MANAGEMENT'S  DISCUSSION  AND ANALYSIS OF RESULTS OF  OPERATIONS  AND  FINANCIAL
CONDITION

Results of Operations

The following  discussion  should be read in conjunction  with the  Consolidated
Financial  Statements  and Notes  thereto  contained  elsewhere  in this  Annual
Report.

Revenue
<TABLE>
<CAPTION>
(dollars in millions)
---------------------                              Percent                 Percent
December 31,                            1998        change        1997      change            1996
<S>                                   <C>          <C>         <C>          <C>             <C>
Software revenue
    Domestic                          $ 107.7          20%      $ 89.7            2%        $  87.6
    International                        63.5          48%        43.0          (19%)          53.1
                                     --------      -------     --------     ---------       --------
    Total software revenue            $ 171.2          29%      $132.7           (6%)       $ 140.7
       Percentage of total revenue         55%                      53%                          52%

Customer support revenue
     Domestic                         $ 57.0           31%      $ 43.4           25%         $  34.8
     International                      16.5           50%        11.0           18%             9.3
                                     --------      -------     --------     ---------       --------
     Total customer support revenue   $ 73.5           35%      $ 54.4           23%         $  44.1
        Percentage of total revenue       24%                       22%                           16%

Professional services revenue
     Domestic                         $ 20.4           47%      $ 13.9            6%         $  13.1
     International                       6.0           18%         5.1          (29%)            7.2
                                     --------      -------     --------     ---------       --------
     Total professional services      $ 26.4           39%      $ 19.0           (6%)        $  20.3
        revenue
        Percentage of total revenue        8%                        7%                            8%

Hardware revenue
     Domestic                         $ 17.1          (16%)     $ 20.4          (28%)        $  28.3
     International                       6.5          (28%)        9.0          (49%)           17.8
                                     --------      -------     --------     ---------       --------
     Total hardware revenue           $ 23.6          (20%)     $ 29.4          (36%)        $  46.1
        Percentage of total revenue        8%                      12%                            17%

Education and other revenue
     Domestic                         $ 10.2           (5%)     $ 10.7          (21%)        $  13.5
     International                       5.3            2%         5.2           24%             4.2
                                     --------      -------     --------     ---------       --------
     Total other revenue              $ 15.5           (3%)     $ 15.9          (10%)        $  17.7
        Percentage of total revenue        5%                        6%                            7%

Total revenue
     Domestic                         $212.4           19%      $178.1            0          $ 177.3
     International                      97.8           33%        73.3          (20%)           91.6
                                     --------      -------     --------     ---------       --------
     Total revenue                    $310.2           23%      $251.4           (7%)        $ 268.9
                                     ========      =======     ========     =========       ========
</TABLE>

Software revenue from the licensing of the Company's software products increased
29% in 1998 due to an increase in the volume of shipments both  domestically and
internationally, including the Company's Panagon product line which was released
during the first quarter of 1998. The magnitude of the increase in 1998 software
revenue is partially attributable to weakness in orders during the first quarter
of 1997 and may not be indicative of future revenue  growth.  The 6% decrease in
software revenue in 1997 was due to a decrease in new domestic orders during the
first quarter of 1997 and a decrease in new  international  orders for the year,
offset by increased demand experienced  domestically during the third and fourth
quarters.

Customer support revenue consists of revenue from maintenance contracts and "fee
for service"  revenues.  Customer support revenue  increased 35% and 23% in 1998
and 1997,  respectively,  due to increased  maintenance revenue  attributable to
growth in the Company's installed base.

Professional  services  revenue  is  generated  primarily  from  consulting  and
implementation services provided to end users of the Company's software products
and technical  consulting  services  provided to the Company's  resellers.  Such
services are  primarily  performed on a time and  material  basis.  Professional
services revenue increased 39% in 1998 over 1997. This increase was attributable

                                       16
<PAGE>
to the Company's  efforts  discussed  below to build its  professional  services
capabilities to support its solutions-oriented  strategy.  Professional services
revenue  decreased  6% in 1997 from 1996.  This  decrease  was  attributable  to
weakness in the international market for such services.

