyze outcomes is larger than the market for departmental
systems at this time. While there is still a need for the specialized functions
of information management in a departmental context, there is also a need to
integrate such an application within the context of all episodes of care.
 
SPACELABS MEDICAL'S PRODUCTS
 
Spacelabs Medical develops, manufactures, markets and services critical care
monitoring, diagnostic cardiology and CIS products, as well as other products
for use in the healthcare industry. Spacelabs Medical's principal products are
its newly introduced Ultraview Care Network ("Ultraview(TM)") line of monitoring
products and its Caremaster Plus lines of monitoring and CIS products.
 
ULTRAVIEW MONITORING PRODUCTS. Through integration of its component elements,
Spacelabs Medical's Ultraview product line forms an advanced and comprehensive
critical care patient monitoring system and the foundation for a CIS. Ultraview
products address the hospital's principal monitoring needs, from adult and
neonatal intensive care units to outpatient surgery, step-down units and patient
transport. The components of the Ultraview system are "user friendly" bedside
and central monitors, "smart" plug-in modules for measuring specific vital
signs, Flexport(R) serial interfaces to other manufacturers' bedside devices, an
integrated telemetry option and a powerful network for access to clinical
information. Spacelabs Medical sells Ultraview products as an integrated system,
as stand-alone monitors or as add-on components to the customer's existing
systems. Sales of Ultraview products to hospitals vary widely in size, depending
on the size and configuration of the system. A typical eight-bed hardwired
system sells for approximately $170,000, while a typical 12-bed telemetry system
sells for approximately $85,000. Hospitals sometimes combine monitoring orders
for many units or even for the entire hospital. Such orders can exceed $1
million. Ultraview monitoring products represent the major portion of Spacelabs
Medical's current business and are compatible with the Company's previous
monitoring system, the Patient Care Monitoring System ("PCMS(TM)").
 
Ultraview Bedside Monitors. The critical care bedside monitor, the core of any
Ultraview system, is connected to the patient via sensors. The bedside monitor
displays, stores and transmits vital signs and physiological data, including
alarms, thereby providing an ongoing picture of a patient's condition.
 
                                        3
<PAGE>   6
 
Ultraview bedside monitors include the 1030, a small portable monitor; the
SL1050, a mid-range color monitor; the 1500, a powerful high-acuity monitor; the
1700, which also provides display independence; and the Universal Clinical
Workstation ("UCW(R)"). The 1700 and the UCW serve not only as advanced bedside
monitors but also as information systems terminals. These monitors may be
networked via both wireless or hardwired networks.
 
Ultraview Modules. The clinician can easily configure the Ultraview bedside
monitor to meet the specific vital sign monitoring needs of an individual
patient by inserting Ultraview modules designed to perform different monitoring
functions. The new Command modules of the Ultraview system combine a large
number of parameters into one compact module. The Ultraview Command modules
contain their own processors and software programs and therefore add computer
power to the Ultraview monitors. The modules collect and analyze the patient's
physiological data from electrodes and sensors.
 
Flexport Serial Interfaces. Spacelabs Medical's Flexport serial interfaces, a
Spacelabs Medical innovation, extend the concept of modules to other
manufacturers' bedside devices. With a Flexport interface, the Ultraview monitor
receives and displays data from other devices much as if it were generated by a
Spacelabs Medical module. Thus, the monitor can integrate vital patient
information and alarms onto a single screen to facilitate clinical decision
making.
 
Ultraview Telemetry. For step-down units, Spacelabs Medical provides its
Ultraview telemetry monitoring systems, which continuously monitor patients'
ECGs while allowing them the freedom to move about as part of the recovery
process. By including telemetry monitors on the Ultraview Care Network,
hospitals can combine, in the same care unit, patients requiring different
levels of care.
 
Ultraview Central Station Monitors. Ultraview central station monitors are the
same hardware as the UCW or 1700 bedside monitors and share the same
fundamental, easy-to-use human interface and mode of operation.
 
DIAGNOSTIC CARDIOLOGY PRODUCTS. In 1997, Spacelabs Medical acquired Spacelabs
Burdick to expand its product offering further across the continuum of care to
include both hospital and primary care out-of-hospital settings. Noninvasive
diagnostic cardiology devices and information management systems that Spacelabs
Burdick has distributed into the physician's office market also have application
in the hospital environment and, beginning in 1998, are sold by the Spacelabs
Burdick hospital sales force. The Spacelabs Burdick sales organization will
continue to sell its current line of cardiology products including ECG, exercise
tolerance test systems, Holter and spirometry products into the primary care
market and will also add certain diagnostic products from the Spacelabs Medical
product line such as ambulatory blood pressure systems and fetal monitors.
 
Electrocardiographs. The Company's line of electrocardiographs covers all price
points and markets, and ranges from small, low-cost units that are primarily
targeted for physician's offices and international markets to fully featured
units that are designed for the most rigorous application, as in the care of
critically ill patients in hospital settings. Electrocardiographs can be
cart-mounted so that they can be moved from bed to bed or room to room.
 
Holter and Ambulatory Blood Pressure ("ABP") Systems. Spacelabs Medical
develops, manufactures, markets and services Holter and ABP monitoring systems.
The Holter systems comprise ECG recorders (tape or solid state) that are worn by
a patient for 24 or 48 hours. The data is then downloaded to an analysis station
that processes the recorded ECG data. ABP monitors gather a patient's blood
pressure measurement over 24 or 48 hours. This data is then "read" by an
analysis station that quantifies the data and prepares reports for physicians.
The recorders are the smallest and lightest available. Report generation
capabilities range from simple, easy-to-use strip printers to a
Windows-compatible software system.
 
Exercise Tolerance Test Systems. Exercise tolerance test systems are diagnostic
cardiology products used to identify latent heart disease not revealed on a
routine resting ECG. The patient is subjected to increasing workloads, typically
on a treadmill, and the cardiogram is monitored for adverse changes in the
heart's response during the increased workload. The product line also includes a
quiet treadmill designed for maximum patient safety.
                                        4
<PAGE>   7
 
INTESYS(R) CLINICAL INFORMATION SYSTEMS. Spacelabs Medical develops,
manufactures, licenses, sells and supports a line of CIS products under the name
Intesys. Intesys CIS form an integrated framework to automate, manage and
analyze the delivery of care. Spacelabs Medical believes that CIS creates a
powerful tool for providing more efficient and effective patient care. The
Company also believes that its substantial installed base of medical devices
that automatically collect vital patient information provides it with a
competitive advantage over other manufacturers' nonintegrated approach to
critical care CIS.
 
Caremaster Plus Departmental Clinical Information Systems. With these systems,
data can be automatically collected from patient monitors, including data from
other vendors' devices integrated through Flexport serial interfaces or gateway.
In addition to maintaining flow sheets, other charting functions are
computerized, such as making notes and observations and charting laboratory
results. The Caremaster Plus computer system has been designed to be interfaced
with other hospital information systems. The 1700, UCW, or another computer
workstation at the patient site or elsewhere on the network can function as a
terminal to enter and review data on the Caremaster Plus record. There are
currently departmental applications for adult, pediatric and neonatal intensive
care; the emergency department; anesthesia; cardiology; and labor and delivery.
 
Caremaster Plus Enterprise Clinical Information Systems. Caremaster Plus
enterprise CIS are for use throughout the healthcare enterprise. The main
components of the system are automated order entry and results reporting, a
resource scheduler to help organize appointments throughout the enterprise, a
clinical pathways and automated point-of-care system for support of
multidisciplinary clinical pathways and comprehensive documentation, a CDR to
integrate information from clinical and administrative systems, and a master
patient index to address the problem of patients being identified differently by
disparate systems. The enterprise-wide CIS market is characterized by a sales
cycle of up to two years. Once a system is sold, a period of implementation may
be required before customer acceptance and final payment to the Company occurs.
 
Quality In Care Software. The Quality In Care ("QuIC")(1) software application
is a cross-patient analytical tool that helps administrators and clinicians
analyze clinical practice and make critical decisions regarding the quality and
effectiveness of intensive care from clinical and cost perspectives.
 
Ultraview Web Source -- Remote Connectivity System (RCS). The RCS is the
Company's first Internet telemedicine solution to provide comprehensive patient
information access, including remote access to lab results, the electronic
patient chart and the clinical data repository. The increasing demands in
today's healthcare environment often challenge healthcare organizations to
supply clinicians with information wherever they may be. The Remote Connectivity
System provides clinicians with the ability to conveniently view patient records
from a remote location, such as the home or office, using the World Wide Web or
their organization's intranet.
 
Interfaces. Most healthcare providers today have implemented multiple disparate
information applications within their organization. As the desire for
integration of information within these organizations increases, the need for
information systems interfaces has also increased. In keeping with an open
architecture design philosophy, the Company is able to provide a wide array of
interfaces that will exchange data between its own and other vendors'
HL7-compliant systems. HL7 is an industry standard communication protocol.
 
While the Intesys products have been designed to meet the needs of the evolving
healthcare provider industry, because of the rapid change in the evolving US
healthcare delivery system, there can be no assurance that Intesys or its
components will fully satisfy user requirements and result in significant
commercial sales.
 
MEDICAL SUPPLIES. A substantial market exists for disposable supplies such as
patient electrodes, specialty graph paper, sensors and connecting lead wires
that are used with medical devices. Spacelabs Medical sells a broad line of such
supplies as an adjunct to its medical device business. In most cases, these
products are obtained from original equipment manufacturers and are manufactured
 
---------------
 
(1)QuIC is a registered trademark of DSA Systems, Inc.
                                        5
<PAGE>   8
 
to Spacelabs Medical's specifications. In some cases, Spacelabs Medical
re-markets other manufacturers' products for use with Spacelabs Medical's
products.
 
HEALTH SCREENING PRODUCTS AND SERVICES. The Company's Vita-Stat subsidiary is
one of the leading US providers of consumer health-screening products and
services. Automated equipment for blood pressure measurement and for
cardiovascular risk profiling and weight management are placed by lease or other
arrangement in pharmacies, work sites, hospitals, health clubs and other public
access locations. This business has grown to include point-of-sale advertising
at blood-pressure-based consumer health centers located in approximately 11,000
pharmacies and grocery stores nationwide.
 
RESEARCH AND DEVELOPMENT
 
Spacelabs Medical conducts extensive research and development activities, both
internally and by funding projects undertaken by outside groups. Such activities
include the design and development of new products for its patient monitoring
systems, diagnostic cardiology products and CIS. Spacelabs Medical is
continuously seeking ways to improve its product line and enhance the
functionality of its patient monitoring and CIS. This process of improvement
offers the opportunity for additional revenue from upgrades and the sale of new
functions and features. In 1998, research and development expenses were $30.7
million or 11.2% of revenue. In 1997, excluding the acquisition of in-process
research and development, research and development expenses were $31.6 million
or 11.9% of revenue, compared to $28.3 million or 11.4% of revenue in 1996. See
Item 7, "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Operating Expenses."
 
Although Spacelabs Medical intends to continue to conduct extensive research and
development activities, there can be no assurance that it will be able to
develop and market new products on a cost-effective and timely basis, that such
products will compete favorably with products developed by others or that
Spacelabs Medical's technology will not be superseded by new discoveries or
developments.
 
MANUFACTURING
 
Spacelabs Medical manufactures the majority of its products in Redmond,
Washington. The Company's Spacelabs Burdick diagnostic cardiology products are
manufactured in Deerfield, Wisconsin, and the fetal monitoring products are
manufactured in Hamden, Connecticut. The Company conducts regular product
reviews to reduce manufacturing costs and continually pursues improvement
programs to eliminate waste and redundancy.
 
Certain devices are purchased from third parties for sale by Spacelabs Medical,
including computers, peripheral accessories and remote displays. The Company
also purchases subassemblies, such as display screens and printer mechanisms,
and other materials and component parts used by Spacelabs Medical in the
manufacture of its products. Many of these are available from multiple supply
sources. Spacelabs Medical does depend, however, on certain single-source
vendors for some important component parts. While any of these single-source
items could be replaced over time, abrupt disruption in the supply of a
single-source part could have a material adverse effect on the Company's ability
to manufacture products relying on such items. In addition, component parts of
certain of the Company's products are manufactured in countries that have
periodically experienced political pressure, such as Taiwan, which could delay
or disrupt the supply of these component parts. Spacelabs Medical cannot predict
whether there is a substantial likelihood of abrupt disruption in the supply of
any of these items. However, it has taken steps to mitigate the effect of
disruption in the supply of some items by either maintaining an inventory of
certain critical components or locating another source of certain parts that
would be available in the event of an interruption of supply.
 
SALES AND MARKETING
 
Spacelabs Medical's hospital products are marketed in the United States
primarily through its direct sales organization. The Company's direct field
sales force consists of sales personnel and clinical application specialists
located throughout the United States. Products sold into the physician's office
                                        6
<PAGE>   9
 
market are sold through dealerships supported by a direct sales organization.
Spacelabs Medical frequently contracts for the sale of its products with
hospital buying groups, proprietary hospital chains and US government agencies.
These "corporate accounts" can generate multimillion dollar contracts, and the
Company believes that the loss of a major contract could have a material adverse
effect on its operations.
 
Spacelabs Medical markets its products in over 100 countries through a
combination of direct sales organizations and independent distributors.
International sales, service and sales administration activities are managed
from the Company's corporate offices and through subsidiary offices located in
Australia, Austria, Belgium, Canada, China, France, Germany, Hong Kong, India,
Italy, Mexico, the Netherlands, Singapore, Sweden, Taiwan and the United
Kingdom. International sales are broadly distributed worldwide so that
disruption of distribution in any single foreign market would not have a major
effect on Spacelabs Medical's total annual revenue. Sales to foreign customers
including export sales accounted for approximately 29.7% of Spacelabs Medical's
revenue in 1998. See Note 15 of "Notes to Consolidated Financial Statements."
 
In addition to direct and distributor sales to end users, Spacelabs Medical also
sells its ABP monitors, Holter recorders, noninvasive blood pressure products
and other products and components for distribution on an OEM basis by other
medical products companies.
 
Spacelabs Medical's marketing efforts include the development of relationships
with current and prospective customers, participation in annual professional
meetings for clinicians and hospitals, advertisement in trade journals, direct
mail and telephone marketing.
 
CUSTOMER SUPPORT AND WARRANTY
 
Spacelabs Medical warrants most of its new products (exclusive of software) for
all parts and labor generally for the earlier of 14 months from the date of
original delivery or 12 months from first online operation. Under the terms of
the warranty, the customer is assured of service and parts so that the equipment
will operate in accordance with specifications. Spacelabs Medical warrants that
software will perform in accordance with specifications at the delivery date and
up to five months thereafter if the customer gives notice of any nonconformance.
Spacelabs Medical offers a variety of post-warranty service agreements that
permit customers to contract for the level of equipment maintenance they
require. In addition, Spacelabs Medical offers specific software support
agreements, reflecting the growing use of Spacelabs Medical's software products
that can be updated. Service is provided at rates competitive with those offered
by Spacelabs Medical's competitors. Software licenses for Intesys products
generally have a shorter warranty period and require software support
agreements. Some new diagnostic cardiology products are warranted, inclusive of
software, for all parts and labor during the warranty term, which may be one
year, three years or five years, depending upon the product. Diagnostic
cardiology products are serviced in the field by the Spacelabs Medical service
organization. In addition, authorized diagnostic cardiology dealers maintain the
equipment they sell and provide on-site field service whenever it is practical.
Such dealers participate in ongoing technical certification programs to ensure
their technical expertise. The Company's warranty costs are included in cost of
sales in its Consolidated Financial Statements.
 
Customers receive installation, technical training, clinical in-service and
documentation support appropriate for the product type. In the United States,
Spacelabs Medical's direct service force provides 24-hour-a-day, 7-day-a-week
technical phone support with its software support agreements and, when needed,
on-site repair. Internationally, Spacelabs Medical provides service either
through a direct organization or through distributors or third-party
organizations.
 
Spacelabs Medical believes that its customer service and support are an integral
part of its competitive strategy. Service capability, availability and
responsiveness play an important role in marketing and selling medical equipment
and systems, particularly as the technological complexity of the products
increases. Unlike some other areas of medical electronics, monitoring
manufacturers cannot depend on significant conversion to service contracts after
the warranty period.
 
                                        7
<PAGE>   10
 
COMPETITION
 
The worldwide markets for patient monitoring, diagnostic cardiology and CIS are
intensely competitive. Spacelabs Medical faces competition from many US and
international companies, some of which have far greater financial, marketing,
service, technical, and research and development resources than those of the
Company. Within the critical care patient monitoring markets, Hewlett-Packard
Company's Medical Products Group ("HP") is Spacelabs Medical's primary worldwide
competitor. Other critical care monitoring competitors include Marquette Medical
Systems, Inc. ("Marquette"), which is owned by General Electric; Nihon Kohden
Corporation; and Siemens AG. Monitoring competitors in niche markets include
Datascope Corporation, Datex Medical Instrumentation, Inc., Medical Data
Electronics and Protocol Systems, Inc., plus many other small companies in
countries outside the United States. The primary competitors in the diagnostic
cardiology markets are Marquette, HP, Quinton, Zymed, Welch-Allyn/Schiller,
Mortara and a number of smaller niche companies. Spacelabs Medical faces
competition in CIS from HP and Marquette as well as from a number of small niche
vendors both in the United States and in other countries, and from hospital
information system vendors such as HBO & Co., Shared Medical Systems, Meditech
and Cerner. Alliances and other cooperative arrangements among competitors
and/or other third parties are becoming more common. This may increase
competitive pressures.
 
Spacelabs Medical believes that the principal competitive factors in the market
for critical care patient monitoring, diagnostic cardiology and CIS products are
clinical utility, system technology, life-cycle cost-benefits and customer
support and service. Price has become an increasingly important competitive
factor and, at times, the decisive factor, as hospitals come under increasing
pressure to forego added features in exchange for lower prices. Spacelabs
Medical also believes that the size of a particular manufacturer's installed
base is a competitive factor. In terms of acquisition costs, installation and
user training, hospitals make a long-term commitment when selecting a monitoring
or clinical information system. This factor tends to limit competition based on
changes in technology since hospitals cannot readily replace individual system
components with those from another manufacturer. Instead, hospitals will look to
their supplier for upgrades and, if not forthcoming, wait to replace the whole
system at the end of its useful life, typically seven or more years. Spacelabs
Medical believes that it competes favorably with respect to each of these
competitive factors.
 
CHANGES IN HEALTHCARE
 
Spacelabs Medical's critical care monitoring products are capital equipment
purchased primarily by hospitals within their responsibility to the Integrated
Delivery Network ("IDN"). The decision to purchase monitoring equipment, either
to replace existing units or as part of a renovation or expansion, is part of
the IDN's general capital budgeting process. While some aspects of monitoring
may be billed separately, the costs of monitoring products are normally
recovered by the buyer as part of general charges for intensive care, operating
room and so forth. Reimbursement often covers only a portion of charges. In
general, purchases are driven by the need to provide adequate monitoring to meet
contemporary standards of care. Within this context, monitoring products, along
with other capital equipment, are purchased as a hospital or foreign health
authority can commit the funds. Any reimbursement changes that tend to reduce a
hospital's profitability or specifically reduce capital reimbursement will tend
to depress capital equipment spending. Hospital managers also may delay
purchases during periods of uncertainty about future reimbursement and cash
flow.
 
Spacelabs Medical's diagnostic cardiology products are used by healthcare
providers on both an inpatient and outpatient basis. Providers seek
reimbursement from third-party payors in the United States, principally
Medicare, Medicaid and private health insurance plans. Such reimbursement for
diagnostic tests is subject to the regulations and policies of government
agencies and other third-party payors. Worldwide, these third-party payors and
governmental agencies are under increasing pressure to contain medical costs.
 
Limits on reimbursement or other cost-containment measures imposed by
third-party payors or foreign health authorities may adversely affect the
financial condition and ability of hospitals and others to
 
                                        8
<PAGE>   11
 
purchase products, such as Spacelabs Medical's principal products, by reducing
funds available for capital expenditures or otherwise.
 
EMPLOYEES
 
As of February 4, 1999, Spacelabs Medical had approximately 1,500 full-time
employees. None of Spacelabs Medical's US employees are covered by collective
bargaining agreements and the Company considers its employee relations to be
satisfactory worldwide.
 
                               ITEM 2. PROPERTIES
 
Spacelabs Medical's corporate offices are at 15220 NE 40th Street, Redmond,
Washington, 98052 in 400,300 square-feet of office and manufacturing space owned
by the Company. The Company's patient monitoring and CIS products are designed
and manufactured at this location. The Spacelabs Burdick products are designed
and manufactured in a 100,000 square-foot leased facility in Deerfield,
Wisconsin. The fetal monitoring product line is manufactured in a 16,000
square-foot leased facility in Hamden, Connecticut. The Company believes that
its facilities are adequate to meet its capacity requirements.
 
                           ITEM 3. LEGAL PROCEEDINGS
 
Spacelabs Medical is subject to various product liability and other proceedings
that arise in the ordinary course of its business. While the outcome of these
proceedings cannot be predicted with certainty, Spacelabs Medical believes that
none of such proceedings, individually or in the aggregate, will have a material
adverse effect on the Company's business, financial condition or financial
statements.
 
Spacelabs Medical maintains insurance coverage that it believes is appropriate
to its business and that is typical of similarly situated companies. There can
be no assurance that Spacelabs Medical's current insurance coverage will prove
adequate or that the amount or type of coverage available to the Company will
remain available on a cost-effective basis.
 
                                        9
<PAGE>   12
 
          ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
None.
 
                      EXECUTIVE OFFICERS OF THE REGISTRANT
 
Set forth below is certain information regarding the executive officers of
Spacelabs Medical:
 
<TABLE>
<S>                             <C>
Carl A. Lombardi, 55            Chairman of the Board and Chief Executive Officer of
                                Spacelabs Medical since 1992; Group Vice President of
                                Westmark from 1987 to 1992; President of Spacelabs Medical
                                since 1981.
 
Eugene V. DeFelice, 40          Vice President, General Counsel and Secretary of Spacelabs
                                Medical since 1997; General Counsel and Secretary of
                                Spacelabs Medical from 1996 to 1997; General Counsel and
                                Member of the Board of Huntleigh Healthcare, Inc. in 1995;
                                Assistant General Counsel, Division of Hoffmann-LaRoche from
                                1986 to 1994.
 
Dennis E. Larsen, 51            Vice President, Business Development of Spacelabs Medical
                                since 1998; Vice President and Supplies Products General
                                Manager of Spacelabs Medical from 1995 to 1998; Vice
                                President, Business Development of Spacelabs Medical from
                                1990 to 1995.
 
Timothy R. Miskimon, 49         Senior Vice President, International Operations of Spacelabs
                                Medical since 1998; Vice President, International of
                                Spacelabs Medical from 1992 to 1998.
 
James A. Richman, 52            Vice President and acting Chief Financial Officer of
                                Spacelabs Medical since 1995; Corporate Controller of
                                Spacelabs Medical from 1992 to 1995.
 
Michael R. Stringer, 55         Vice President and General Manager of Specialty Products,
                                Spacelabs Medical since 1997; President, Pacific Consulting
                                Group, LLC in 1996; Vice President of Sales, Medical
                                Division of Stryker Corporation from 1994 to 1995; Vice
                                President, Sales and Marketing of Hamilton Scientific, Inc.
                                from 1989 to 1994.
</TABLE>
 
                                       10
<PAGE>   13
 
                                    PART II
 
           ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
                              SHAREHOLDER MATTERS
 
Market and Market Price for Common Stock. Spacelabs Medical common stock, $0.01
par value per share, is traded over the counter under the symbol SLMD and is an
authorized security for quotation on the NASDAQ National Market ("NASDAQ/NM").
 
The market prices of a share of Spacelabs Medical common stock are set forth
below. The prices reflect the high and low trading prices for each quarter as
reported by NASDAQ/NM.
 
<TABLE>
<CAPTION>
                                                               Quarter ended
-----------------------------------------------------------------------------------------------
                                             March        June        September        December
-----------------------------------------------------------------------------------------------
<S>                                          <C>          <C>         <C>              <C>
1998
  High                                        $24 1/4     $22 1/8        $18 1/4         $23 1/8
  Low                                          18 5/16     14 1/2         15 1/2          14
-----------------------------------------------------------------------------------------------
1997
  High                                        $23 1/2     $24 3/4        $26             $22 3/8
  Low                                          19 1/2      19 3/4         21 1/4          18
-----------------------------------------------------------------------------------------------
</TABLE>
 
Holders. The approximate number of holders of record of Spacelabs Medical common
stock, as recorded on the books of Spacelabs Medical's Registrar and Transfer
Agent as of February 4, 1999, was 5,982.
 
Dividends. Spacelabs Medical has not paid cash dividends on its common stock and
does not currently have any plans to pay such dividends in the foreseeable
future. The dividend policy of Spacelabs Medical is reviewed from time to time
by the Company's Board of Directors in light of its earnings and financial
condition and such other business considerations, as the Board of Directors
considers relevant.
 
                                       11
<PAGE>   14
 
                  ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
The information set forth below should be read in conjunction with Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Consolidated Financial Statements and Notes thereto included
in this Form 10-K.
 
<TABLE>
<S>                                         <C>        <C>         <C>        <C>        <C>
-------------------------------------------------------------------------------------------------
 
(dollars in thousands, except per-share
  data)                                         1998       1997        1996       1995       1994
-------------------------------------------------------------------------------------------------
FOR THE YEAR ENDED
  Revenue.................................  $274,240   $265,279    $247,953   $252,912   $247,198
  Gross margin............................   123,438    131,354     124,871    129,416    128,052
  Gross margin as a percent of revenue....      45.0%      49.5%       50.4%      51.2%      51.8%
  Selling, general and administrative.....    91,266     79,475      74,189     70,587     68,513
  Research and development................    30,715     31,614      28,293     30,076     30,494
  Acquisition of in-process research &
     development..........................     --        33,967       8,797      --         --
  Restructuring of operations.............     3,559        911       7,126      2,290      3,700
  Other income (expense)..................     6,475     (1,467)      1,608      3,282      3,520
  Income (loss) before income taxes.......     4,373    (16,080)      8,074     29,745     28,865
  Net income (loss).......................     2,713    (20,398)      2,562     18,631     18,063
  Net income (loss) as a percent of
     revenue..............................       1.0%     (7.7%)        1.0%       7.4%       7.3%
  Basic net income (loss) per share(1)....  $   0.29   $  (2.13)   $   0.25   $   1.77   $   1.71
  Diluted net income (loss) per
     share(1).............................  $   0.29   $  (2.13)   $   0.25   $   1.73   $   1.68
-------------------------------------------------------------------------------------------------
AT YEAR-END
  Receivables.............................  $ 82,574   $ 70,691    $ 63,004   $ 59,292   $ 46,948
  Inventories.............................    65,912     59,779      56,114     55,912     60,097
  Working capital.........................   120,629    120,647     131,728    155,122    143,692
  Total assets............................   286,047    290,192     257,445    254,433    234,054
  Long-term obligations...................    65,143     66,846      13,500     14,250     11,200
  Shareholders' equity....................   161,021    164,869     196,348    204,069    185,354
 
  Book value per share(2).................  $  17.08   $  17.42    $  19.97   $  19.39   $  17.58
-------------------------------------------------------------------------------------------------
</TABLE>
 
(1) Basic net income (loss) per share is based on the weighted average number of
    common shares outstanding. Diluted net income (loss) per share is based on
    the weighted average number of common shares and dilutive potential common
    shares outstanding.
 
(2) Book value per share is based on the number of common shares outstanding as
    of year-end.
 
                                       12
<PAGE>   15
 
      ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                           AND RESULTS OF OPERATIONS
 
MARKET OVERVIEW
 
US Medical Devices Market
 
Changes in the fundamental economics of healthcare delivery and restructuring
and consolidation among healthcare providers continued throughout 1998. In
reaction to this restructuring and consolidation, healthcare providers' capital
expenditures are being reevaluated and reprioritized to respond to the needs of
these newly formed organizations. Though the market for the medical devices sold
by the Company is affected by advances in technology, it remains primarily a
replacement market driven by a provider's decision to replace older or obsolete
equipment. As a result, healthcare providers have discretion in the timing of
their equipment purchases and can delay them. In this market, competition for
business is intense, creating continued pricing pressure. The restructuring and
consolidation among healthcare providers has increased the complexity of selling
capital equipment. Today's providers have larger and more complicated purchasing
processes and more difficult issues needing solutions provided by the Company's
products. These factors contribute to uncertainty in revenue projections both on
a quarterly and an annual basis.
 
International Medical Devices Market
 
During 1998, international revenue was negatively impacted by unfavorable
foreign currency exchange rates and by economic conditions in parts of the
Company's Asia/Pacific region. This situation impacted 1997 revenue beginning in
July and accelerated throughout the remainder of 1997 and 1998. In late 1998,
evidence of further negative economic impact was experienced in Latin America
and the Middle East. The combination of political, economic and healthcare
delivery policies and the Company's tactical sales approach can influence the
market for capital equipment and the Company's performance in any country or
region in any given year. The effects of worldwide political and economic
dynamics, including currency exchange rates, are not in the control of the
Company and, therefore, the impact on the Company's performance and financial
statements cannot be predicted.
 
Intesys Clinical Information Systems Market
 
The market for Clinical Information Systems ("CIS"), while significant, remains
in the early stages of development. The impact of managed care and the
subsequent restructuring that has occurred among providers has, in many cases,
delayed purchases of these products. Healthcare providers are rethinking their
information systems strategies to support the business and patient management
needs of their organization in this environment of healthcare reform. Because
the market is emerging and the healthcare delivery system remains in a period of
transition, it is difficult to predict the rate of growth of the market and,
therefore, the Company's ability to produce revenue from this product line. The
Company believes that changes in the healthcare environment will create
incentives to optimize process efficiencies, control costs and increase the
quality of patient care and, consequently, create increased demand for these
products. Automation of data collection, analysis and distribution can play an
important role in realizing such efficiencies and increasing the quality of care
that healthcare providers deliver.
 
Year 2000
 
A major challenge for healthcare providers in 1999 will be ensuring that their
information systems and medical devices are prepared to deal with the problems
presented by the Year 2000 computer problem. The allocation of providers'
resources to solve this problem may compete for resources that may otherwise
have been directed to the purchase and implementation of new CIS applications or
medical devices such as those offered by the Company. This competition for
resources may adversely affect the customers' willingness to purchase medical
device and CIS products in 1999.
 
                                       13
<PAGE>   16
 
RESULTS OF OPERATIONS
 
REVENUE
--------------------------------------------------------------------------------
 
<TABLE>
<CAPTION>
         (dollars in millions)              1998   Change    1997   Change   1996
----------------------------------------------------------------------------------
<S>                                        <C>     <C>      <C>     <C>     <C>
 
US Revenue.............................    $192.9    10.5%  $174.6    5.5%  $165.5
International Revenue..................      81.3   (10.3%)   90.7   10.0%    82.5
                                           ------           ------          ------
Total Revenue..........................    $274.2     3.4%  $265.3    7.0%  $248.0
                                           ======           ======          ======
----------------------------------------------------------------------------------
</TABLE>
 
Revenue for 1998 was $274.2 million, up 3.4% from $265.3 million in 1997.
Revenue for 1997 was up $17.3 million or 7.0% from 1996. The 1998 increase was
due to the inclusion of a full year of diagnostic cardiology product line
revenue in 1998 from the Company's August 1997 acquisition of Spacelabs Burdick.
The increase in 1997 revenue was due to growth in the Company's international
revenue and the consolidation of Spacelabs Burdick for the 18 weeks from the
date of acquisition to the end of the 1997 fiscal year.
 
US revenue increased to $192.9 million, up 10.5% from $174.6 million in 1997. US
revenue in 1997 was up 5.5% over 1996. Growth in both 1998 and 1997 was
attributable primarily to the addition of diagnostic cardiology products from
the acquisition of Spacelabs Burdick. Although patient monitoring revenue was
down from 1997, it grew at an accelerating rate over the year. The Company
experienced increased customer interest and sales activity in the latter half of
1998 as a result of the introduction of the new Ultraview Care Network, which
replaces approximately 80% of the Company's monitoring line. While management is
encouraged by these activities, the market for patient monitoring equipment
continues to be extremely competitive as a result of changes in the US
healthcare delivery system.
 
International revenue, including export sales, declined by 10.3% to $81.3
million in 1998 from $90.7 million in 1997. 1997 revenue grew 10.0% over 1996.
International revenue made up 29.7% of total revenue in 1998, compared with
34.2% in 1997 and 33.3% in 1996. International revenue in 1998 was negatively
impacted by unfavorable currency exchange rates and difficult economic
conditions in various parts of the world, most notably Asia, the Middle East and
Latin America. Growth in international revenue in 1997 was a result of continued
penetration of international markets and the addition of the diagnostic
cardiology line.
 
At December 31, 1998, the Company had approximately $67.1 million of backlog
orders believed to be firm, compared to $44.8 million on December 26, 1997. Of
the $67.1 million, it is estimated that approximately 90% will ship within the
next 12 months. The increase in backlog is attributable to the strengthening of
the US sales organization and increased acceptance of the Company's new
Ultraview Care Network, which was introduced during 1998. Backlog is subject to
seasonal variation and historically has been greater in the fourth fiscal
quarter of the past three years.
 
GROSS MARGIN
--------------------------------------------------------------------------------
 
<TABLE>
<CAPTION>
         (dollars in millions)              1998   Change    1997   Change   1996
----------------------------------------------------------------------------------
<S>                                        <C>     <C>      <C>     <C>     <C>
 
Gross margin...........................    $123.4    (6.1%) $131.4    5.2%  $124.9
As a % of revenue......................     45.0%            49.5%           50.4%
----------------------------------------------------------------------------------
</TABLE>
 
Gross margin as a percentage of revenue was 45.0% in 1998, compared to 49.5% in
1997 and 50.4% in 1996. Current year margins were impacted by a $4.0 million
inventory write-down during the first half of 1998 as a result of the
introduction of new monitoring products as well as charges related to Year 2000
compliance for products previously sold to customers and the write-off of
obsolete product line technology. Excluding these unusual charges, gross margin
for 1998 would have been 47.5%. Gross margin in 1998 was also adversely affected
by the consolidation of the Spacelabs Burdick cardiology
 
                                       14
<PAGE>   17
 
product line for the entire year as compared to only 18 weeks in 1997. Gross
margins on Spacelabs Burdick products are generally lower than the Company's
historic margins because Spacelabs Burdick products are sold primarily through
distributor sales channels at prices that are typically lower than those from
sales to end users. In addition, the Company's gross margin continued to be
influenced by unfavorable foreign exchange rates and worldwide pricing pressures
attributable to increased competition and changes in the healthcare environment.
The Company believes that pressure on gross margin from aggressive worldwide
competitive pricing will continue. The decrease in 1997 gross margin percentage
resulted primarily from the partial year consolidation of Spacelabs Burdick
during that year.
 
OPERATING EXPENSES
 
<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------
         (dollars in millions)             1998       Change       1997       Change       1996
------------------------------------------------------------------------------------------------
<S>                                       <C>         <C>         <C>         <C>         <C>
 
Selling, general and administrative.....  $ 91.3       14.8%      $ 79.5       7.1%       $ 74.2
 
As a % of revenue.......................   33.3%                   30.0%                   29.9%
------------------------------------------------------------------------------------------------
 
Research and development................  $ 30.7      (2.8%)      $ 31.6      11.7%       $ 28.3
 
As a % of revenue.......................   11.2%                   11.9%                   11.4%
------------------------------------------------------------------------------------------------
</TABLE>
 
Selling, general and administrative expenses increased 14.8% to $91.3 million
(33.3% of revenue) in 1998 from $79.5 million (30.0% of revenue) in 1997. The
increase resulted primarily from the consolidation of Spacelabs Burdick,
including amortization of the related goodwill, for the entire year in 1998 as
compared to 18 weeks in 1997. In addition, the economic conditions in certain
international markets led to increased bad debt provisions in 1998. In 1997,
selling, general and administrative expenses increased by 7.1% over 1996 due to
the addition of Spacelabs Burdick, international expansion and greater
investment in Intesys sales and marketing efforts.
 