Hardware  revenue is now generated  primarily  from the sale of 12-inch  optical
storage  and  retrieval  libraries  (OSAR) and  third-party  hardware.  Hardware
revenue decreased 20% and 36% in 1998 and 1997, respectively, as expected due to
customers ordering competitive products. The Company expects hardware revenue to
continue  to decline  in both  absolute  dollars  and as a  percentage  of total
revenue.

Other  revenue is generated  from the sale of spare parts,  education  services,
supplies and "third party" products.  Other revenue decreased 3% and 10% in 1998
and 1997, respectively, as expected due to a decrease in demand for spare parts.
The decrease in revenue for spare parts was  partially  offset by an increase in
revenue from education services.

International  revenue  represented  32%, 29% and 34% of total revenues in 1998,
1997 and 1996,  respectively.  The  relatively low percentage in 1997 was due to
weakness in order levels in the  European  market and, to a lesser  extent,  the
strengthening of the U.S. dollar against foreign currencies. The Company expects
international revenue to continue to represent a significant percentage of total
revenue.  However,  the current  economic  crises in several parts of the world,
particularly  Asia and Latin America,  is and could continue to adversely affect
international  sales.  In addition,  international  revenues  could be adversely
affected if the U.S. dollar strengthens against international currencies.

Cost of Revenue

<TABLE>
<CAPTION>
(dollars in millions)
---------------------                                       Percent             Percent
December 31,                                        1998     change       1997   change       1996
<S>                                              <C>        <C>        <C>      <C>        <C>
Cost of software revenue                         $  16.8       25%     $  13.4     (13%)   $  15.4
    Percentage of software revenue                    10%                   10%                 11%
Cost of customer support revenue                 $  34.7       29%     $  26.9      13%    $  23.9
    Percentage of customer service revenue            47%                   49%                 54%
Cost of professional services revenue            $  22.5       52%     $  14.8      (9%)   $  16.3
    Percentage of professional services 
     revenue                                          85%                   78%                 80%
Cost of hardware revenue                         $  13.2      (35%)    $  20.3     (31%)   $  29.6
    Percentage of hardware revenue                    56%                   69%                 64%
Cost of education and other revenue              $  16.6       12%     $  14.8      10%    $  13.4

Percentage of other revenue                          107%                   93%                 76%
                                                 -----------------     -----------------------------
Cost of total revenue                             $103.8       15%     $  90.2      (9%)   $  98.6
                                                 =================     =============================
</TABLE>
The cost of software  revenue  includes  royalties paid to third parties and the
cost of software  distribution.  The cost of software revenue as a percentage of
software  revenue was 10% in 1998 and 1997 compared to 11% in 1996. The decrease
in 1997 was due to savings related to the consolidation of software distribution
activities.

The cost of  customer  support  revenue  includes  customer  support  personnel,
supplies, and the cost of third party hardware maintenance. The cost of customer
support revenue as a percentage of customer support revenue  decreased to 47% in
1998  from  49% in 1997  and 54% in 1996.  The  decrease  in 1998 was due to the
higher  proportion of fees for service revenue and the transition of higher cost
hardware maintenance services to a third party contractor.  The decrease in 1997
is primarily  due to the  transition  of hardware  maintenance  to a third party
contractor, offset by lower margins associated with international maintenance.

The cost of professional  services  revenue  consists  primarily of professional
services  personnel  and  third  party  contractors.  The  cost of  professional
services revenue as a percentage of professional  services revenue  increased to
85% in 1998 from 78% in 1997. This increase was primarily due to the addition of
professional  services personnel to support the Company's  announced strategy of
delivering  complete  document  management  solutions  to  customers,  including
related  consulting  services.  Most of these personnel were added in the latter

                                       17
<PAGE>
half of 1998 and did not  become  productive  prior to the end of the year.  The
cost of professional  services revenue as a percentage of professional  services
revenue  decreased  to  78%  in  1997  from  80%  in  1996.  This  decrease  was
attributable  to a reduction  in the  professional  services  cost  structure in
response to decreasing international professional services revenue.

The Company  believes that  competition  for qualified  technical and managerial
personnel for its  professional  services  segment is intense and will remain so
for the  foreseeable  future.  This may result in higher levels of  compensation
expense and, hence, higher cost of professional services revenue. Such costs may
also be adversely  affected if the Company uses outside  contractors  at greater
than anticipated levels to fulfill contracts.