Research and development costs in 1998 decreased to $30.7 million (11.2% of
revenue) from $31.6 million (11.9% of revenue) in 1997. The decrease reflects
the impact of certain cost reduction initiatives implemented during 1998. In
1997, research and development costs increased 11.7% over 1996 as a result of
the consolidation of Spacelabs Burdick and AKD operations.
 
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------
                  (dollars in millions)                    1998             1997             1996
--------------------------------------------------------------------------------------------------
<S>                                                        <C>             <C>               <C>
In-process research & development........................  --              $ 34.0            $ 8.8
--------------------------------------------------------------------------------------------------
 
As a % of revenue........................................  --               12.8%             3.5%
--------------------------------------------------------------------------------------------------
</TABLE>
 
In connection with its 1997 and 1996 acquisitions, the Company expensed $34.0
million and $8.8 million, respectively, representing purchased in-process
research and development ("IPR&D") that had not yet reached technological
feasibility and had no alternative future use. These expenditures were
recognized as a period expense in accordance with Statement of Financial
Accounting Standards No. 2 and Financial Accounting Standards Board
Interpretation No. 4. The 1997 amount consisted of $21.4 million, $6.6 million
and $6.0 million, relating to the acquisitions of Spacelabs Burdick, AMS and
AKD, respectively. The 1996 amount consisted of $7.3 million related to the
acquisition of JRS Clinical Technologies, Inc. ("JRS") and $1.5 million related
to an investment with DSA Systems, Inc. ("DSA"). The value assigned to IPR&D for
each of the acquisitions was determined by an independent appraiser using a
discounted cash flow method. This involves estimating the costs to develop the
purchased in-process technology into commercially viable products, estimating
the resulting net cash flows from such projects, and discounting the net cash
flows back to their present values. The discount rate includes a factor that is
intended to take into account the uncertainty surrounding the successful
development of the purchased in-process technology. The resulting net cash flows
were based on
 
                                       15
<PAGE>   18
 
management's estimates of revenue, cost of sales, research and development
costs, selling, general and administrative expenses, and income taxes from such
projects.
 
The $21.4 million value assigned to IPR&D for the Spacelabs Burdick acquisition
was based upon research efforts in four separate technological areas: diagnostic
ECG equipment ($10.5 million), Stress analysis products ($2.2 million), Holter
data recording products ($2.2 million) and Pyramis clinical information systems
software ($6.5 million). The nature of the efforts required to develop these
areas into commercially viable products includes the completion of all planning,
designing, prototyping, verification and testing activities that are necessary
to establish that the product can be produced to meet its design specifications.
The estimated cost to be incurred to develop the IPR&D into commercially viable
products was approximately $2.9 million in the aggregate through the year 2000.
Net cash flows for each area were derived by management based on the following
assumptions:
 
     - The estimated revenue was based upon projected annual revenue growth
       rates from future products expected to be derived once technological
       feasibility is achieved. These annual growth rates range from 15% to 27%.
       Revenue was expected to begin in 1998 for certain ECG, Stress and Pyramis
       products and in 1999 for Holter products.
 
     - Gross margin percentage was estimated to be slightly higher than
       historical Spacelabs Burdick margins based upon manufacturing synergies
       to be achieved through combining certain manufacturing processes.
 
     - The estimated selling, general and administrative expenses were projected
       to decrease slightly from historical Spacelabs Burdick levels due to
       operating synergies.
 
     - Each area was assigned a discount rate, ranging from 25% to 35%,
       commensurate with the estimated level of uncertainty involved in
       achieving successful development.
 
As of the end of 1998, the Company has continued development in all four IPR&D
project areas. Research and development costs incurred from the date of
acquisition through December 31, 1998 totaled approximately $1.5 million on
these projects. Certain products in the ECG, Stress and Pyramis areas became
commercially available during 1998, substantially in line with original timing
estimates. Revenues earned from the date of acquisition through December 31,
1998 totaled approximately $10.1 million from such products. The estimated costs
still to be incurred to complete development of all the IPR&D products is
approximately $3.0 million through the year 2001.
 
The $6.6 million value assigned to IPR&D in the AMS acquisition related to
research efforts in three technological areas: fetal monitoring equipment ($1.9
million), BirthNet(TM) 5.0 perinatal information systems software ($2.5 million)
and perinatal sensors ($2.2 million). The estimated cost to be incurred to
develop the IPR&D into commercially viable products was approximately $3.4
million in the aggregate through the year 2001. Net cash flows for each area
were derived by management based on the following assumptions:
 
     - Revenue estimates were based upon projected annual revenue growth rates
       of 16% to 54% from future products expected to be derived once
       technological feasibility is achieved. Revenue was expected to begin in
       1997 for BirthNet 5.0 software and certain perinatal sensors and in 1999
       for fetal monitoring products under development.
 
     - Gross margin percentage was estimated to be slightly higher than
       historical AMS margins on comparable products based upon manufacturing
       synergies to be achieved through combining certain manufacturing
       processes.
 
     - The estimated selling, general and administrative expenses were projected
       to be consistent with historical Spacelabs levels.
 
     - Each area was assigned a discount rate, ranging from 37% to 45%,
       commensurate with the estimated level of uncertainty involved in
       achieving successful development.
 
As of December 31, 1998, the development efforts in the acquired IPR&D areas
were either completed or are still under development. Research and development
costs incurred from the date of acquisition
                                       16
<PAGE>   19
 
through December 31, 1998 totaled approximately $3.0 million on these projects.
BirthNet 5.0 and certain perinatal sensors became commercially available in
1997, substantially in line with original timing estimates. Revenues earned from
the date of acquisition through December 31, 1998 totaled approximately $1.3
million from such products. The estimated costs still to be incurred to complete
development of all the IPR&D products is approximately $0.8 million through the
year 2001.
 
The $6.0 million value of IPR&D in the AKD acquisition related to two software
projects: clinical data repository ("CDR") software and master participant index
("MPI") software. The cost to complete the development efforts on these projects
was estimated to be approximately $2.5 million through 1999. Net cash flows were
estimated by management based on the following assumptions:
 
     - Revenue from these two products was expected to begin in 1998 and grow at
       an annual rate of 33%.
 
     - Gross margin and selling, general and administrative expenses were
       estimated to be consistent with the Company's historical margins and
       expense levels of other CIS products.
 
     - A discount rate of 45% was assigned to the net cash flows of each
       project, commensurate with the estimated level of uncertainty involved in
       achieving successful development.
 
Both the CDR and MPI projects were completed and are being marketed by the
Company at December 31, 1998 as part of the Company's Intesys CIS software line.
Actual research and development costs incurred subsequent to the acquisition
date to complete these projects totaled approximately $0.7 million. Additional
development costs associated with these projects is not expected to exceed
$100,000. Through December 31, 1998, the Company had generated approximately
$4.7 million in revenue from the sale of these products.
 
Similar methodology was applied to purchased IPR&D expensed in 1996 in
connection with the JRS and DSA acquisitions. The Company has not continued to
develop the software technology acquired in the JRS acquisition due to
incompatibility with other CIS development activities.
 
If the IPR&D projects discussed above are not successfully developed, the
revenue and profitability of the Company may be adversely affected in future
periods. Additionally, the value of related intangible assets may become
impaired.
--------------------------------------------------------------------------------
 
<TABLE>
<CAPTION>
                   (dollars in millions)                      1998        1997        1996
------------------------------------------------------------------------------------------
<S>                                                           <C>         <C>         <C>
Restructuring of operations.................................  $3.6        $0.9        $7.1
As a % of revenue...........................................  1.3%        0.3%         2.9%
------------------------------------------------------------------------------------------
</TABLE>
 
During the first half of 1998, the Company recorded charges totaling
approximately $3.6 million associated with a restructuring program related to
improving the Company's cost structure. The charges represent the cost of
employee severance benefits and related expenditures for 86 employees, office
closure costs associated with the elimination of two research offices and three
sales offices, and related asset impairment charges. A summary of these charges
follows:
 
<TABLE>
<CAPTION>
                                 Employee         Other          Asset         Office
                                 Severance      Personnel      Impairment      Closure
                                 Benefits         Costs         Charges         Costs       Total
                                 ---------      ---------      ----------      -------      ------
<S>                              <C>            <C>            <C>             <C>          <C>
1998 charges...................   $1,364         $1,224           $601          $370        $3,559
Utilized in 1998...............    1,240          1,074            601           370         3,285
                                  ------         ------           ----          ----        ------
Remaining liability at December
  31, 1998.....................   $  124         $  150           $ --          $ --        $  274
                                  ======         ======           ====          ====        ======
</TABLE>
 
As of December 31, 1998, 85 employees have separated in connection with the 1998
restructuring activities.
 
                                       17
<PAGE>   20
 
In conjunction with the 1997 acquisition of Spacelabs Burdick, the Company
recorded a charge of $0.9 million related to the restructuring of certain
duplicative activities. A summary of these charges follows:
 
<TABLE>
<CAPTION>
                                             Employee           Asset
                                             Severance        Impairment
                                             Benefits          Charges          Other        Total
                                             ---------        ----------        -----        -----
<S>                                          <C>              <C>               <C>          <C>
1997 charges...............................    $212              $351           $348         $911
Utilized in 1997...........................      95                --             13          108
                                               ----              ----           ----         ----
Liability at December 31, 1997.............     117               351            335          803
Reclassifications..........................      14               167           (181)          --
Utilized in 1998...........................     131               518            154         (803)
                                               ----              ----           ----         ----
Remaining liability at December 31, 1998...    $ --              $ --           $ --         $ --
                                               ====              ====           ====         ====
</TABLE>
 
The Company also incurred restructuring charges of $7.1 million in 1996 related
to the consolidation of manufacturing and customer service operations in its
Redmond, Washington facility.
 
OTHER INCOME (EXPENSE)
 
<TABLE>
<CAPTION>
 
-----------------------------------------------------------------------------------------------
(dollars in millions)                                            1998         1997         1996
-----------------------------------------------------------------------------------------------
<S>                                                             <C>          <C>          <C>
Interest income.........................................        $ 0.5        $ 1.4        $ 2.4
-----------------------------------------------------------------------------------------------
Interest expense........................................        $(4.8)       $(2.3)       $(0.6)
-----------------------------------------------------------------------------------------------
Other income (expense), net.............................        $10.8        $(0.6)       $(0.2)
-----------------------------------------------------------------------------------------------
</TABLE>
 
Interest income in 1998 totaled $0.5 million compared to $1.4 million in 1997
and $2.4 million in 1996. The decrease in interest income for both years was due
to a reduction in cash available for investment as the Company has used cash to
minimize outstanding borrowings under revolving and term loan facilities
associated with the August 1997 acquisition of Spacelabs Burdick.
 
Interest expense in 1998 increased to $4.8 million from $2.3 million in 1997 and
$0.6 million in 1996. The increase in interest expense in 1998 was principally
due to a full year of interest expense on the loan used to finance the
acquisition of Spacelabs Burdick. The increase in interest expense in 1997 over
1996 was also due to the Spacelabs Burdick acquisition loan and the
capitalization of interest costs of $0.4 million in 1996 related to the
construction of the Company's Redmond, Washington facility.
 
Other income in 1998 includes a gain of $13.1 million from the sale of Physio
Control International Corporation ("Physio") common stock. During the same
period, the Company also incurred $2.1 million in charges primarily related to
the write-down of certain other assets and recognized foreign currency gains
totaling $363,000 as a result of the weakening of the US dollar against the
currencies of the Company's foreign operations. Other income (expense) in 1997
and 1996 included losses from foreign currency fluctuations of $709,000 and
$236,000, respectively, due to the strengthening of the US dollar against the
currencies of the Company's foreign operations.
 
                                       18
<PAGE>   21
 
TAXES AND NET INCOME
 
<TABLE>
<CAPTION>
 
----------------------------------------------------------------------------------------------
(dollars in millions, except per-share data)                   1998        1997          1996
----------------------------------------------------------------------------------------------
<S>                                                           <C>          <C>           <C>
Income taxes................................................  $ 1.7        $  4.3        $5.5
Effective tax rate..........................................   38.0%       *             *
Net income (loss)...........................................  $ 2.7        $(20.4)       $2.6
Diluted net income (loss) per share.........................  $0.29        $ (2.13)      $0.25
----------------------------------------------------------------------------------------------
</TABLE>
 
* Not meaningful
 
The 1998 effective tax rate of 38.0% reflects the mix of federal, state and
foreign tax rates. The effective tax rates for both 1997 and 1996 were not
meaningful due to the nondeductibility of certain acquired IPR&D charges.
Excluding the impact of the IPR&D, the effective tax rates for 1997 and 1996
were 36.7% and 37.4%, respectively. Management believes the Company's net
deferred tax assets of $28.7 million at December 31, 1998 are more likely than
not to be realized based on amounts available for carryback to previous taxable
years, tax strategies involving the sale of appreciated property and future
profitability expectations. Failure to meet future profitability expectations
could result in increases to the valuation allowance for deferred tax assets.
 
As a result of the above factors, the Company reported net income of $2.7
million or $0.29 per share in 1998, compared to a net loss of $20.4 million or
($2.13) per share in 1997 and net income of $2.6 million or $0.25 per share in
1996.
 
CAPITAL RESOURCES AND LIQUIDITY
 
<TABLE>
<CAPTION>
 
-----------------------------------------------------------------------------------
                                                                             Dollar       Percent
(dollars in millions)                                  1998        1997      Change        Change
-----------------------------------------------------------------------------------
<S>                                                  <C>         <C>         <C>         <C>
Cash and cash equivalents..........................  $  1.5      $ 11.9      $(10.4)      (87.4)%
Short-term investments.............................      --         1.0        (1.0)     (100.0)%
Marketable securities..............................      --        10.9       (10.9)     (100.0)%
Working capital....................................   120.6       120.6          --            --
Long-term obligations..............................    65.1        66.8        (1.7)       (2.5)%
-------------------------------------------------------------------------------------------------
</TABLE>
 
The Company's combined cash and cash equivalents were $1.5 million at December
31, 1998, compared to $11.9 million as of December 26, 1997. Working capital was
$120.6 million at both December 31, 1998 and December 26, 1997. During 1998, the
Company liquidated its short-term investment portfolio and sold its marketable
securities (comprised principally of Physio common stock).
 
The Company used $7.1 million in cash from operating activities in 1998,
compared to $12.8 million in 1997. The primary operating uses of cash in 1998
included an increase of $11.6 million in accounts receivable and $5.5 million in
inventory, offset in part by an increase of $5.3 million in accounts payable and
accrued expenses. The increase in accounts receivable is principally
attributable to a slowdown in international collections as a result of the
economic situation in parts of Asia, the Middle East and Latin America coupled
with growth in certain European countries having longer collection cycles. The
increase in inventory is primarily due to new product introductions during 1998.
The change in accounts payable and accrued expenses is largely due to the
increase in inventories and timing of payments. Cash used in operating
activities in 1998 and 1997 also included restructuring costs in 1998 and 1997
and the acquisition of in-process research and development costs in 1997.
 
The Company generated $5.0 million in cash from investing activities in 1998
compared to $41.5 million used in investing activities in 1997. Investing
activities in 1998 include $13.1 million in cash generated from the sale of
Physio common stock and $1.0 million from the sale of short-term investments.
The
 
                                       19
<PAGE>   22
 
Company invested $8.3 million in property, plant and equipment in 1998, compared
to $9.6 million in 1997. Significant capital expenditures in 1998 included costs
of ongoing efforts to upgrade financial software in the Company's international
subsidiary locations and to implement a new service call tracking system.
Management expects 1999 capital expenditures to be consistent with 1998 and 1997
levels. During 1997, the Company used $37.1 million in investing activities
primarily related to the acquisitions of Spacelabs Burdick, AMS and AKD.
 
During 1998, the Company used $7.5 million in financing activities, compared to
$40.6 million generated by such activities in 1997. Significant financing uses
of cash during 1998 included $7.2 million in debt repayments and approximately
$2.0 million related to the Company's stock repurchase programs authorized by
the Board of Directors in 1995 and 1997. At December 31, 1998, approximately
866,600 shares remain authorized for repurchase under the programs. Shares
acquired under the repurchase programs are being used to service the Company's
various employee benefit plans and may be used for other purposes the Company
deems appropriate.
 
In 1997, in conjunction with the acquisition of Spacelabs Burdick, the Company
entered into a $65.0 million long-term loan agreement with its primary lender,
consisting of a $35 million revolving component and a $30 million term
component. The total outstanding balance of the facility may vary in amount
through July 2000, over which time no principal repayments are required. The
balance outstanding at the end of this period is repayable in 20 equal quarterly
installments commencing in October 2000. The loan bears interest at margins over
LIBOR and contains restrictive covenants. The Company was in compliance with
such covenants at December 31, 1998. As of December 31, 1998, $20.3 million was
outstanding under the revolving loan, $30 million was outstanding under the term
loan and $14.7 million was available for future borrowings under the revolving
loan, subject to compliance with certain loan covenants. During 1998, the
Company made scheduled principal payments of $0.8 million on other long-term
debt of $12.8 million, which is due in total in December 2002. This debt also
bears interest at a margin over LIBOR. The Company entered into interest rate
swap agreements in 1997 on the $30.0 million term portion of its $65.0 million
facility and on the $12.8 million loan. The variable interest rates on these
loans have been swapped for fixed rates of 7.07% and 6.66%, respectively. In
addition to the above, the Company has available $5.0 million of domestic lines
of credit as well as several small credit lines to meet the operating
requirements of its international subsidiaries.
 
Management believes that cash flow from operations, together with available
credit lines, will continue to be sufficient to meet ongoing operating
requirements as well as the Company's investment in capital additions and
research and development activities. In connection with research and
development, cash may be used from time to time to acquire technology or to fund
strategic ventures.
 
THE YEAR 2000 ISSUE
 
The "Year 2000 issue" refers to various problems that may result from the
improper processing of dates and date-sensitive calculations by computers and
other machinery as we enter the year 2000. These problems generally arise from
the fact that many computer programs and embedded microchips in equipment use
only two digits to identify the year in a date. This may result in a computer or
information system component failing to distinguish or properly characterize
dates in the twenty-first century. This could cause system failures or
miscalculations leading to disruptions including, but not limited to, the
operations of the Company, data and financial information management, the
receipt of goods from the Company's suppliers and the provision of goods and
services to the Company's customers.
 