The  cost  of  hardware  revenue  includes  the  cost  of  manufacturing  OSARs,
third-party  purchased hardware and the cost of hardware integration  personnel.
The cost of hardware  revenue as a percentage of hardware  revenue  decreased to
56% in  1998  from  69% in  1997  and  64% in  1996.  The  decrease  in  1998 is
attributable to a reduction in fixed  manufacturing  costs. The increase in 1997
is due to a decrease in hardware  revenue  without a  corresponding  decrease in
fixed costs  related to the Company's  hardware  manufacturing  and  integration
activities.

The cost of  education  and other  revenue  includes  the costs of spare  parts,
education services,  supplies and third party product. The cost of education and
other revenue as a percentage  of education and other revenue  increased to 107%
in 1998 from 93% in 1997. This increase was primarily due to the increased costs
of education services.

Research and Development and Selling, General and Administrative Expense

<TABLE>
<CAPTION>
(dollars in millions)
----------------------                              Percent                  Percent
December 31,                              1998       change         1997      change          1996
<S>                                    <C>          <C>          <C>         <C>           <C>
Research and development               $  50.1          22%      $  40.9          9%       $  37.6
    Percentage of total revenue            16%                       16%                       14%

Selling, general and administrative    $ 156.8          25%      $ 125.1          6%       $ 117.8
    Percentage of total revenue            51%                       50%                       44%
</TABLE>

Research and  development  expenses  increased  22% in 1998  primarily due to an
increase in salaries and facilities costs and an increase in the use of contract
developers  necessitated  by the intense  competitive  environment  for software
engineers.  The 9% increase in 1997 was primarily  due to a general  increase in
salaries.  As a percentage of total revenue,  research and development  expenses
increased to 16% in 1997 due to the decrease in revenue and the increased  level
of spending.

The Company  expects that  competition  for qualified  technical  personnel will
remain  intense for the  foreseeable  future and may result in higher  levels of
compensation  expense for the Company.  The Company  believes  that research and
development  expenditures,  including  compensation of technical personnel,  are
essential to  maintaining  its  competitive  position and expects these costs to
continue to constitute a significant percentage of revenue.

Selling,  general and  administrative  expenses  increased 25% in 1998 and 6% in
1997.  The increase in 1998 was due  primarily to the expansion of the Company's
sales force, an increase in sales training costs, and an increase in commissions
and advertising which were in part offset by lower legal expenses.  The increase
in 1997 was due primarily to the Company's continued international expansion and
higher legal costs (see Note 12 of Notes to  Consolidated  Financial  Statements
for a description of legal  proceedings).  Selling,  general and  administrative
expenses as a percentage of total  revenue was 51% in 1998,  50% and 44% in 1997
and 1996, respectively. The increase from each year was primarily due to expense
levels increasing at a more rapid rate than revenue.

Restructuring,   Merger,   Write-off  of  Purchased   In-process   Research  and
Development and Other Costs: The $2.0 million in  restructuring  and other costs
in 1998  represents  the costs of a reduction in headcount  associated  with the
restructuring of the Company's sales and marketing operations,  as well as costs
of consolidating facilities. The restructuring and other costs include

                                       18
<PAGE>
approximately $1.1 million for severance payments for 54 employees, $0.7 million
for facility closing costs and $0.2 million of other charges.

The $6.0 million in restructuring  and other costs in 1997 represented the costs
of  consolidating  the  Watermark  business  unit's  Burlington,   Massachusetts
engineering  and  marketing  functions  with  those  at  FileNET's  Costa  Mesa,
California location,  as well as a reduction in headcount in certain other areas
of the Company.  The  restructuring and other costs include  approximately  $2.2
million for severance payments for 111 employees, $2.2 million for the write-off
of assets  impaired by the  decision to  restructure,  $0.4 million for facility
closing costs, $0.4 million for equipment lease cancellations,  $0.3 million for
cancellation of third party development  contracts,  $0.2 million related to the
withdrawal  of  certain  products  from the  market  and $0.3  million  of other
charges.