State of Readiness
 
The Company has implemented a comprehensive program in an effort to properly
address Year 2000 issues with its internal systems, its products and with its
third-party suppliers and service providers. Components of this program include:
(1) an inventory of material computer systems and embedded technologies produced
or used by the Company; (2) assessment of Year 2000 compliance with material
information technology ("IT") and non-IT systems; (3) repair or replacement of
items that
 
                                       20
<PAGE>   23
 
are determined not to be Year 2000 compliant; (4) test for material Year 2000
compliance; and (5) design, where necessary, of appropriate contingency plans.
 
Internal Systems: During 1998, the Company substantially completed the inventory
and assessment phase of the program with respect to its material internal
computer systems and embedded technologies. This assessment revealed
non-compliance with respect to several significant systems, which are in the
process of being repaired or replaced. Accounting and business software used by
the Company's international subsidiaries is not Year 2000 compliant and is in
the process of being replaced with compliant financial software. As of December
31, 1998, the new software had been successfully implemented in approximately
55% of the Company's international subsidiaries, with the remaining
installations scheduled to be completed and tested by the end of August 1999.
This new software will also assist the Company in accounting for euro-currency
transactions. The Company's primary service call tracking software is not Year
2000 compliant and is being replaced by a new compliant system. The new system
is scheduled to begin rolling out in the first quarter of 1999 and to be
completed and tested in all applicable regions by the end of the third quarter
of 1999. The Company's primary business and manufacturing software (Maxcim)
required minor Year 2000 modifications, which were completed in 1998. The
Company's Spacelabs Burdick operation completed the process of upgrading to
compliant versions of its business, manufacturing and service call tracking
software in 1998. The Company has also identified several software applications,
which are in the process of being replaced or repaired. In addition, the Company
is upgrading certain of its mainframe and network operating systems to Year
2000-compliant versions.
 
Products: The Company has completed the inventory and assessment phases with
respect to products shipped since January 1, 1985 which contain software or
embedded microchips. Each of the Company's products have been assigned to one of
three categories as defined by the Company: "Year 2000 Compliant," "Year 2000
Compliant -- software upgrade required," and "Not Year 2000 Compliant." The
Company maintains a list of these products and their current status on its web
site, which is periodically updated as new information becomes available or as
corrections to previous status updates become known. In addition, registered
customers receive periodic customer service bulletins which provide information
on assessing Year 2000 compliance of the Company's products and how to obtain
and install fixes where necessary. As of the end of January 1999, the Company
estimates it is over 90% complete with developing and testing software upgrades
for its products, and expects to be 100% complete in the first half of 1999.
Software upgrades to correct Year 2000 issues are provided free of charge to the
Company's customers. Installation services are provided free for products
shipped after October 1, 1996 and for customers with current maintenance
agreements. Certain older products will not be made Year 2000 Compliant and
those products have been and are being identified by the Company. In the second
quarter of 1998, the Company accrued approximately $1.2 million related to the
costs of replacing noncompliant embedded microchips with compliant microchips in
certain older monitors covered under service agreements. The Company began
making these updates in the fourth quarter of 1998 and expects to complete the
program by the end of 1999.
 
Suppliers and Service Providers: The Company's Year 2000 program includes
contacting the Company's material suppliers who provide both IT assets and
non-IT related goods and services. The Company has initiated this program to (1)
evaluate such suppliers' or service providers' Year 2000 compliance plans and
state of readiness and (2) determine the extent to which the Company is
vulnerable to those third parties' failure to remediate their Year 2000
compliance issues. During the fourth quarter of 1998 and the first part of 1999,
the Company expanded this program to include a broader analysis of suppliers and
service providers throughout all areas of the corporation. To date, the Company
has obtained information on Year 2000 compliance from approximately 80% of
critical suppliers and has obtained written certifications from approximately
50% of such suppliers of their Year 2000 compliance. There remain a number of
critical suppliers from whom appropriate assurances have not yet been received.
In addition, the Company is evaluating responses from approximately 30% of its
critical suppliers to determine their adequacy and to determine whether
contingency plans should be designed or alternative suppliers engaged to avoid
interruption of the Company's business should such third parties fail to
remediate their Year 2000 issues in a timely fashion. The Company will
 
                                       21
<PAGE>   24
 
continue its efforts to monitor the progress of its key suppliers and continue
efforts to obtain and evaluate responses from them throughout 1999.
 
Costs to Address the Year 2000 Issue
 
The total cost to the Company of achieving Year 2000 compliance is not expected
to exceed $5.5 million. The total includes, but is not limited to: (1) the cost
of identifying, assessing, and repairing or replacing internal IT and non-IT
systems, including capitalizable costs of approximately $2.5 million associated
with implementation of the Company's new international business and accounting
software and new service call tracking software, which projects were accelerated
in order to be available as Year 2000 solutions; (2) the cost of developing and
testing software and hardware fixes for non-compliant products; (3) customer
satisfaction costs associated with communication, delivery and installation of
product fixes; (4) costs associated with evaluating the Year 2000 compliance
status of suppliers and service providers; and (5) the cost of developing
contingency plans. Included in the total costs of $5.5 million is $1.2 million
relating to the Year 2000 upgrade of products previously sold to customers,
which was accrued in the second quarter of 1998. Expenditures through December
31, 1998 totaled approximately $2.8 million.
 
Risks and Contingency Plans
 
The Company is continuing its assessment of the risks associated with the Year
2000 issue and its program to address such issues is ongoing. The Company's
determination is not complete and there are no assurances that it will be
completed in a timely manner or, if it is completed, that it will be completely
accurate. Based on the results of this evaluation, the Company will attempt to
develop contingency plans for its critical systems and processes. Such
contingency plans have not yet been developed. There are no assurances that such
plans will be adequate or completed in a timely manner. If the Company is unable
to remediate its Year 2000 issues in a timely manner, the Company's
manufacturing operations may be unable to build and deliver products due to
internal system failures, and vendors may be unable to deliver services, raw
materials and components. The failure to remediate material systems, suppliers,
or products may have a material adverse effect on the operations of the Company.
The Company's efforts to develop contingency plans may include such
considerations as alternative suppliers, increase in certain inventory levels of
certain key components, and the replacement of IT systems with manual systems.
The Company expects to develop such contingency plans before January 1, 2000.
Additionally, the Company and many other businesses, have potential
unquantifiable exposure arising from third-party systems outside of the general
operational control of the Company, and which may be effected by Year 2000
issues. These include but are not limited to such systems as the national and
worldwide banking information systems, transportation, governmental systems, and
utilities. It may not be possible to develop adequate or any risk assessment and
contingency plans for such widespread systems failures. Finally, this Year 2000
disclosure contains estimates and forward-looking statements. Those estimates
and statements are subject to inherent uncertainty and there is no guaranty that
they are accurate.
 
THE EURO CONVERSION
 
Beginning January 1, 1999, the authority to direct monetary policy for certain
participating countries in the European Union is now exercised by the new
European Central Bank. During a transition period between January 1, 1999 and
January 1, 2002, private parties may pay for goods and services using either the
euro or the participating country's legacy currency on a "no compulsion, no
prohibition" basis. Beginning January 1, 2002, the participating countries will
only use new euro-denominated bills and coins.
 
The euro conversion may create technical challenges to adapt information
technology and other systems to accommodate euro-denominated transactions. The
participating countries' adoption of a single currency may result in greater
transparency of pricing for the Company's products, making Europe a more
competitive environment. Currently, the effects of the euro conversion on the
operations of the Company are uncertain. The Company has initiated but not yet
completed an analysis
                                       22
<PAGE>   25
 
to facilitate the development of a plan for the conversion. While management
currently believes that it will complete an adequate analysis and implement the
plan in a timely manner and avoid any material adverse effect, there is the
possibility that this may not occur.
 
NEW ACCOUNTING PRONOUNCEMENTS
 
In June 1998, the Financial Accounting Standards Board ("FASB") issued FASB
Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities," which is required to be adopted by the Company in the year 2000.
Statement 133 requires all derivatives to be recorded on the balance sheet at
fair value and establishes accounting standards for different types of hedging
activities including fair value hedges, cash flow hedges and hedges of foreign
currency exposures. Although the Company has not fully assessed the impact of
this pronouncement on its financial statements, its initial assessment is that
Statement 133 will not have a material impact on the Company's financial
position or results of operations.
 
INFLATION
 
Although the Company cannot accurately anticipate the effects of inflation, the
Company does not believe inflation has had or is likely to have a material
effect on its results of operations or liquidity.
 
FORWARD-LOOKING INFORMATION
 
Statements that are not based on historical facts are forward-looking statements
subject to uncertainties and risks including, but not limited to, product and
service demand and acceptance; adverse economic conditions; adverse exchange
rate fluctuations and political risks; the impact of competition on pricing,
capacity and supply constraints or difficulties; the failure to achieve product
development objectives; and other risks detailed in this document and other of
the Company's Securities and Exchange Commission filings.
 
                                       23
<PAGE>   26
 
      ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
FOREIGN CURRENCY
 
Substantially all of the revenue and operating expenses of the Company's foreign
subsidiaries are denominated in local currencies and translated into US dollars
at rates of exchange approximating those existing at the date of the
transactions. Foreign currency translation impacts primarily revenue and
operating expenses as a result of foreign exchange rate fluctuations. Because
the Company's inventories are manufactured in the United States, foreign
currency fluctuations generally do not affect its cost of goods sold. The
Company's foreign currency transaction risk is primarily limited to amounts
receivable from its foreign subsidiaries, which are denominated in local
currencies (approximately $6.3 million at December 31, 1998). To minimize
foreign currency transaction risk, the Company ensures that its foreign
subsidiaries remit amounts to the US parent in a timely manner. Foreign country
short-term borrowing facilities are utilized where necessary to ensure prompt
payments. The Company does not currently utilize foreign currency hedging
contracts.
 
If the US dollar uniformly increases in strength by 10% in 1999 relative to the
currencies in which the Company's sales are denominated, income before taxes
would decrease by $2.5 million for the year ending December 31, 1999. This
calculation assumes 1999 foreign currency sales and expenses approximate those
of 1998, that each exchange rate would change in the same direction relative to
the US dollar and that amounts receivable from its foreign subsidiaries remains
constant. In addition to the direct effects of changes in exchange rates, which
are a changed dollar value of the resulting sales, changes in exchange rates
also 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 prices.
 
INTEREST RATES
 
The Company's earnings are affected by changes in short-term interest rates as a
result of its short and long term borrowings. To limit the potential effects of
interest rate changes, the Company has entered into interest rate swap
agreements to convert a portion of its variable interest rate debt into fixed
rates. The Company does not enter into derivative or interest rate transactions
for speculative purposes. At December 31, 1998, the Company's variable rate
long-term debt totaled $63.1 million and variable rate short-term borrowings
totaled $2.7 million. The Company has interest rate swap agreements with a
notional amount aggregating $42.8 million, effectively converting $12.8 million
and $30.0 million of its variable rate long-term debt to fixed rates of 6.66%
and 7.07%, respectively.
 
If market interest rates average 2% more in 1999 than they did in 1998, the
Company's interest expense, after considering the effects of its interest rate
swap agreements, would increase, and income before income taxes would decrease
by $0.5 million. These amounts are determined by considering the impact of
hypothetical interest rates on the Company's outstanding borrowings as of
December 31, 1998, giving consideration to its interest rate swap agreements,
and does not consider changes in the actual level of borrowings that may occur
subsequent to December 31, 1998. This analysis also does not consider the
effects of the reduced level of overall economic activity that could exist in
such an environment nor does it consider likely actions that management could
take with respect to the Company's financial structure to mitigate the exposure
to such a change.
 
                                       24
<PAGE>   27
 
              ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                            SPACELABS MEDICAL, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                              December 31,        December 26,
                                                                  1998                1997
                                                              ------------        ------------
                                                                       (in thousands)
<S>                                                           <C>                 <C>
                                            ASSETS
Current assets
  Cash, cash equivalents and short-term investments.........    $  1,467            $ 12,934
  Marketable equity securities..............................          --              10,859
  Trade receivables, net of allowance for doubtful accounts
     of $2,972 and $2,708...................................      82,575              70,691
  Inventories (Note 2)......................................      65,912              59,779
  Prepaid expenses..........................................       3,387               2,304
  Deferred income taxes (Note 7)............................      27,171              22,557
                                                                --------            --------
          Total current assets..............................     180,512             179,124
Property, plant and equipment, net (Note 3).................      65,146              65,334
Deferred income taxes (Note 7)..............................       1,558               1,495
Goodwill, net of accumulated amortization of $6,884 and
  $5,522....................................................      24,856              27,770
Other assets................................................      13,975              16,469
                                                                --------            --------
                                                                $286,047            $290,192
                                                                ========            ========
 
                             LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
  Short-term borrowings (Note 4)............................    $  2,666            $  1,314
  Current portion of long-term obligations (Note 5).........         750               5,507
  Accounts payable..........................................      23,056              19,015
  Accrued expenses (Note 6).................................      25,003              25,116
  Deferred revenue..........................................       5,660               4,082
  Taxes on income...........................................       2,748               3,443
                                                                --------            --------
          Total current liabilities.........................      59,883              58,477
Long-term obligations (Note 5)..............................      65,143              66,846
Commitments and contingencies (Notes 10, 11 and 12).........          --                  --
Shareholders' equity (Notes 8 and 11):
  Preferred stock, $1.00 par value; authorized -- 6.0
     million shares; issued -- none.........................          --                  --
  Common stock, $0.01 par value; authorized -- 50.0 million
     shares; issued -- 11.3 million; outstanding -- 9.4 and
     9.5 million shares.....................................         113                 113
  Additional paid-in capital................................     100,690             100,274
  Common stock in treasury, at cost; 1.8 million shares.....     (41,239)            (40,871)
  Accumulated other comprehensive income (loss).............      (3,556)              3,053
  Retained earnings.........................................     105,013             102,300
                                                                --------            --------
          Total shareholders' equity........................     161,021             164,869
                                                                --------            --------
                                                                $286,047            $290,192
                                                                ========            ========
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       25
<PAGE>   28
 
                            SPACELABS MEDICAL, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                                       Year Ended
                                                       ------------------------------------------
                                                       December 31,   December 26,   December 27,
                                                           1998           1997           1996
                                                       ------------   ------------   ------------
                                                         (in thousands, except per-share data)
<S>                                                    <C>            <C>            <C>
Revenue..............................................    $274,240       $265,279       $247,953
Cost of Sales........................................     150,802        133,925        123,082
                                                         --------       --------       --------
Gross Margin.........................................     123,438        131,354        124,871
                                                         --------       --------       --------
Operating expenses
  Selling, general and administrative................      91,266         79,475         74,189
  Research and development...........................      30,715         31,614         28,293
  Acquisition of in-process research and development
     (Note 17).......................................          --         33,967          8,797
  Restructuring of operations (Note 16)..............       3,559            911          7,126
                                                         --------       --------       --------
          Total operating expenses...................     125,540        145,967        118,405
                                                         --------       --------       --------
Income (loss) from operations........................      (2,102)       (14,613)         6,466
Other income (expense)
  Interest income....................................         470          1,435          2,407
  Interest expense (Note 5)..........................      (4,842)        (2,281)          (593)
  Other income (expense), net (Note 14)..............      10,847           (621)          (206)
                                                         --------       --------       --------
Income (loss) before income taxes (Note 7)...........       4,373        (16,080)         8,074
Income taxes (Note 7)................................       1,660          4,318          5,512
                                                         --------       --------       --------
Net income (loss)....................................    $  2,713       $(20,398)      $  2,562
                                                         ========       ========       ========
Basic net income (loss) per share (Note 9)...........    $   0.29       $  (2.13)      $   0.25
                                                         ========       ========       ========
Diluted net income (loss) per share (Note 9).........    $   0.29       $  (2.13)      $   0.25
                                                         ========       ========       ========
Weighted average common shares (Note 9)..............
  Basic..............................................       9,394          9,565         10,149
                                                         ========       ========       ========
  Diluted............................................       9,476          9,565         10,317
                                                         ========       ========       ========
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       26
<PAGE>   29
 
                            SPACELABS MEDICAL, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                                       Year Ended
                                                       ------------------------------------------
                                                       December 31,   December 26,   December 27,
                                                           1998           1997           1996
                                                       ------------   ------------   ------------
                                                                     (in thousands)
<S>                                                    <C>            <C>            <C>
Operating activities
  Net income (loss)..................................    $  2,713       $(20,398)      $  2,562
  Adjustments to reconcile net income (loss) to net
     cash provided (used) by operating activities
     Depreciation and amortization...................       9,953          9,399          8,584
     Gain on sale of marketable securities...........     (13,114)            --             --
     Acquired in-process research and development....          --          6,000          2,087
     Asset write-downs...............................       4,119             --             --
     Deferred income tax (benefit) provision.........      (1,801)           212         (1,036)
     Contribution to ISSOP 401(k) plan in common
       stock.........................................         681            706            672
     Changes in operating assets and liabilities
       Increase in trade receivables.................     (11,583)        (2,614)        (3,730)
       Increase in inventories.......................      (5,526)          (369)           (97)
       (Increase) decrease in prepaid expenses.......        (942)           297           (488)
       Increase (decrease) in accounts payable and
          accrued expenses...........................       5,271         (5,071)         6,082
       Increase in deferred revenue..................       1,571            217            577
       Increase (decrease) in taxes on income........         720           (982)         1,665
     Other...........................................         806           (165)           242
                                                         --------       --------       --------
Cash provided (used) by operating activities.........      (7,132)       (12,768)        17,120
                                                         --------       --------       --------
Investing activities
  Investment in property, plant and equipment........      (8,334)        (9,615)       (18,285)
  Proceeds from sale of investment...................      13,135             --             55
  Proceeds from maturity of short-term investments...       1,023          5,206             62
  Business acquisitions, net of cash acquired, and
     other investments...............................        (617)       (37,129)          (916)
  Other..............................................        (178)             5             --
                                                         --------       --------       --------
Cash provided (used) by investing activities.........       5,029        (41,533)       (19,084)
                                                         --------       --------       --------
Financing activities
  Increase (decrease) in short-term borrowings.......       1,352          1,299           (235)
  Principal payments on long-term debt...............      (7,167)        (3,130)          (750)
  Proceeds from long-term debt.......................          --         52,000             --
  Purchase of treasury stock.........................      (1,959)       (10,708)       (18,343)
  Exercise of stock options..........................         247          1,122            795
                                                         --------       --------       --------
Cash provided (used) by financing activities.........      (7,527)        40,583        (18,533)
                                                         --------       --------       --------
Effect of exchange rate changes on cash..............        (814)          (205)          (133)
                                                         --------       --------       --------
Decrease in cash and cash equivalents................     (10,444)       (13,923)       (20,630)
Cash and cash equivalents at beginning of year.......      11,911         25,834         46,464
                                                         --------       --------       --------
Cash and cash equivalents at end of year.............    $  1,467       $ 11,911       $ 25,834
                                                         ========       ========       ========
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       27
<PAGE>   30
 
                            SPACELABS MEDICAL, INC.
 
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------------------------
                                       Common Stock                    Common Stock       Accumulated
                                        Outstanding     Additional      In Treasury          Other                      Total
                                      ---------------    Paid-In     -----------------   Comprehensive   Retained   Shareholders'
                                      Shares   Amount    Capital     Shares    Amount    Income (Loss)   Earnings      Equity
---------------------------------------------------------------------------------------------------------------------------------
                                                                            (in thousands)
---------------------------------------------------------------------------------------------------------------------------------
<S>                                   <C>      <C>      <C>          <C>      <C>        <C>             <C>        <C>
Balance, December 29, 1995..........  10,526    $113     $101,029    $ 726    $(16,571)     $  (638)     $120,136     $204,069
  Comprehensive income:
    Net income......................                                                                        2,562        2,562
    Foreign currency translation
      adjustment....................                                                            (56)                       (56)
    Unrealized gain on investment
      securities, net of tax effect
      of $3,424.....................                                                          6,360                      6,360
                                                                                            -------      --------     --------
    Total comprehensive income......                                                          6,304         2,562        8,866
    Exercise of stock options.......      55                 (341)     (55)      1,076                                     735
    Amortization of unearned
      compensation (Note 11)........                          289                                                          289
    Contribution of shares to ISSOP
      401(k) plan...................      29                   61      (29)        611                                     672
    Issuance of restricted shares...      20                 (412)     (20)        412                                  --
    Purchase of treasury shares.....    (796)                          796     (18,343)                                (18,343)
    Forfeitures of unearned
      compensation..................      (4)                  78        4         (78)                                 --
    Stock compensation tax
      benefits......................                           60                                                           60
                                      ------    ----     --------    -----    --------      -------      --------     --------
Balance, December 27, 1996..........   9,830     113      100,764    1,422     (32,893)       5,666       122,698      196,348
  Comprehensive loss:
    Net loss........................                                                                      (20,398)     (20,398)
    Foreign currency translation
      adjustment....................                                                         (2,645)                    (2,645)
    Unrealized gain on investment
      securities, net of tax effect
      of $20........................                                                             32                         32
                                                                                            -------      --------     --------
    Total comprehensive loss........                                                         (2,613)      (20,398)     (23,011)
    Exercise of stock options.......      64                 (191)     (64)      1,313                                   1,122
    Amortization of unearned
      compensation (Note 11)........                          412                                                          412
    Contribution of shares to ISSOP
      401(k) plan...................      33                  (59)     (33)        765                                     706
    Issuance of restricted shares...      34                 (787)     (34)        787                                  --
    Purchase of treasury shares.....    (491)                          491     (10,708)                                (10,708)
    Forfeitures of unearned
      compensation..................      (5)                 135        5        (135)                                 --
                                      ------    ----     --------    -----    --------      -------      --------     --------
Balance, December 26, 1997..........   9,465     113      100,274    1,787     (40,871)       3,053       102,300      164,869
  Comprehensive loss:
    Net income......................                                                                        2,713        2,713
    Foreign currency translation
      adjustment....................                                                           (217)                      (217)
    Realized gain on investment
      securities previously reported
      in comprehensive income, net
      of tax effect of $3,443.......                                                         (6,392)                    (6,392)
                                                                                            -------      --------     --------
    Total comprehensive loss........                                                         (6,609)        2,713       (3,896)
    Exercise of stock options.......      18                 (129)     (18)        376                                     247
    Amortization of unearned
      compensation (Note 11)........                          298                                                          298
    Contribution of shares to ISSOP
      401(k) plan...................      38                 (197)     (38)        878                                     681
    Issuance of restricted shares...      22                 (510)     (22)        510                                  --
    Purchase of treasury shares.....    (110)                          110      (1,959)                                 (1,959)
    Forfeitures of unearned
      compensation..................      (8)                 173        8        (173)                                 --
    Stock compensation tax
      benefits......................                          781                                                          781
                                      ------    ----     --------    -----    --------      -------      --------     --------
Balance, December 31, 1998..........   9,425    $113     $100,690    1,827    $(41,239)     $(3,556)     $105,013     $161,021
                                      ======    ====     ========    =====    ========      =======      ========     ========
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       28
<PAGE>   31
 
                            SPACELABS MEDICAL, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                 (dollars in thousands, except per-share data)
 
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The consolidated financial statements include the accounts of Spacelabs Medical,
Inc. and its subsidiaries ("Company"). Intercompany transactions have been
eliminated. Certain reclassifications have been made to prior period financial
statements to conform to the current presentation.
 
During 1998, the Company changed its fiscal year end from the 52- or 53-week
period ending on the last Friday in December to December 31. The five-day
transition period from December 26, 1998 to December 31, 1998 is included in the
1998 fiscal year.
 
Operations
 
The Company develops, manufactures, markets and services patient monitoring,
diagnostic cardiology and clinical information systems ("CIS") products for use
throughout the healthcare industry. The Company's principal products are used
for diagnosis, monitoring and information management across the healthcare
continuum. The Company also sells the disposable and replaceable supplies to
support these products.
 
Cash Equivalents and Short-Term Investments
 
All liquid investments with a maturity of three months or less at the date of
purchase are considered to be cash equivalents. Short-term investments of $1,023
at December 26, 1997 were comprised of debt securities issued by the US Treasury
and government agencies. At December 31, 1998, the Company did not own any such
investments.
 
Marketable Equity Securities
 
At December 26, 1997, the Company's marketable equity securities portfolio was
comprised primarily of an investment in common stock of Physio Control
International Corporation ("Physio"). This investment was classified as
available-for-sale and carried at market value, with unrealized gains and losses
excluded from the consolidated statements of operations and reported as a
component of comprehensive income on the Consolidated Statements of
Shareholders' Equity. During 1998, the Company sold its investment in Physio and
recognized a pre-tax gain of $13,114 which is included in other income
(expense), net.
 
Inventories
 
Inventories are valued at the lower of cost, as determined by the first-in,
first-out method, or market.
 
Property, Plant and Equipment
 
Property, plant and equipment are stated at cost. Significant additions and
improvements are capitalized. Maintenance and repairs are expensed as incurred.
When properties are retired or otherwise disposed of, gains and losses are
reflected in the consolidated statements of operations. Depreciation is provided
for on the straight-line method over the following estimated useful lives:
 
<TABLE>
<S>                                                           <C>
Buildings...................................................  40 years
Machinery and equipment.....................................  3 - 10 years
</TABLE>
 
                                       29
<PAGE>   32
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Leasehold improvements are amortized over the shorter of their useful lives or
the term of the lease. The Company continually evaluates the estimated useful
lives of its property, plant and equipment and from time to time makes changes
to these estimates based on experience and trends in utility. During 1998, the
Company changed the estimated useful lives of certain machinery and equipment
that resulted in a $329 decrease in depreciation expense from that which would
have been recorded under the old useful lives. During 1997, the Company made a
similar change with respect to other machinery and equipment that resulted in a
$750 decrease in depreciation expense from that which would have been recorded
under the old useful lives.
 
Goodwill and Other Assets
 
Goodwill is amortized using the straight-line method over 20 to 40 years. Other
Assets includes trademarks, patents and other intangible assets which are being
amortized using the straight-line method over 5 to 40 years. Amortization of
goodwill and other intangible assets was $1,532, $875 and $347 in 1998, 1997 and
1996, respectively, and is included in selling, general and administrative
expense.
 
Foreign Currency
 
Revenue and expenses of the Company's international operations denominated in
foreign currencies are translated to US dollars at average rates of exchange
prevailing during the year. Assets and liabilities are translated at the
exchange rate on the balance sheet date. Translation adjustments resulting from
this process are accumulated and charged or credited to shareholders' equity.
Gains and losses on foreign currency transactions are included in other income
(expense), net.
 
Revenue Recognition
 
Revenue from the sale of equipment is generally recognized upon shipment.
Revenue derived from equipment service contracts is deferred and recognized on a
straight-line basis over the lives of the contracts. In accordance with AICPA
Statement of Position 97-2 "Software Revenue Recognition" ("SOP 97-2"), software
revenue is divided into different elements based upon vendor-specific objective
information. As specified in SOP 97-2, revenue from the sale of software
licenses is either recognized upon shipment or on the percentage-of-completion
method, depending on such factors as the extent and complexity of implementation
required and whether significant payment terms are contingent upon completion of
future milestones. Revenue from software implementation services is recognized
as the services are provided. Software maintenance revenue is deferred and
recognized on a straight-line basis over the life of the maintenance agreement.
 
Advertising Costs
 
The Company expenses the production costs of advertising the first time the
advertising takes place. Advertising expense totaled $1,245, $1,512 and $1,791
in 1998, 1997 and 1996, respectively.
 
Income Taxes
 
Deferred tax assets and liabilities have been established for the expected
future tax consequences of events that have been recognized in the Company's
consolidated financial statements and tax returns. These deferred tax assets and
liabilities are determined based on the differences between the financial
statement carrying amounts and tax bases of assets and liabilities using
currently enacted tax rates that are expected to be in effect during the years
in which the differences are anticipated to reverse.
 
                                       30
<PAGE>   33
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Product Warranties
 
The Company provides currently for the estimated cost to repair or replace
products sold under warranties. Such warranties for hospital equipment and CIS
are generally for the earlier of 14 months from the date of original delivery or
12 months from first online operation. Primary care products are warranted,
inclusive of software, for all parts and labor during the warranty term, which
ranges from one to five years.
 
Accounting Estimates
 
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual
results may differ from these estimates.
 
Concentrations of Risk
 
Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of trade accounts receivable which reflect a
broad customer base both nationally and internationally. The Company's trade
accounts receivable were distributed geographically as follows:
 
<TABLE>
<CAPTION>
                                                              1998      1997
                                                              ----      ----
<S>                                                           <C>       <C>
North America...............................................   63%       58%
Europe......................................................   22%       23%
Asia-Pacific................................................    8%       13%
Other.......................................................    7%        6%
                                                              ---       ---
                                                              100%      100%
                                                              ===       ===
</TABLE>
 
As the Company continues to expand internationally, a greater portion of its
receivables are with customers located in foreign countries. While the Company
attempts to secure payments with banking instruments such as letters of credit,
some export sales are transacted with credit terms, and therefore collection of
receivables is affected by local economic conditions. Also, with respect to
foreign export sales, collection may be more difficult in the event of default
than in the US.
 
The Company frequently contracts for the sale of its products with hospital
buying groups, proprietary hospital chains and US government agencies. These
contracts can generate significant revenue and the Company believes the loss of
a major contract could have an adverse effect on its operations.
 
The Company depends on single-source vendors for certain integral component
parts. While any of these vendors could be replaced over time, abrupt disruption
in the supply of a single-source part could have an adverse effect on the
Company's manufacture of the products of which such items are a component. In
addition, component parts of certain of the Company's products are manufactured
in Asian countries that periodically experience political and economic
difficulties.
 
Income Per Share
 
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 128,
Earnings Per Share, the Company has reported both basic and diluted net income
(loss) per common share for each period presented. Basic income per share is
computed on the basis of the weighted average number of shares outstanding for
the year. Diluted income per share is computed on the basis of the
 
                                       31
<PAGE>   34
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
weighted average number of common shares plus dilutive potential common shares
outstanding. Dilutive potential common shares are calculated under the treasury
stock method and consist of unexercised employee stock options and unvested
restricted shares outstanding.
 
Stock-Based Compensation
 
SFAS No. 123, Accounting for Stock-Based Compensation, permits a company to
choose either a fair-value-based method or the Accounting Principles Board
("APB") Opinion 25 intrinsic-value-based method of accounting for stock-based
compensation arrangements. SFAS No. 123 requires pro forma disclosures of net
income and earnings per share computed as if the fair-value-based method had
been applied in financial statements of companies that continue to account for
such arrangements under APB Opinion 25. The Company records stock-based
compensation using the APB Opinion 25 intrinsic-value-based method.
 
Impairment of Long-Lived Assets
 
The Company periodically assesses the recoverability of long-lived assets
including property, plant and equipment, goodwill and other intangible assets.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset to future undiscounted net cash flows expected to be
generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured as the amount by which the carrying
amount of the assets exceeds the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or the fair value less costs
to sell.
 
2. INVENTORIES
 
<TABLE>
<CAPTION>
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Raw materials and components................................  $18,067    $16,965
Work in progress............................................   10,511      8,516
Finished products...........................................   18,468     16,115
Demonstration equipment.....................................    5,502      5,635
Customer service parts and equipment........................   13,364     12,548
                                                              -------    -------
                                                              $65,912    $59,779
                                                              =======    =======
</TABLE>
 
3. PROPERTY, PLANT AND EQUIPMENT
 
<TABLE>
<CAPTION>
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Land and improvements.......................................  $14,293    $14,293
Buildings...................................................   36,625     36,494
Leasehold improvements......................................    2,125      1,958
Machinery and equipment.....................................   76,886     72,201
                                                              -------    -------
                                                              129,929    124,946
Accumulated depreciation and amortization...................  (64,783)   (59,612)
                                                              -------    -------
                                                              $65,146    $65,334
                                                              =======    =======
</TABLE>
 
                                       32
<PAGE>   35
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
4. SHORT-TERM BORROWINGS
 
At December 31, 1998, the Company had available US unsecured bank lines of
credit totaling $5,000 for issuances of letters of credit, banker's acceptances
and performance bonds. There were no balances outstanding under these agreements
at December 31, 1998 or December 26, 1997.
 
The Company has available for working capital purposes unsecured bank lines of
credit maintained by various foreign subsidiaries aggregating $7,137 at December
31, 1998. The Company had drawn $2,666 and $1,314 under these lines at December
31, 1998 and December 26, 1997, respectively.
 
5. LONG-TERM OBLIGATIONS
 
<TABLE>
<CAPTION>
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Unsecured bank debt originated in 1995......................  $12,750    $13,500
Unsecured term debt originated in 1997......................   30,000     30,000
Unsecured revolving bank debt originated in 1997............   20,340     22,000
Promissory note relating to AKD acquisition.................       --      4,757
Post-retirement benefits (Note 10)..........................    2,140      2,096
Other.......................................................      663         --
                                                              -------    -------
Total obligations...........................................   65,893     72,353
Less current portion........................................     (750)    (5,507)
                                                              -------    -------
                                                              $65,143    $66,846
                                                              =======    =======
</TABLE>
 
The $12,750 unsecured bank debt bears monthly interest payable at a margin over
the one-month LIBOR (6.38% at December 31, 1998). Principal on the note is due
in monthly installments of $62.5 until December 7, 2002, at which time the
remaining principal amount of $9,750 is due.
 
In conjunction with the 1997 acquisition of Burdick, Inc. (renamed Spacelabs
Burdick, Inc. on December 31, 1998 and referred to herein as "Spacelabs
Burdick"), the Company entered into a long-term loan agreement with its primary
lender. The loan commitment consists of $30,000 in term debt and up to $35,000
in revolving debt. The total outstanding balance of the facility may vary in
amount through July 2000, over which time no principal repayments are required.
Amounts remaining unpaid on both the term and revolving components of the
facility at the end of this period will be repayable in 20 equal quarterly
installments commencing in October 2000. As of December 31, 1998, there was
$30,000 outstanding on the term component, $20,340 outstanding on the revolving
component and $14,660 was available for future borrowings under the revolving
debt, subject to compliance with certain loan covenants. Interest on the term
debt is payable at a margin over the three-month LIBOR (5.92% at December 31,
1998). The revolving debt bears interest at a margin over the primary lender's
cost of funds (6.13% at December 31, 1998).
 
Restrictive terms of the bank debt agreements require that the Company maintain
specified financial ratios and comply with certain other loan covenants. The
Company was in compliance with these covenants at December 31, 1998.
 
To manage interest costs and risks associated with interest rate fluctuations on
its long-term debt, the Company has entered into two interest rate swap
agreements with its primary lender. The first of such agreements, in the
notional amount equivalent to the indebtedness, effectively exchanges the
variable rate on the Company's 1995 long-term debt for a fixed rate of 6.66%.
The swap agreement expires in 2002. The second agreement, in the notional amount
equivalent to the principal balance of the $30,000 term debt, effectively
exchanges the variable rate on this debt for a fixed rate of 7.065%. This swap
 
                                       33
<PAGE>   36
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
agreement expires in 2005. The differential to be paid or received under either
of the arrangements is accrued as interest rates change and is recognized as an
increase or reduction to interest expense over the life of the agreements. The
counterparty under the swap arrangements is a major financial institution and
credit loss from counterparty nonperformance is not anticipated.
 
In conjunction with the 1997 acquisition of Ameritech Knowledge Data, Inc.
("AKD"), the Company issued an unsecured promissory note to pay Ameritech Health
Connections, Inc. $7,138 at an interest rate of 7.5%. The note was repaid in
November 1998.
 