The $16.0 million merger,  restructuring  and write-off of purchased  in-process
research  and  development  costs in 1996  consisted  of $10.0  million  for the
write-off of purchased  in-process research and development costs related to the
acquisition of  International  Financial  Systems Ltd.  (IFSL),  $4.2 million in
merger costs related to the Saros acquisition, and $1.8 million in restructuring
costs related to the Saros and Watermark acquisitions. The restructuring charges
represented  the  costs  of  consolidating  the  various  companies'  sales  and
administrative  functions and include $1.4 million for severance payments for 30
employees and $0.4 million for the write-off of certain contractual  obligations
and other costs.

At December 31, 1998, accrued restructuring and other costs of $1.7 million were
included  in  other  accrued  liabilities.  The  Company  anticipates  that  the
remaining restructuring costs will be expended during 1999.

Other Income:  Other income,  net of other  expenses,  was $3.8 million in 1998,
$3.2  million in 1997 and $2.8 million in 1996.  The  increases in 1998 and 1997
were  primarily  due to  increases  in interest  income  associated  with higher
balances of cash and marketable securities.

Provision for Income Taxes: The  provision for income taxes was a charge of $0.4
million  in 1998,  compared  to a benefit of $2.2  million  and a charge of $4.5
million recorded in 1997 and 1996, respectively.  The effective tax rate was 29%
in 1998 and 28% in 1997.  The 1996  effective  tax rate was 246% as a result  of
expensing the purchased  in-process  research and development  costs without tax
benefit,  nondeductible  one-time  costs and  earnings  generated in certain low
taxed jurisdictions,  partially offset by the utilization of tax losses incurred
in the United States.

Quantitative  and Qualitative  Disclosures  about  Market  Risk: The  Company is
exposed to a variety of risks, including changes in interest rates affecting the
return on its  investments  and  foreign  currency  fluctuations.  In the normal
course of business,  the Company employs established  policies and procedures to
manage its  exposure  to  fluctuations  in interest  rates and foreign  currency
values.

Interest Rate Risk: The  Company's  exposure  to market rate risk for changes in
interest  rates relates  primarily to the Company's  investment  portfolio.  The
Company  has  not  used  derivative  financial  instruments  in  its  investment
portfolio.  The Company places its investments with high-quality issuers and, by
policy,  limits the amount of credit  exposure  to any one  issuer.  The Company
protects  and  preserves  its  invested  funds by limiting  default,  market and
reinvestment  risk. The Company's  investments in marketable  securities consist
primarily of high-grade  corporate and government  securities with maturities of
less than three years.  Investments purchased with an original maturity of three
months or less are considered to be cash equivalents. The Company classifies all
of its  investments  as  available-for-sale.  Available-for-sale  securities are
carried at fair value, with unrealized gains and losses, net of tax, reported in
a separate component of stockholders' equity.

Foreign  Currency:  Risk The Company has entered into forward  foreign  exchange
contracts  primarily  to hedge  amounts  due from and the net assets of selected
subsidiaries  denominated  in  foreign  currencies  (mainly  in Europe  and Asia
Pacific)  against  fluctuations in exchange  rates.  The Company has not entered
into forward foreign exchange contracts for speculative or trading purposes. The
Company's  accounting  policies for these  contracts  are based on the Company's
designation of the contracts as hedging  transactions.  The criteria the Company
uses for designating a contract as a hedge include the contract's  effectiveness
in risk reduction and one-to-one matching of derivative instruments to

                                       19
<PAGE>
underlying transactions.  Gains and losses on forward foreign exchange contracts
are  recognized  in  income  in the same  period  as  gains  and  losses  on the
underlying  transactions.  If an  underlying  hedged  transaction  is terminated
earlier than initially  anticipated,  the offsetting gain or loss on the related
forward  foreign  exchange  contract  would be  recognized in income in the same
period.  In addition,  since the Company enters into forward contracts only as a
hedge, any change in currency rates would not result in any material net gain or
loss, as any gain or loss on the underlying foreign currency denominated balance
would  be  offset  by the  gain or loss on the  forward  contract.  The  Company
operates in certain countries in Latin America,  Eastern Europe and Asia Pacific
where there are limited forward  currency  exchange markets and thus the Company
has unhedged  transaction  exposures in these  currencies.  The following  table
summarizes the notional amounts,  which are equivalent to the fair market value,
of the Company's foreign currency  agreements  entered into in December 1998 and
1997, all maturing in three months:

<TABLE>
<CAPTION>
(in thousands)
---------------
At December 31,                         1998                                    1997
                          ----------------------------------    ------------------------------------
                          Notional Amount    Notional Amount    Notional Amount     Notional Amount
                                Purchased               Sold          Purchased                Sold
<S>                              <C>               <C>                 <C>                <C>
European currencies              $ 11,238          $ (8,488)           $ 31,261           $  35,775
Australian dollar                                    (2,938)                                (4,299)
Asian currencies                      929                                                     (698)
Canadian dollar                                        (522)                                (1,014)

         Total                   $ 12,167          $(11,948)           $ 31,261           $  29,764
</TABLE>

Management  believes  that  inflation  has not had a  significant  impact on the
prices of the Company's  products,  the cost of its materials,  or its operating
results  for the three  years  ended  December  31,  1998.  

Financial  Condition

Liquidity and Capital Resources:  As of  December 31, 1998,  combined cash, cash
equivalents, and marketable securities (short and long-term) were $82.2 million,
an increase of $10.4  million  from the $71.8  million at the end of 1997.

Cash  provided  by  operating  activities  in 1998  was  $33.3  million  and was
comprised primarily of additions to net income for depreciation and amortization
expense and increases in accounts payable,  accrued  compensation,  and unearned
maintenance  revenue.  Cash used by investing  activities totaled $23.7 million,
consisting  of  capital  expenditures  offset  by the net sale and  maturity  of
marketable  securities.  Cash provided by financing  activities was $9.1 million
consisting  of  proceeds  of $13.5  million  from  issuance  of common  stock in
connection  with the exercise of employee  stock options and the employee  stock
purchase plan, offset by $4.4 million to repurchase common stock.

Cash provided by operating  activities in 1997 was $24.7  million.  Cash used by
the net loss  for the year was  offset  by lower  accounts  receivable  balances
associated  with a lower  average  days  sales  outstanding,  lower  inventories
associated with the Company's  decrease in hardware revenue and additions to net
income for  depreciation  and  amortization.  Cash used by investing  activities
totaled $11.3 million, consisting of capital expenditures offset by the net sale
and maturity of marketable  securities.  Cash used by financing  activities  was
$2.6 million and was the result of the  repurchase  of common stock at a cost of
$5.6 million, offset by proceeds from the issuance of common stock in connection
with the  exercise of employee  stock  options and the employee  stock  purchase
plan.

Cash used by  operating  activities  in 1996 was $1.7  million.  The  balance is
primarily  due to a net  loss  and the  effect  of  higher  accounts  receivable
balances   associated   with  higher  revenue  and  higher  average  days  sales
outstanding,  offset  in  part  by the  non-cash  additions  to net  income  for
write-off of  capitalized  and  purchased  in-process  research and  development
costs,  depreciation,  and  amortization of capitalized  software.  Cash used by
investing  activities totaled $16.7 million,  consisting of capital expenditures
and the purchase of IFSL,  offset by proceeds from the sale of equipment and the
net sale and maturity of marketable  securities.  Net cash provided by financing

                                       20
<PAGE>

activities  was $2.6 million and was the result of proceeds from the issuance of
common stock and stock option income tax benefits,  offset by the  repurchase of
common stock.  

The Company's capital  expenditures were $32.5 million in 1998, $14.3 million in
1997, and $17.9 million in 1996. The Company's primary capital  expenditures are
for research and development  equipment,  demonstration and training  equipment,
enhancements   to  its  internal   network  and  business   systems,   leasehold
improvements on leased property,  and furniture for new offices. The increase in
1998  capital  expenditures  over the  levels  of the  prior  two  years was due
primarily to large internal  information  technology  infrastructure and systems
projects,  as well as  expenditures  incurred  for  leasehold  improvements  and
furnishings  for the  Company's  office in  Kirkland,  Washington.  The  Company
anticipates  that  it  will  acquire  approximately  $26.0  million  of  capital
equipment in 1999.  During the first  quarter of 1998,  the Company  repurchased
$4.4  million of its common  stock.  The Company  repurchased  $10.2  million of
common  stock in 1997 and 1996 for a total of $14.6  million in treasury  stock.