Scheduled maturities of long-term debt at December 31, 1998 are as follows:
 
<TABLE>
<S>                                                           <C>
1999........................................................  $   750
2000........................................................    3,267
2001........................................................   10,818
2002........................................................   20,568
2003........................................................   10,068
Thereafter..................................................   17,619
                                                              -------
                                                              $63,090
                                                              =======
</TABLE>
 
6. ACCRUED EXPENSES
 
<TABLE>
<CAPTION>
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Salaries and other compensation.............................  $ 7,375    $ 4,771
Product warranty obligations................................    5,046      5,303
Employee benefit insurance liabilities......................    1,489      1,714
Restructuring of operations (Notes 16 and 18)...............    1,423      4,238
Sales and use taxes.........................................    2,322      3,346
Other.......................................................    7,348      5,744
                                                              -------    -------
                                                              $25,003    $25,116
                                                              =======    =======
</TABLE>
 
7. INCOME TAXES
 
The components of income (loss) before income taxes are:
 
<TABLE>
<CAPTION>
                                                               1998       1997       1996
                                                              ------    --------    ------
<S>                                                           <C>       <C>         <C>
US operations...............................................  $4,690    $(15,676)   $7,366
International operations....................................    (317)       (404)      708
                                                              ------    --------    ------
                                                              $4,373    $(16,080)   $8,074
                                                              ======    ========    ======
</TABLE>
 
The provision for income taxes consists of the following:
 
<TABLE>
<CAPTION>
                                                               1998       1997      1996
                                                              -------    ------    -------
<S>                                                           <C>        <C>       <C>
Current
  US federal................................................  $ 3,131    $3,727    $ 5,355
  US state and local........................................      313       562        271
  International (benefit)...................................       17      (183)       922
Deferred provision (benefit)................................   (1,801)      212     (1,036)
                                                              -------    ------    -------
                                                              $ 1,660    $4,318    $ 5,512
                                                              =======    ======    =======
</TABLE>
 
                                       34
<PAGE>   37
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Deferred income tax assets and liabilities consist of the following:
 
<TABLE>
<CAPTION>
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Deferred income tax assets
  Inventory obsolescence provisions.........................  $12,266    $10,911
  Product warranty obligations..............................    1,565      1,752
  Net operating loss carryforwards..........................    3,264      3,337
  Deferred revenue..........................................    4,033      2,923
  Uniform inventory capitalization..........................    2,638      2,274
  Accrued compensation and benefits.........................    1,991      1,634
  Employee benefit insurance liabilities....................      547        604
  Allowance for doubtful accounts...........................      802        791
  Restructuring of operations...............................      530      2,043
  Depreciation and amortization.............................      478      1,761
  Other.....................................................    4,239      3,053
                                                              -------    -------
                                                               32,353     31,083
  Valuation allowance.......................................   (2,615)    (2,558)
                                                              -------    -------
                                                              $29,738    $28,525
                                                              =======    =======
Deferred income tax liabilities
  Deferred gain on sale of building.........................  $ 1,009    $ 1,030
  Unrealized gain on investment securities..................       --      3,443
                                                              -------    -------
                                                              $ 1,009    $ 4,473
                                                              =======    =======
</TABLE>
 
The provision for income taxes differs from the amount of income tax determined
by applying the applicable US statutory federal income tax rate to pretax income
(loss), as a result of the following:
 
<TABLE>
<CAPTION>
                                                               1998      1997       1996
                                                              ------    -------    ------
<S>                                                           <C>       <C>        <C>
Taxes at the US statutory rate..............................  $1,531    $(5,628)   $2,826
Increases (decreases) in taxes resulting from
  State and local taxes.....................................     203        371       176
  International operations..................................    (399)      (163)      575
  Foreign sales corporation.................................    (629)      (518)     (628)
  Nondeductible amortization of goodwill....................     574        297        96
  Nondeductible in-process research and development.........      --      9,788     2,316
  Other, net................................................     380        171       151
                                                              ------    -------    ------
                                                              $1,660    $ 4,318    $5,512
                                                              ======    =======    ======
</TABLE>
 
The valuation allowance for deferred tax assets increased by $57, $2,115 and
$264 in 1998, 1997 and 1996, respectively. These changes primarily relate to net
operating loss carryforwards generated or utilized by foreign operations and the
1997 acquisition of Spacelabs Burdick. Management believes the Company's net
deferred tax assets at December 31, 1998 are more likely than not to be realized
based on amounts available for carryback to previous years, tax strategies
involving the sale of appreciated property and future profitability
expectations. Failure to meet such profitability expectations could result in
increases to the valuation allowance for deferred tax assets.
 
                                       35
<PAGE>   38
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
At December 31, 1998, the Company had net operating loss carryforwards for US
federal tax purposes of approximately $8,440, resulting from the acquisitions of
Spacelabs Burdick and a 1990 acquisition. These net operating loss carryforwards
expire between 2004 and 2011. In accordance with SFAS 109, tax benefits from
future utilization of net operating loss carryforwards associated with Spacelabs
Burdick will reduce the recorded goodwill balance rather than income tax
provisions.
 
At December 31, 1998, the Company also had international net operating loss
carryforwards for tax purposes of approximately $96, which contain carryforward
periods ranging from five years to unlimited years.
 
Provision has not been made for US or additional foreign taxes on the
undistributed earnings of the Company's foreign subsidiaries, which total
approximately $2,124 at December 31, 1998. These earnings, which are expected to
be reinvested, could become subject to additional tax if they were to be
remitted as dividends, lent to the Company, or if the Company should sell its
stock in these subsidiaries.
 
8. SHAREHOLDERS' EQUITY
 
Purchase of Treasury Shares
 
The Board of Directors authorized the repurchase of up to three million shares
of the Company's common stock, subject to certain limitations and conditions. In
addition, the Board of Directors has also approved odd-lot repurchase programs.
The Company repurchased 110,000, 491,200 and 796,200 shares in 1998, 1997 and
1996, respectively. As of December 31, 1998, the Company had purchased 2,239,954
shares at a total cost of $50,058. The shares are used to service the Company's
employee benefit plans and may be used for other purposes the Company deems
appropriate.
 
9. NET INCOME (LOSS) PER SHARE
 
The following table reconciles the numerators and denominators of the basic and
diluted per-share computations for net income (loss) in 1998, 1997 and 1996.
 
<TABLE>
<CAPTION>
                                                                      Weighted
                                                                       Average
                                                    Income/(loss)      Shares       Income/(loss)
                                                     (Numerator)    (Denominator)     Per Share
                                                    -------------   -------------   -------------
<S>                                                 <C>             <C>             <C>
1998
Basic net income per share........................    $  2,713          9,394          $ 0.29
                                                                                       ======
Effect of dilutive stock options and unvested
  restricted stock................................          --             82
                                                      --------         ------
Diluted net income per share......................    $  2,713          9,476          $ 0.29
                                                      ========         ======          ======
1997
Basic and diluted net loss per share..............    $(20,398)         9,565          $(2.13)
                                                      ========         ======          ======
1996
Basic net income per share........................    $  2,562         10,149          $ 0.25
                                                                                       ======
Effect of dilutive stock options and unvested
  restricted stock................................          --            168
                                                      --------         ------
Diluted net income per share......................    $  2,562         10,317          $ 0.25
                                                      ========         ======          ======
</TABLE>
 
                                       36
<PAGE>   39
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Stock options representing 1,459,350 and 641,025 potential shares for 1998 and
1996, respectively, were not included in the computation of diluted net income
per share because the options' exercise price was greater than the average
market price of common shares and their effect would be antidilutive. Stock
options and unvested restricted stock representing 2,474,370 potential shares
were not included in the computation of diluted loss per share for 1997, because
the representative share increments would be antidilutive.
 
10. RETIREMENT PLANS
 
Pension and Post-Retirement Plans
 
Except for employees of the Company's Spacelabs Burdick operations,
substantially all employees of the Company's US operations are covered under
noncontributory defined benefit pension plans. The benefits under these plans
are based on the employees' years of service and highest consecutive five-year
average compensation. The Company also provides unfunded health care and life
insurance benefits to certain retirees of its Spacelabs Burdick subsidiary.
Current employees of the Company are not entitled to these benefits upon
retirement.
 
A summary of these plans as required by SFAS No. 132 is as follows:
 
<TABLE>
<CAPTION>
                                                                                 Post-Retirement
                                                           Pension Benefits          Benefits
                                                          ------------------    ------------------
                                                           1998       1997       1998       1997
                                                          -------    -------    -------    -------
<S>                                                       <C>        <C>        <C>        <C>
Change in benefit obligation:
  Benefit obligation at beginning of year...............  $22,574    $19,616    $ 2,096    $    --
  Service cost..........................................    1,355      1,129         --         --
  Interest cost.........................................    1,600      1,398        173         49
  Actuarial (gain) loss.................................      (92)    (1,102)        26         --
  Change in assumptions.................................    1,115      2,151         --         --
  Acquisition...........................................       --         --         --      2,067
  Benefits paid.........................................     (578)      (618)      (129)       (20)
                                                          -------    -------    -------    -------
  Benefit obligation at end of year.....................   25,974     22,574      2,166      2,096
                                                          -------    -------    -------    -------
 
Change in plan assets:
  Fair value of assets at beginning of year.............   19,950     15,872         --         --
  Actual return on plan assets..........................    1,668      2,346         --         --
  Employer contribution.................................      788      2,350        129         20
  Benefits paid.........................................     (578)      (618)      (129)       (20)
                                                          -------    -------    -------    -------
  Fair value of assets at end of year...................   21,828     19,950         --         --
                                                          -------    -------    -------    -------
</TABLE>
 
                                       37
<PAGE>   40
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
<TABLE>
<CAPTION>
                                                                                 Post-Retirement
                                                           Pension Benefits          Benefits
                                                          ------------------    ------------------
                                                           1998       1997       1998       1997
                                                          -------    -------    -------    -------
<S>                                                       <C>        <C>        <C>        <C>
Funded status...........................................   (4,146)    (2,624)    (2,166)    (2,096)
Unrecognized net actuarial loss.........................    4,341      3,241         26         --
Unrecognized prior service cost.........................       70        264         --         --
                                                          -------    -------    -------    -------
Prepaid (accrued) benefit cost..........................  $   265    $   881    $(2,140)   $(2,096)
                                                          =======    =======    =======    =======
 
Weighted average assumptions:
  Discount rate.........................................     7.00%      7.25%      7.00%      7.25%
  Expected return on plan assets........................     9.00%      9.00%
  Rate of compensation increase.........................     5.50%      5.50%
</TABLE>
 
For 1998, future benefit costs for the post-retirement plan were estimated
assuming medical costs would increase at a 9.2% annual rate, with the rate
decreasing for six years after 1998 until it reaches 5%, and remain constant
thereafter.
 
<TABLE>
<CAPTION>
                                                               1998      1997      1996
                                                              ------    ------    ------
<S>                                                           <C>       <C>       <C>
Components of net periodic benefit costs:
Retirement plan:
  Service cost..............................................  $1,355    $1,129    $1,377
  Interest cost.............................................   1,600     1,398     1,349
  Expected return on plan assets............................  (1,816)   (1,611)   (1,394)
  Recognized net actuarial loss.............................      71        --       222
  Amortization of prior service cost........................     194       203       203
                                                              ------    ------    ------
Net periodic benefit cost...................................  $1,404    $1,119    $1,757
                                                              ======    ======    ======
Post-retirement plan:
  Net periodic benefit cost -- interest cost only...........  $  173    $   49
                                                              ======    ======
</TABLE>
 
A one-percentage point change in the assumed healthcare cost trend rate would
have the following effects:
 
<TABLE>
<CAPTION>
                                                              1% Increase    1% Decrease
                                                              -----------    -----------
<S>                                                           <C>            <C>
Effect on total service and interest costs..................     $ 16           $ (14)
Effect on post-retirement benefit obligation................     $232           $(199)
</TABLE>
 
ISSOP 401(k) Plan
 
Spacelabs Medical ISSOP 401(k) Plan: The Company maintains an Incentive Savings
and Stock Ownership Plan for the majority of its full-time US resident employees
with at least 60 days of service. Under the plan, participating employees may
defer up 16% of their pretax salary, but not more than statutory limits. The
Company contributes, in Common Stock, fifty cents for each dollar contributed by
a participant, provided the participant contribution does not exceed 6% of the
employee's earnings. Matching contributions vest on a cumulative basis at 20%
per year over a five-year period. Company contributions to the savings plan were
$681, $706, and $672 in 1998, 1997 and 1996, respectively.
 
                                       38
<PAGE>   41
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Spacelabs Burdick, Inc. 401(k) Savings Plan: Full-time employees of the
Company's Spacelabs Burdick operations are not eligible to participate in the
Spacelabs Medical ISSOP 401(k) Plan; however, they are entitled to participate
in a separate 401(k) savings plan as described below. Under the Spacelabs
Burdick, Inc. 401(k) Savings Plan, participants may elect to defer up to 16% of
their pretax salary, but not more than statutory limits. The Company contributes
twenty-five cents for each dollar contributed by a participant, provided the
participant contribution does not exceed 4% of the employee's earnings. Company
contributions under the Spacelabs Burdick, Inc. 401(k) Savings Plan vest over a
five-year period. The Company contributed $106 and $33 to this plan in 1998 and
1997, respectively.
 
11. STOCK OPTION PLANS
 
At December 31, 1998, the Company had five stock-based compensation plans, which
are described below. The Company applies APB Opinion No. 25 and related
interpretations in accounting for its plans, under which no compensation cost
has been recognized for its stock option awards. Pro forma information regarding
net income (loss) and net income (loss) per share is required by Statement of
Financial Accounting Standards No. 123, and has been determined as if the
Company had accounted for its stock options pursuant to the fair value method of
that Statement. The fair value of each option grant is estimated on the date of
grant using the Black-Scholes option-pricing model with the following weighted
average assumptions:
 
<TABLE>
<CAPTION>
                                                              1998      1997      1996
                                                              ----      ----      ----
<S>                                                           <C>       <C>       <C>
Dividend yield..............................................    0%        0%        0%
Volatility..................................................   32%       34%       36%
Risk-free interest rate.....................................  5.5%      6.3%      5.7%
Expected life (years):
  Nonofficer Employee Plan..................................  4.0       4.4       4.1
  1992 Plan.................................................  6.8       5.2       4.8
  Director Plan.............................................  4.7       4.3       4.2
</TABLE>
 
For purposes of pro forma disclosures, the estimated weighted average value of
the options granted of $6.54, $9.20 and $10.09 per share during 1998, 1997 and
1996, respectively, is amortized to expense over the options' vesting period.
The Company's pro forma information is as follows:
 
<TABLE>
<CAPTION>
                                                                1998       1997       1996
                                                               ------    --------    ------
<S>                                    <C>                     <C>       <C>         <C>
Net income/(loss)                      As reported...........  $2,713    $(20,398)   $2,562
                                       Pro forma.............  $  430    $(23,482)   $  903
Basic net income/(loss) per share      As reported...........  $ 0.29    $  (2.13)   $ 0.25
                                       Pro forma.............  $ 0.05    $  (2.45)   $ 0.09
Diluted net income/(loss) per share    As reported...........  $ 0.29    $  (2.13)   $ 0.25
                                       Pro forma.............  $ 0.05    $  (2.45)   $ 0.09
</TABLE>
 
In July 1998, the Company initiated a one-time program that allowed current
employees other than executive officers to exchange all, but not some, of their
options for new options under the Nonofficer Employee Plan on a one-for-one
basis. The options have new five-year terms, are exercisable at the market price
of the shares on the date of the grant, and vest in increments of 25% over four
years commencing on the date of grant. Options representing an aggregate of
approximately 864,000 shares were exchanged under this program.
 
                                       39
<PAGE>   42
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Summaries of the plans are as follows:
 
THE 1992 OPTION, STOCK APPRECIATION RIGHT, RESTRICTED STOCK, STOCK GRANT AND
PERFORMANCE UNIT PLAN (THE "1992 PLAN"):
 
Under the 1992 Plan, as amended and restated, for each calendar year from and
including 1995 through May 10, 2000, the number of shares authorized for
issuance is increased each year by up to 2% of the adjusted average common
shares outstanding of the Company used to calculate diluted earnings per share
as reported in the annual report to stockholders for the preceding year. In
addition, any shares authorized for issuance under the formula in any previous
year (1995 or later) but not actually issued under the 1992 Plan will be added
to the number of shares that become authorized for issuance in any current year.
Within the limit established by the formula, over the term of the 1992 Plan, not
more than an aggregate of 500,000 shares of common stock may be issued pursuant
to the exercise of incentive stock options under the 1992 Plan and not more than
an aggregate of 500,000 shares may be issued pursuant to grants or awards of
restricted stock, stock grants or performance units under the 1992 Plan.
 
At December 31, 1998, 229,795 shares were available for future grant under the
1992 Plan. In accordance with the replenishment formula, total shares available
for future grant as of January 1, 1999 was 419,305. As of December 31, 1998,
416,876 shares were available for issuance on exercise of incentive stock
options over the remaining term of the 1992 Plan, and 473,500 shares were
available for restricted stock awards, stock grants and performance unit awards
over the remaining term of the 1992 Plan.
 
Stock options and restricted shares granted under the 1992 Plan generally vest
on a cumulative basis at 25% each year over a four-year period and have a
maximum term of 10 years. Stock options are granted at an exercise price equal
to the fair market value of the Company's common stock on the date of grant.
 
THE 1992 STOCK OPTION AND DEFERRAL PLAN FOR NONEMPLOYEE DIRECTORS (THE "DIRECTOR
PLAN"):
 
The Director Plan, as amended, provides for the grant of options to acquire up
to a total of 150,000 shares of common stock to nonemployee directors. At
December 31, 1998, options representing 54,500 shares were outstanding and
89,500 shares were available for future grant. Stock options granted under the
Director Plan are generally exercisable on the day of the Annual Meeting next
following the date of grant, if the optionee has continued to serve as a
director until such meeting. The maximum term for options granted under the
Director Plan is 5 years for those granted prior to 1996 and 10 years
thereafter. All options are granted at an exercise price equal to the fair
market value of the Company's common stock on the date of grant.
 
THE SPACELABS MEDICAL, INC. 1992 ADJUSTMENT PLAN (THE "ADJUSTMENT PLAN"):
 
The Adjustment Plan was established in 1992. Under this plan, there are 193,362
stock options outstanding at December 31, 1998. Use of this plan for grant of
stock options and other awards was terminated in 1992. All outstanding options
under this plan are vested and have a maximum term of 10 years. The option with
the longest remaining term expires in 2001.
 