The Company anticipates that its present cash balances, together with internally
generated funds and credit lines, will be sufficient to meet its working capital
and capital expenditure needs throughout 1999.

Other Matters

Year 2000:  With the  approach of the year 2000,  the  Company  recognized  that
significant issues could arise in connection with the computer software products
it  licenses  and the  internal  business  systems  which are  essential  to its
operations.  In 1997, the Company implemented a year 2000 Integrity Program (the
Program) to ensure that the Company's  computer  software  products and internal
business systems will function properly in the year 2000 and thereafter.

The  Program,  as it relates to the  software  products  licensed to  customers,
includes year 2000  compliance  testing and  certification  of certain  existing
software  products.  All new generations of the Company's software products will
be released as year 2000  compliant.  Not all current  software  products of the
Company are year 2000  compliant  and the Company does not plan to make them so.
Upgraded year 2000 compliant  versions of such software  products are being made
available to customers and resellers who will then bear the  responsibility  for
installing  the upgraded  software  product in order to make their  systems year
2000 compliant.  Some of the Company's  customers are running  software  product
versions that are not year 2000 compliant. The Company has been encouraging such
customers to migrate to current software product  versions.  It is possible that
the Company may experience increased expenses in addressing migration issues for
such customers. The Company's customer support organization initiated a program,
Customer  Service  Profile  2000,  to review the status of each Company  product
currently  installed at a customer location and it provided the diagnostics used
in this  program to its  resellers  for their use at their  customer  locations.
Customers  who have  support  agreements  with the  Company  have been  directly
informed  as to  whether  or not the  particular  software  products  they  have
installed  are year 2000  compliant.  All  customers  are kept  informed  of the
release of year 2000 compliant  updates and upgrades via the Company's Web site.
The inability of any of the Company's  software  products to properly manage and
manipulate  data in the year 2000  could  result in  increased  warranty  costs,
customer   satisfaction   issues,   potential   lawsuits  and  other  costs  and
liabilities, as well as customers being unable to run software licensed from the
Company  and   incurring   significant   costs  from  the   resultant   business
interruption.  The  Company  has spent an  estimated  $1.0  million on year 2000
product related  projects  through  December 31, 1998. The 1999 expense for year
2000 product related projects is estimated to be less than $1.0 million.  Demand
for the Company's  software  products could be adversely  impacted to the extent
customers and potential customers are temporarily  distracted by their year 2000
remediation  efforts,  as such products compete for Information  Technology (IT)
resources  that have been  diverted  for such  remedial  efforts  which may have
higher priority than implementing document management systems.

The Company  has also  initiated  communications  with  significant  third party
vendors of computer  software with which the Company's systems interface or upon
which the Company's  software products depend in order to coordinate  efforts to
minimize the extent to which the  Company's  business will be vulnerable to such
third  parties'  failure to remediate  their own year 2000 issues.  Although the
Company's  compliance testing utilizes the embedded  third-party  software as an
essential  part of its  software  being  tested,  the  Program  does not include
certification  of  customer-developed  applications  which run on the  Company's

                                       21
<PAGE>

software products or third party software which is incorporated in the Company's
software  products.  Customers  and third party  vendors  will  remain  directly
responsible for year 2000 compliance testing of their software.

The Company  requires that  contingency  plans be developed and validated in the
event  that any of its  products  cannot  be  updated  and  certified  year 2000
compliant  before its scheduled  release date.  The Company  expects to have its
contingency  plans in place by October 31,  1999.  In  addition,  the Company is
forming a rapid  response  team as part of its  Customer  Services and IT groups
that will respond to any problems during the year 2000 date change period.

The  Program  also  includes a review of all  internal  IT systems for year 2000
compliance.  This year 2000  compliance  effort for IT  systems is divided  into
three  categories:  1) applications  development  and support;  2) IT production
services and operations; and 3) business communications (data, voice and video).
The program  methodology  consists of four phases: I) assessment;  II) potential
impact analysis; III) compliance integration;  and IV) update,  assessment,  and
contingency  plan.

The Company's significant business systems (financial,  operational,  marketing,
customer  support,  etc.) have been reviewed and are either  currently year 2000
compliant or will be upgraded  and/or  replaced so as to be year 2000 tested and
compliant  during  1999.  All of  the  hardware  and  software  deployed  in the
Company's  technical  infrastructure  is  either  fully  year  2000  tested  and
compliant or is scheduled to be replaced with year 2000 compliant  components by
October  31,  1999.  The  Company is also  evaluating  IT related  environmental
systems (heating, air conditioning, security, etc.) and intends to make all such
systems year 2000  compliant by October 31, 1999.  To the extent  possible,  the
Company will develop and execute  contingency  plans designed to allow continued
operation in the event of failure of the Company's or third parties'  systems by
October 31, 1999. For those business,  infrastructure and environmental  systems
that are to be upgraded in order to achieve year 2000  compliance,  the majority
were already  scheduled for upgrade for other  business  reasons.  The Company's
cost to fund such year 2000  compliance  projects has been $0.2 million  through
December  31,  1998.  The 1999  expense  for year 2000  compliance  projects  is
estimated to be less than $0.6 million.

Although  the Company is not aware of any material  operational  issues or costs
associated  with  preparing its software  products and internal  systems for the
year  2000,  there can be no  assurance  that  there  will not be a delay in, or
increased costs associated with, the implementation of the necessary systems and
changes to address the year 2000 issue.  The  Company's  inability  to implement
such  systems  and  changes  could have an adverse  effect on future  results of
operations.  The costs of the Company's  year 2000 project and the date on which
the  Company  believes  it will be  completed  are  based on  management's  best
estimates and include  assumptions  regarding  third party  modification  plans.
However,  in particular due to the potential impact of third party  modification
plans,  there can be no  assurance  that these  estimates  will be achieved  and
actual results could differ materially from those anticipated.

The  foregoing  statements  are based upon  management's  best  estimates at the
present  time,  which were  derived  utilizing  numerous  assumptions  of future
events,  including the continued availability of certain resources,  third party
modification  plans and other  factors.  There can be no  guarantee  that  these
estimates will be achieved and actual results could differ materially from those
anticipated.  Specific  factors  that  might  cause  such  material  differences
include,  but are not limited to, the nature and amount of programming  required
to upgrade or replace  each of the  affected  programs,  and the  success of the
Company's external customers, resellers, and vendors and suppliers in addressing
the year 2000 issue.

The EURO Conversion:  On January 1, 1999, eleven of the fifteen-member countries
of the European Union  established fixed conversion rates between their existing
sovereign currencies and the EURO. These countries have agreed to adopt the EURO
as their common legal  currency from that date.  The EURO will trade on currency
exchanges and be available for non-cash transactions. These countries will issue
sovereign debt exclusively in EURO and will redenominate  outstanding  sovereign
debt.  Effective on January 1, 1999, these countries no longer control their own
monetary  policies  by  directing  independent  interest  rates  for the  legacy
currencies.  Instead,  the authority to direct monetary policy,  including money
supply  and  official  interest  rates for the  EURO,  is  exercised  by the new
European Central Bank.

The legacy currencies are scheduled to remain legal tender in these countries as
a  denomination  of the EURO  between  January 1, 1999 and  January 1, 2002 (the
"transition  period").  During the transition period, public and private parties
may pay for goods and  services  using either the EURO or the  country's  legacy
currency on a "no compulsion,  no prohibition" basis. However,  conversion rates

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<PAGE>
will no longer  be  computed  directly  from one  legacy  currency  to  another.
Instead, a "triangulation" process will be applied whereby an amount denominated
in one legacy  currency  first will be converted  into an amount  denominated in
EURO,  and the resultant  EURO-denominated  amount is converted  into the second
legacy  currency.

The Company has made the necessary  changes to its internal  business systems to
support transactions  denominated in the EURO, including establishing EURO price
lists for affected  countries.  The Company is in the process of evaluating  the
impact that the conversion to the EURO will have on its financial  condition and
results of operations.  Based on this evaluation to date, the Company  currently
does not believe that there will be a material  adverse  impact on its financial
condition or results of operations as a result of the EURO conversion.