                                       40
<PAGE>   43
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
THE 1993 NONOFFICER EMPLOYEE OPTION, STOCK APPRECIATION RIGHT, RESTRICTED STOCK,
STOCK GRANT AND PERFORMANCE UNIT PLAN (THE "NONOFFICER EMPLOYEE PLAN"):
 
Under the Nonofficer Employee Plan, as amended, 1,800,000 shares of common stock
were reserved for issuance upon the exercise of stock options at prices
determined by the Company's Nonofficer Employee Plan Committee, for issuance of
restricted shares for cash equal to the par value of the shares of common stock
and for issuance upon the payment of the base price assigned to stock
appreciation rights or performance unit awards. At December 31, 1998, 631,968
shares were available for future grant under the Nonofficer Employee Plan. Stock
options and restricted shares granted under the Nonofficer Employee Plan
generally vest on a cumulative basis at 25% per year over a four-year period and
have a maximum term of 10 years.
 
THE MANAGEMENT INCENTIVE COMPENSATION PLAN (THE "MIC PLAN"):
 
The MIC Plan provides for the grant of incentive compensation awards to officers
and key employees of the Company and its subsidiaries. Incentive compensation
awards may be in cash, common stock or any combination thereof. Under the MIC
Plan, 100,000 shares of common stock were reserved for issuance. At December 31,
1998, 78,200 shares are available for future grant under the MIC Plan.
 
SUMMARY OF STOCK OPTION PLANS
 
A summary of options granted and outstanding is presented below:
 
<TABLE>
<CAPTION>
                                                                           Weighted-
                                                                            Average
                                                                           Exercise
                                                                Shares       Price
                                                              ----------   ---------
<S>                                                           <C>          <C>
Balance at January 1, 1996..................................   1,532,561    $20.87
  Granted...................................................     405,200     26.31
  Exercised.................................................     (54,338)    13.42
  Canceled..................................................    (140,125)    24.44
                                                              ----------
Balance at December 27, 1996 (1,005,464 exercisable)........   1,743,298    $22.07
  Granted...................................................     969,700     22.42
  Exercised.................................................     (64,160)    17.49
  Canceled..................................................    (218,818)    23.65
                                                              ----------
Balance at December 26, 1997 (1,108,353 exercisable)........   2,430,020    $22.19
  Granted...................................................   1,511,550     18.26
  Exercised.................................................     (17,838)    14.45
  Canceled..................................................  (1,296,421)    22.75
                                                              ----------
Balance at December 31, 1998 (981,502 exercisable)..........   2,627,311    $19.70
                                                              ==========
</TABLE>
 
The following table summarizes information about stock options outstanding at
December 31, 1998:
 
<TABLE>
<CAPTION>
                                 Options Outstanding                     Options Exercisable
                   -----------------------------------------------   ----------------------------
                     Number                                            Number
                   Outstanding    Weighted-Avg.       Weighted-      Exercisable     Weighted-
    Range of           at           Remaining            Avg.            at             Avg.
Exercise Prices     12/31/98     Contractual Life   Exercise Price    12/31/98     Exercise Price
---------------    -----------   ----------------   --------------   -----------   --------------
<S>                <C>           <C>                <C>              <C>           <C>
$ 8.34 - $12.75       154,636          1.9              $11.18         154,636         $11.18
 13.44 -  18.50     1,104,325          4.6               16.71         118,650          17.33
 20.25 -  27.38     1,368,350          6.8               23.04         708,216          23.44
---------------     ---------          ---              ------         -------         ------
$ 8.34 - $27.38     2,627,311          5.6              $19.70         981,502         $20.77
===============     =========          ===              ======         =======         ======
</TABLE>
 
                                       41
<PAGE>   44
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
The following table summarizes information about restricted shares:
 
<TABLE>
<CAPTION>
                                                                    Shares
                                                              -------------------
                      Restricted Stock                          1998       1997
                      ----------------                        --------    -------
<S>                                                           <C>         <C>
Outstanding at beginning of year............................    44,350     24,750
Granted.....................................................    22,000     34,500
Vested......................................................   (13,475)    (9,250)
Canceled....................................................    (7,500)    (5,650)
                                                              --------    -------
Outstanding at end of year..................................    45,375     44,350
                                                              ========    =======
Weighted-average fair value of restricted shares granted
  during the year...........................................  $  19.10    $ 22.04
                                                              ========    =======
</TABLE>
 
Restricted shares are issued at par value. Unearned compensation of $486 in 1998
and $539 in 1997, representing the unamortized balance of the fair market value
of the Company's common stock at the date of grant, is amortized over the
four-year vesting period. Amortization of restricted share compensation was
$298, $386 and $252 in 1998, 1997 and 1996, respectively.
 
12. COMMITMENTS AND CONTINGENCIES
 
Leases
 
The Company leases certain property and equipment under long-term operating
leases expiring on various dates through 2016, some of which contain renewal
options. Many of these leases contain clauses for escalations and payment of
real estate taxes, maintenance, insurance and certain other operating expenses
of the properties. Net annual rental expense under these leases was $5,197,
$4,736 and $4,980 in 1998, 1997 and 1996, respectively.
 
Minimum aggregate future rentals are as follows:
 
<TABLE>
<S>                                                           <C>
1999........................................................  $ 3,892
2000........................................................    2,805
2001........................................................    1,719
2002........................................................    1,018
2003........................................................      979
Thereafter..................................................    5,876
                                                              -------
                                                              $16,289
                                                              =======
</TABLE>
 
The Company leases certain property and office space to others under short-term
operating leases expiring on various dates through 2001, some of which contain
renewal options. Net rental income under these leases was $209 in 1998, $216 in
1997 and $223 in 1996.
 
Litigation
 
Various lawsuits and claims are pending against the Company. Although the
outcome of such lawsuits and claims cannot be predicted with certainty, the
disposition thereof will not, in the opinion of management both individually and
in the aggregate, result in a material adverse effect on the Company's results
of operations and financial position.
 
                                       42
<PAGE>   45
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
\13. SUPPLEMENTAL CASH FLOW INFORMATION
 
The following provides additional information concerning cash flow activities:
 
<TABLE>
<CAPTION>
                                                               1998      1997      1996
                                                              ------    ------    ------
<S>                                                           <C>       <C>       <C>
Interest paid ($56 capitalized in 1998 and $498 in 1996)....  $4,542    $1,577    $1,277
                                                              ======    ======    ======
Income taxes paid...........................................  $2,740    $4,854    $4,768
                                                              ======    ======    ======
Non-cash investing and financing activities:
Tax benefit of stock option exercises.......................  $  781    $   --    $   60
                                                              ======    ======    ======
</TABLE>
 
14. OTHER INCOME (EXPENSE)
 
During 1998, the Company realized gains totaling $13,113 related to the sale of
its investment in Physio. Other income (expense) also includes $2,128 in charges
primarily related to the write-down of certain other assets.
 
Foreign currency exchange gains and losses consist of realized gains and losses
on cash transactions involving various foreign currencies and unrealized gains
and losses resulting from exchange rate fluctuations primarily affecting
inter-company accounts. Net gains (losses) from foreign currency transactions
included in other income (expense), net were $363, $(709) and $(236) in 1998,
1997 and 1996, respectively.
 
15. SEGMENT INFORMATION
 
In June 1997, the Financial Accounting Standards Board issued Statement No. 131,
"Disclosures about Segments of an Enterprise and Related Information," which the
Company has adopted in 1998. The Company identifies its business segments based
on management responsibility using a combination of products and geographic
factors. The Company has three reportable segments: US Monitoring, US Cardiology
and International. The US Monitoring segment manufactures, markets, distributes
and services patient monitoring devices and related supplies, clinical
information systems and healthcare screening products throughout the United
States. The US Cardiology segment manufactures, markets, distributes and
services diagnostic cardiology devices and related supplies throughout the
United States. The International segment distributes the Company's monitoring
and cardiology products and related supplies to its subsidiaries and
distributors outside of the United States. The Company measures segment profit
or loss as operating income less research and development, restructuring
charges, acquisition of in-process research and development and certain
unallocated corporate general and administrative expenses. The Company has no
inter-segment revenue.
 
<TABLE>
<CAPTION>
                                                          1998          1997        1996
                                                        --------      --------    --------
<S>                                                     <C>           <C>         <C>
Revenue:
  US Monitoring.......................................  $152,684      $160,941    $165,490
  US Cardiology.......................................    40,222        13,636          --
  International.......................................    81,334        90,702      82,463
                                                        --------      --------    --------
  Total revenue.......................................  $274,240      $265,279    $247,953
                                                        ========      ========    ========
Depreciation and amortization:
  US Monitoring.......................................  $  3,316      $  3,868    $  4,292
  US Cardiology.......................................     1,273           453          --
  International.......................................     1,212         1,347       1,614
  Unallocated.........................................     4,152         3,731       2,678
                                                        --------      --------    --------
  Total depreciation and amortization.................  $  9,953      $  9,399    $  8,584
                                                        ========      ========    ========
</TABLE>
 
                                       43
<PAGE>   46
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
<TABLE>
<CAPTION>
                                                          1998          1997        1996
                                                        --------      --------    --------
<S>                                                     <C>           <C>         <C>
Segment profit:
  US Monitoring.......................................  $ 33,081      $ 39,454    $ 43,562
  US Cardiology.......................................     3,672         1,371          --
  International.......................................     7,389        14,658      11,342
                                                        --------      --------    --------
  Total segment profit................................  $ 44,142      $ 55,483    $ 54,904
Reconciliation of segment profit to income (loss)
  before income taxes:
  Unallocated general and administrative expenses.....  $ (4,802)     $ (3,604)   $ (4,222)
  Unallocated cost of sales expenses..................    (7,168)(a)        --          --
  Research and development............................   (30,715)      (31,614)    (28,293)
  Restructuring and acquisition of in-process research
     and development..................................    (3,559)      (34,878)    (15,923)
  Other income (expense)..............................     6,475        (1,467)      1,608
                                                        --------      --------    --------
  Income (loss) before income taxes...................  $  4,373      $(16,080)   $  8,074
                                                        ========      ========    ========
</TABLE>
 
---------------
(a) Includes inventory and assets write-downs and accrual for Year 2000 warranty
    issues.
 
<TABLE>
<CAPTION>
                                                          1998          1997        1996
                                                        --------      --------    --------
<S>                                                     <C>           <C>         <C>
Total assets:
  US Monitoring.......................................  $103,106      $ 95,407    $ 96,795
  US Cardiology.......................................    18,914        11,205          --
  International.......................................    64,197        59,960      54,765
  Unallocated.........................................    99,830       123,620     105,885
                                                        --------      --------    --------
  Total assets........................................  $286,047      $290,192    $257,445
                                                        ========      ========    ========
Capital expenditures:
  US Monitoring.......................................  $  5,115      $  5,954    $ 11,027
  US Cardiology.......................................     1,279           136          --
  International.......................................     1,078         2,222       5,021
  Unallocated.........................................       862         1,303       2,237
                                                        --------      --------    --------
  Total capital expenditures..........................  $  8,334      $  9,615    $ 18,285
                                                        ========      ========    ========
</TABLE>
 
The following geographic information includes revenue based on product shipment
destination and property, plant and equipment based on physical location:
 
<TABLE>
<CAPTION>
                                                            1998        1997        1996
                                                          --------    --------    --------
<S>                                                       <C>         <C>         <C>
Revenue:
  United States.........................................  $192,906    $174,577    $165,490
  Rest of world.........................................    81,334      90,702      82,463
                                                          --------    --------    --------
  Total.................................................  $274,240    $265,279    $247,953
                                                          ========    ========    ========
Property, plant and equipment, net:
  United States.........................................  $ 64,346    $ 64,549    $ 60,939
  Rest of world.........................................       800         785         776
                                                          --------    --------    --------
  Total.................................................  $ 65,146    $ 65,334    $ 61,715
                                                          ========    ========    ========
Net assets of international operations..................  $ 20,727    $ 21,304    $ 23,045
                                                          ========    ========    ========
</TABLE>
 
                                       44
<PAGE>   47
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
16. RESTRUCTURING OF OPERATIONS
 
During the first half of 1998, the Company recorded charges totaling $3,559
associated with a restructuring program related to improving the Company's cost
structure. The charges represent the cost of employee severance benefits and
related expenditures for 86 employees, office closure and moving costs
associated with the elimination of two research offices and three sales offices,
and related asset impairment charges. A summary of these charges follows:
 
<TABLE>
<CAPTION>
                                       Employee       Other        Asset       Office
                                       Severance    Personnel    Impairment    Closure
                                       Benefits       Costs       Charges       Costs     Total
                                       ---------    ---------    ----------    -------    ------
<S>                                    <C>          <C>          <C>           <C>        <C>
1998 charges.........................   $1,364       $1,224         $601        $370      $3,559
Utilized in 1998.....................    1,240        1,074          601         370       3,285
                                        ------       ------         ----        ----      ------
Remaining liability at December 31,
  1998...............................   $  124       $  150         $ --        $ --      $  274
                                        ======       ======         ====        ====      ======
</TABLE>
 
As of December 31, 1998, 85 employees have separated in connection with the 1998
restructuring activities.
 
In conjunction with the 1997 acquisition of Spacelabs Burdick, the Company
recorded a charge of $911 related to the restructuring of certain duplicative
activities. A summary of these charges follows:
 
<TABLE>
<CAPTION>
                                                        Employee       Asset
                                                        Severance    Impairment
                                                        Benefits      Charges      Other    Total
                                                        ---------    ----------    -----    -----
<S>                                                     <C>          <C>           <C>      <C>
1997 charges..........................................    $212          $351       $ 348    $ 911
Utilized in 1997......................................      95            --          13      108
                                                          ----          ----       -----    -----
Liability at December 31, 1997........................     117           351         335      803
Reclassifications.....................................      14           167        (181)      --
Utilized in 1998......................................     131           518         154     (803)
                                                          ----          ----       -----    -----
Remaining liability at December 31, 1998..............    $ --          $ --       $  --    $  --
                                                          ====          ====       =====    =====
</TABLE>
 
The Company also incurred restructuring charges of $7,126 in 1996 related to the
consolidation of manufacturing and customer service operations in its Redmond,
Washington facility.
 
17. ACQUISITION OF IN-PROCESS RESEARCH AND DEVELOPMENT
 
In 1997 and 1996, the Company acquired in-process research and development
("IPR&D") associated with various investment and acquisition activities as
follows:
 
<TABLE>
<CAPTION>
                                                               1997       1996
                                                              -------    ------
<S>                                                           <C>        <C>
Spacelabs Burdick, Inc......................................  $21,400    $   --
Advanced Medical Systems....................................    6,567        --
Ameritech Knowledge Data, Inc...............................    6,000        --
JRS Technologies, Inc.......................................       --     7,312
DSA Systems, Inc............................................       --     1,485
                                                              -------    ------
                                                              $33,967    $8,797
                                                              =======    ======
</TABLE>
 
Each IPR&D project identified at the time of the acquisition was evaluated as to
its state of completion and its technological feasibility in accordance with
Statement of Financial Accounting Standards No. 2
 
                                       45
<PAGE>   48
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
and Financial Accounting Standards Board Interpretation No. 4. Since the
acquired IPR&D had not demonstrated technological feasibility and had no
alternative future use, it was recognized as a period expense.
 
The value assigned to IPR&D for each of the acquisitions was determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from such
projects, and discounting the net cash flows back to their present values. The
discount rate includes a factor that takes into account the uncertainty
surrounding the successful development of the purchased in-process technology.
The resulting net cash flows were based on management's estimates of revenue,
cost of sales, research and development costs, selling, general and
administrative expenses and income taxes from such projects.
 
18. BUSINESS COMBINATIONS
 
On August 21, 1997, the Company acquired for cash all the outstanding shares of
common stock of Spacelabs Burdick. Spacelabs Burdick develops and manufactures
diagnostic cardiology equipment in Milton, Wisconsin. The Spacelabs Burdick
acquisition was recorded under the purchase method of accounting. Accordingly,
the results of Spacelabs Burdick's operations from August 21, 1997 are included
in the Company's consolidated financial statements. The purchase price of
$51,234, including acquisition costs, has been allocated to assets acquired and
liabilities assumed based on their fair market value at the date of acquisition,
as well as to acquired in-process research and development (see Note 17). The
excess of the purchase price over the fair market value of the net identifiable
tangible assets has been recorded as goodwill of $19,110 and other intangible
assets of $6,698.
 
In connection with the acquisition, the Company initiated a plan to integrate
the Spacelabs Burdick operations into the Company's existing operations. The
integration plan was to eliminate duplicate technologies and production
capacity, relocate the Spacelabs Burdick operation to a smaller facility in the
same regional area and provide for consolidation of the workforce attributed to
the integrated operations. Estimated costs associated with this plan were:
 
<TABLE>
<CAPTION>
                               Employee       Other      Eliminate     Facility
                               Severance    Personnel    Duplicate     Closure
                               Benefits       Costs      Technology     Costs      Other    Total
                               ---------    ---------    ----------    --------    -----    ------
<S>                            <C>          <C>          <C>           <C>         <C>      <C>
Acquisition liability........   $1,246       $1,254         $361         $809      $594     $4,264
Utilized in 1997.............       --           --           --           --        33         33
                                ------       ------         ----         ----      ----     ------
Remaining liability at
  December 26, 1997..........    1,246        1,254          361          809       561      4,231
Utilized in 1998.............      207          744           --          275       258      1,484
Liability adjustment.........      832          319          129          318        --      1,598
                                ------       ------         ----         ----      ----     ------
Remaining liability at
  December 31, 1998..........   $  207       $  191         $232         $216      $303     $1,149
                                ======       ======         ====         ====      ====     ======
</TABLE>
 
During 1998, the original accrual estimates decreased by $1.6 million, which
resulted in a corresponding decrease in goodwill. Any future decreases in the
accrual estimates will likewise decrease goodwill, while increases in the
original accrual estimate will be recorded as operating expenses.
 
The following unaudited pro forma financial information presents the combined
results of operations of the Company and Spacelabs Burdick as if the acquisition
had occurred as of the beginning of 1997 and 1996 after giving effect to certain
adjustments, including amortization of goodwill, increased interest expense on
debt related to the acquisition, in-process research and development and
restructuring
 
                                       46
<PAGE>   49
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
charges, and related income tax effects. The pro forma financial information
does not necessarily reflect the results of operations that would have occurred
had the Company and Spacelabs Burdick operated as a single entity during such
periods.
 
<TABLE>
<CAPTION>
                                                                1997        1996
                                                              --------    --------
<S>                                                           <C>         <C>
Revenue.....................................................  $293,180    $299,995
Net loss....................................................  $(24,247)   $(22,505)
Basic and diluted net loss per share........................  $  (2.54)   $  (2.22)
</TABLE>
 
The Company also acquired Advanced Medical Systems, Inc. ("AMS") and AKD in the
first and third quarters of 1997, respectively. The total purchase price of
these two acquisitions, including acquisition costs, was $14,991 and the
purchase method of accounting was used. To determine fair market value and
acquired in-process research and development in these two acquisitions, the
basis of allocation was the same as that used in the Spacelabs Burdick purchase.
Pro forma financial information has not been included for these two acquisitions
because, exclusive of the impact of in-process research and development, they
are not material to the Company's operations.
 
19. FAIR VALUE OF FINANCIAL INSTRUMENTS
 
The following fair value amounts have been determined using available market
information and appropriate valuation methodologies. However, considerable
judgment is required in interpreting market data to develop the estimates of
fair value. Accordingly, the estimates presented herein are not necessarily
indicative of the amounts that the Company could realize in a current market
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts
provided below.
 
<TABLE>
<CAPTION>
                                                                1998                   1997
                                                         -------------------    -------------------
                                                         Carrying     Fair      Carrying     Fair
                                                          Amount      Value      Amount      Value
                                                         --------    -------    --------    -------
<S>                                                      <C>         <C>        <C>         <C>
Cash, cash equivalents and short-term investments......  $ 1,467     $ 1,467    $12,934     $12,934
Marketable equity securities and long-term investments
  Physio Control International Corporation.............       --          --    $10,413     $10,413
  Investments for which it is not practicable to
     estimate fair value...............................  $ 4,151          --    $ 4,651          --
  Other................................................  $   950     $   950    $ 1,732     $ 1,732
Long-term debt.........................................  $65,893     $65,893    $72,353     $72,353
Interest rate swap agreements..........................       --     $(1,981)        --     $  (823)
</TABLE>
 
Cash, Cash Equivalents and Short-term Investments: The fair value of short-term
investments is estimated based on quoted market prices for those or similar
investments. At December 31, 1998 and December 26, 1997, the carrying values
approximated fair values.
 
Marketable Equity Securities: The fair value of these securities is based on
quoted market prices.
 
Long-Term Investments: The fair value of other investments was estimated based
on existing market conditions. Investments for which it was not practicable to
estimate the fair value consist primarily of the stock of two nonpublic
companies.
 
Long-Term Debt: The carrying amount of the Company's long-term debt approximates
its fair value as interest rates on the underlying debt instruments are variable
in nature and tied to prevailing market rates.
 
                                       47
<PAGE>   50
                            SPACELABS MEDICAL, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
                 (dollars in thousands, except per-share data)
 
Interest Rate Swap Agreement: The fair value of this agreement, as well as the
fair value of the previously existing swap arrangement, was based upon an
estimate of the amount at which the agreements could be settled between the
counterparties.
 
20. QUARTERLY FINANCIAL DATA (UNAUDITED)
 
<TABLE>
<CAPTION>
                                                                 Quarter
                                                   ------------------------------------
                                                   First     Second    Third     Fourth     Year
                                                   ------    ------    ------    ------    ------
                                                        (in millions, except per-share data)
<S>                                                <C>       <C>       <C>       <C>       <C>
1998
Revenue..........................................  $ 66.5    $66.0     $ 67.5    $74.2     $274.2
Gross Margin.....................................    26.2     28.0       32.8     36.4      123.4
Income (loss) before income taxes................    (1.4)    (0.5)       2.7      3.5        4.3
 
Net income (loss)................................    (0.9)    (0.3)       1.7      2.2        2.7
Basic net income (loss) per share................  $(0.09)   $(0.03)   $ 0.18    $0.23     $ 0.29
Diluted net income (loss) per share..............   (0.09)   (0.03)      0.18     0.23       0.29
 
1997
Revenue..........................................  $ 63.0    $62.1     $ 65.3    $74.9     $265.3
Gross Margin.....................................    31.5     31.2       32.4     36.3      131.4
Income (loss) before income taxes................    (1.3)     4.7      (24.1)     4.6      (16.1)
Net income (loss)................................    (3.3)     3.0      (23.0)     2.9      (20.4)
 
Basic net income (loss) per share................  $ (.34)   $ .31     $(2.41)   $ .31     $(2.13)
Diluted net income (loss) per share..............    (.34)     .31      (2.41)     .30      (2.13)
</TABLE>
 
Significant events impacting quarterly results are discussed in Notes 14, 16, 17
and 18.
 
                                       48
<PAGE>   51
 
                            SPACELABS MEDICAL, INC.
 
                          INDEPENDENT AUDITORS' REPORT
 
The Board of Directors and Shareholders
Spacelabs Medical, Inc.
 
We have audited the consolidated financial statements of Spacelabs Medical, Inc.
and subsidiaries as listed in the accompanying index. In connection with our
audits of the consolidated financial statements, we also have audited the
financial statement schedule as listed in the accompanying index. These
consolidated financial statements and the financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements and the financial statement
schedule based on our audits.
 
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Spacelabs Medical,
Inc. and subsidiaries as of December 31, 1998 and December 26, 1997 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998 in conformity with generally accepted
accounting principles. Also in our opinion, the related financial statement
schedule, when considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly, in all material respects, the
information set forth therein.
 
                                      KPMG LLP
 
Seattle, Washington
February 3, 1999
 
                                       49
<PAGE>   52
 
                                  SCHEDULE II
 
                            SPACELABS MEDICAL, INC.
 
                       VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                         Additions
                                                  -----------------------
                                     Balance at                Charged to                   Balance at
                                     Beginning    Charged to     Other                        End of
            Description              of Period     Expense      Accounts    Deductions(2)     Period
            -----------              ----------   ----------   ----------   -------------   ----------
<S>                                  <C>          <C>          <C>          <C>             <C>
Year ended December 31, 1998
  Valuation accounts deducted from
     assets:
  Allowance for doubtful
     accounts......................    $2,708        $951        --             $687          $2,972
                                       ======        ====         ====          ====          ======
Year ended December 26, 1997
  Valuation accounts deducted from
     assets:
  Allowance for doubtful
     accounts......................    $1,709        $241         $958(1)       $200          $2,708
                                       ======        ====         ====          ====          ======
Year ended December 27, 1996
  Valuation accounts deducted from
     assets:
  Allowance for doubtful
     accounts......................    $1,780        $ 16        --             $ 87          $1,709
                                       ======        ====         ====          ====          ======
</TABLE>
 
---------------
(1) Includes $715 and $243 relating to the acquisition of Spacelabs Burdick and
    AMS, respectively.
 
(2) Accounts charged off, net of recoveries.
 
                                       50
<PAGE>   53
 
            ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
                      ACCOUNTING AND FINANCIAL DISCLOSURE
 
None.
 
                                    PART III
 
        ITEMS 10-13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
Except for the information included in Part I, Item 4 of this report, the
information required by Part III (Items 10-13) is set forth in Spacelabs
Medical's definitive proxy statement, which will be filed pursuant to Regulation
14A within 120 days of December 31, 1998. Such information is incorporated
herein by reference and made a part hereof.
 
                                    PART IV
 
    ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
A. LIST OF DOCUMENTS FILED AS A PART OF THIS REPORT
 
  1. INDEX TO FINANCIAL STATEMENTS
 
     - Consolidated Balance Sheets as of December 31, 1998 and December 26, 1997
 
     - Consolidated Statements of Operation for each of the years in the
       three-year period ended December 31, 1998
 
     - Consolidated Statements of Cash Flows for each of the years in the
       three-year period ended December 31, 1998
 
     - Consolidated Statements of Shareholders' Equity for each of the years in
       the three-year period ended December 31, 1998
 
     - Notes to Consolidated Financial Statements
 
  2. INDEX TO FINANCIAL STATEMENT SCHEDULES
 
     - Schedule II -- Valuation and Qualifying Accounts
 
  3. INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
      EXHIBIT NO.                            DESCRIPTION
      -----------                            -----------
      <C>            <S>
            *3.1     Certificate of Incorporation of Spacelabs Medical, Inc.
         ++++3.2     Amended and Restated By-Laws of Spacelabs Medical, Inc.
            *4.1     Form of Rights Agreement dated as of June 26, 1992 between
                     Spacelabs Medical, Inc. and First Chicago Trust Company of
                     New York, as Rights Agent, which includes as Exhibit A the
                     Certificate of Designation relating to the Series A
                     Participating Cumulative Preferred Stock and as Exhibit B
                     the form of Rights Certificate.
            *4.2     Form of Common Stock Certificate of Spacelabs Medical, Inc.
       #++++10.3     1992 Option, Stock Appreciation Right, Restricted Stock,
                     Stock Grant and Performance Unit Plan of Spacelabs Medical,
                     Inc., as amended and restated on May 10, 1995.
          #*10.4     Spacelabs Medical, Inc. 1992 Adjustment Plan.
           #10.5     Stock Option and Deferral Plan for Nonemployee Directors, as
                     amended and restated on October 30, 1998.
</TABLE>
 
                                       51
<PAGE>   54
 
<TABLE>
<CAPTION>
      EXHIBIT NO.                            DESCRIPTION
      -----------                            -----------
      <C>            <S>
          #*10.6     Management Incentive Compensation Plan of Spacelabs Medical,
                     Inc.
       *****10.7     Amended and Restated Change of Control Agreement dated July
                     24, 1998 between Spacelabs Medical, Inc. and Carl A.
                     Lombardi.
           *10.16    Letter Agreement dated September 8, 1984 between Spacelabs
                     Medical, Inc. and Technology Concepts Inc. and amendment
                     thereto dated August 12, 1985.
           *10.17    Software OEM License Agreement dated January 20, 1984
                     between Spacelabs Medical, Inc. and Hunter & Ready, Inc.
           *10.18    Software Development and Production License Agreement
                     between Spacelabs Medical, Inc. and Ready Systems
                     Corporation.
         #++10.19    1993 Nonofficer Employee Option, Stock Appreciation Right,
                     Restricted Stock, Stock Grant and Performance Unit Plan of
                     Spacelabs Medical, Inc.
         +++10.20    Product Development and Purchase Agreement dated October 26,
                     1991 between Spacelabs Medical, Inc. and General Scanning,
                     Inc.
         +++10.21    Development and Manufacturing Agreement dated February 11,
                     1992 between Spacelabs Medical, Inc. and Wyse Technology,
                     Inc.
         ***10.22    VxWorks(TM(2) Software License Agreement dated August 27,
                     1991 as amended by amendments dated January 31, 1992 and
                     April 24, 1992 between Spacelabs Medical, Inc. and Wind
                     River Systems, Inc.
         ***10.23    ASIC Design and Purchase Agreement between Spacelabs
                     Medical, Inc. and LSI Logic Corporation signed by Spacelabs
                     Medical, Inc. on March 9, 1992.
        ++++10.27    Limited Liability Company Agreement of SMD Software, L.L.C.
                     dated January 1, 1996 between Spacelabs Medical, Inc. and
                     DSA Systems, Inc.
        ++++10.28    Stock Purchase and Option Agreement dated February 10, 1995
                     by and among Spacelabs Medical, Inc., JRS Clinical
                     Technologies, Inc. ("JRS") and certain of the shareholders
                     of JRS.
            10.31    Loan Agreement among Spacelabs Medical, Inc. (California),
                     Seattle-First National Bank and Spacelabs Medical, Inc.
                     (Delaware) dated December 7, 1995, as amended and restated
                     on July 16, 1997, October 16, 1997 and October 15, 1998.
        ++++10.32    ISDA Master Agreement between Spacelabs Medical, Inc. and
                     Seattle-First National Bank dated October 12, 1995.
        ****10.34    Agreement and Plan of Merger dated July 11, 1997 by and
                     among Spacelabs Medical, Inc. (California), SLMD Acquisition
                     Corporation, Burdick, Inc. and certain shareholders of
                     Burdick, Inc.
       *****10.35    Change of Control Agreement dated July 24, 1998 between
                     Spacelabs Medical, Inc. and James A. Richman.
       *****10.36    Change of Control Agreement dated July 24, 1998 between
                     Spacelabs Medical, Inc. and Eugene V. DeFelice.
      ******10.37    Lease Agreement dated April 6, 1998 between Carl Ruedebusch
                     LLC and Burdick, Inc.
            10.38    Modification, dated December 23, 1998, to Loan Agreement
                     among Spacelabs Medical, Inc. (California) Seattle-First
                     National Bank and Spacelabs Medical, Inc. (Delaware) dated
                     December 7, 1995, as amended and restated.
            21.1     Subsidiaries of Spacelabs Medical, Inc.
</TABLE>
 
---------------
 
(2)VxWorks(TM) is a trademark of Wind River Systems, Inc.
 
                                       52
<PAGE>   55
 
<TABLE>
<CAPTION>
      EXHIBIT NO.                            DESCRIPTION
      -----------                            -----------
      <C>            <S>
            23.1     Consent of KPMG LLP.
            27.1     Financial Data Schedule
</TABLE>
 
---------------
       * Previously filed with, and incorporated herein by reference to,
         Registration Statement on Form S-1 of Spacelabs Medical, Inc., file No.
         0-20083.
 
      ** Previously filed with, and incorporated herein by reference to,
         Registration Statement on Form 10 of Westmark International
         Incorporated, File No. 0-15160.
 
     *** Previously filed with, and incorporated herein by reference to, Annual
         Report on Form 10-K of Spacelabs Medical, Inc., File No. 0-20083, filed
         on March 22, 1995.
 
    **** Previously filed with, and incorporated herein by reference to Report
         on Form 8-K of Spacelabs Medical, Inc., filed on September 5, 1997.
 
   ***** Previously filed with, and incorporated herein by reference to 
         Quarterly Report on Form 10-Q of Spacelabs Medical, Inc., filed on 
         August 10, 1998.
 
  ****** Previously filed with, and incorporated herein by reference to 
         Quarterly Report on Form 10-Q of Spacelabs Medical, Inc., filed on 
         November 9, 1998.
 
       + Previously filed with, and incorporated herein by reference to, Annual
         Report on Form 10-K of Westmark International Inc., File No. 0-15160,
         filed on March 21, 1989.
 
      ++ Previously filed with, and incorporated by reference to, Annual Report
         on Form 10-K of Spacelabs Medical, Inc., File No. 0-20083, filed on
         March 16, 1994.
 
     +++ Previously filed and incorporated by reference to, Amendment on Form
         10-K/A to Annual Report on Form 10-K of Spacelabs Medical, Inc., File
         No. 0-20083, filed on May 9, 1995.
 
    ++++ Previously filed and incorporated by reference to Annual Report on Form
         10-K of Spacelabs Medical, Inc., File No. 0-020083, filed on March 22,
         1996.
 
         # Indicates that the Exhibit is a Compensatory Plan or Agreement.
 
                                       53
<PAGE>   56
 
B. REPORTS ON FORM 8-K
 
During the fourth quarter of 1998, the Company filed with the Securities and
Exchange Commission a Form 8-K, dated October 30, 1998, with respect to a change
in the Company's fiscal closing date.
 
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.
 
                                      SPACELABS MEDICAL, INC.
 
                                      (Registrant)
 
                                      By         /s/  CARL A. LOMBARDI
                                        ----------------------------------------
                                        Carl A. Lombardi
                                        Chairman of the Board
 
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>
<S>                                  <C>                <C>                                  <C>
 
       /s/ CARL A. LOMBARDI          February 26, 1999     /s/ THOMAS J. DUDLEY, D.B.A.      February 26, 1999
-----------------------------------                     -----------------------------------
         Carl A. Lombardi                                    Thomas J. Dudley, D.B.A.
  Chairman of the Board and Chief                                    Director
         Executive Officer
 
       /s/ JAMES A. RICHMAN          February 26, 1999    /s/ PHILLIP M. NUDELMAN, PH.D.     February 26, 1999
-----------------------------------                     -----------------------------------
         James A. Richman                                   Phillip M. Nudelman, Ph.D.
   Vice President and Corporate                                      Director
  Controller (Principal Financial
             Officer)
 
       /s/ GILBERT ANDERSON          February 26, 1999      /s/ HARVEY FEIGENBAUM, M.D.      February 26, 1999
-----------------------------------                     -----------------------------------
         Gilbert Anderson                                     Harvey Feigenbaum, M.D.
             Director                                                Director
 
  /s/ ANDREW R. NARA, M.D., PH.D.    February 26, 1999        /s/ PETER H. VAN OPPEN         February 26, 1999
-----------------------------------                     -----------------------------------
    Andrew R. Nara, M.D., Ph.D.                                 Peter H. van Oppen
             Director                                                Director
</TABLE>
 
                                       54
<PAGE>   57

                                INDEX TO EXHIBITS


<TABLE>
<CAPTION>
       EXHIBIT NO.    DESCRIPTION
<S>                   <C>
           10.5       Stock Option and Deferral Plan for Nonemployee
                      Directors, as amended and restated on October 30, 1998.

          10.31       Loan Agreement among Spacelabs Medical, Inc.
                      (California), Seattle-First National Bank and Spacelabs
                      Medical, Inc. (Delaware) dated December 7, 1995, as
                      amended and restated on July 16, 1997, October 16, 1997
                      and October 15, 1998.

          10.38       Modification, dated December 23, 1998, to Loan
                      Agreement among Spacelabs Medical, Inc. (California)
                      Seattle-First National Bank and Spacelabs Medical, Inc.
                      (Delaware) dated December 7, 1995, as amended and
                      restated.

           21.1       Subsidiaries of Spacelabs Medical, Inc.

           23.1       Consent of KPMG LLP.

           27.1       Financial Data Schedule
</TABLE>