Recent  Accounting  Pronouncements:  In  June  1998,  the  Financial  Accounting
Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS)
No. 133,  "Accounting for Derivative  Instruments and Hedging Activities." which
is effective for fiscal year 2000, but earlier  adoption is permitted.  SFAS 133
will require the Company to record all  derivatives on the balance sheet at fair
value. For derivatives that are hedges, changes in the fair value of derivatives
will  be  offset  by the  changes  in the  fair  value  of  the  hedged  assets,
liabilities  or firm  commitments.  The Company  believes the impact of adopting
this  standard  will not be  material to its  results of  operations  or equity.

Environmental Matters:  The  Company  is not  aware  of any  issues  related  to
environmental  matters that have, or are expected to have, a material  affect on
its business.

Facts That May Affect Future Results

This Annual Report may contain forward-looking  statements within the meaning of
the  Private  Securities  Litigation  Reform  Act of  1995,  Section  21e of the
Securities  Exchange Act of 1934,  as amended and Section 27a of the  Securities
Act of 1933,  as amended,  and is subject to the safe  harbors  created by those
sections.  These forward  looking  statements  involve risks and  uncertainties,
including  those  discussed  below  and in the Notes to  Consolidated  Financial
Statements.  The actual results that the Company achieves may differ  materially
from any forward-looking statements, which reflect management's opinions only as
of the date hereof.  The Company  undertakes no obligation to revise or publicly
release  the  results  of any  revisions  to these  forward-looking  statements.
Readers  should  carefully  review  the  factors  described  below  and in other
documents the Company files from time to time with the  Securities  and Exchange
Commission,  including its Annual Report on Form 10-k for 1998 and the Quarterly
Reports on Form 10-q to be filed by the Company in 1999. The Company's business,
financial condition, operating results and prospects can be impacted by a number
of factors,  including but not limited to those set forth below and elsewhere in
this report, any one of which could cause the Company's actual results to differ
materially  from  historical  results or from the Company's  anticipated  future
results. Factors that may affect the Company's business, financial condition and
results of operations include:

Rapid  Technological Change; Product  Development:  The market for the Company's
products is characterized by rapid technological developments, evolving industry
standards,   changes  in  customer   requirements   and   frequent  new  product
introductions  and  enhancements.   The  Company's  continued  success  will  be
dependent upon its ability to continue to enhance its existing products, develop
and introduce,  in a timely  manner,  new products  incorporating  technological
advances  and respond to customer  requirements,  including  without  limitation
enhancements to certain specified Company software products to achieve year 2000
compliance.  There can be no assurance  that the Company will be  successful  in
developing and marketing new products or enhancements  to its existing  products
on a timely basis or that any new or enhanced  products will adequately  address
the changing needs of the  marketplace.  If the Company is unable to develop and
introduce new products or enhancements  to existing  products in a timely manner
in response to changing market  conditions or customer  requirements,  including
without limitation enhancements to certain existing software products to achieve
year 2000  compliance,  the Company's  business and  operating  results could be
adversely  affected.  From time to time,  the  Company  or its  competitors  may
announce new products,  capabilities or technologies  that have the potential to
replace or shorten the life cycles of the Company's existing products. There can
be no assurance that  announcements  of currently  planned or other new products
will not cause customers to delay their purchasing  decisions in anticipation of
such  products,  which  could have a material  adverse  effect on the  Company's
business and operating results.

                                       23
<PAGE>
Uncertainty of Future  Operating  Results;  Fluctuations in Quarterly  Operating
Results Prior growth rates in the Company's revenue and operating results should
not necessarily be considered  indicative of future growth or operating results.
Future operating results will depend upon many factors, including the demand for
the Company's  products;  the effectiveness of the Company's efforts to continue
to integrate  various  products it has  developed or acquired and to achieve the
desired level of sales from such product  integration;  the level of product and
price competition;  the length of the Company's sales cycle; improvements in the
productivity  of the Company's sales force;  seasonality of individual  customer
buying patterns;  the size and timing of individual  transactions;  the delay or
deferral  of  customer  implementations;  the  budget  cycles  of the  Company's
customers;  the timing of new product  introductions and product enhancements by
the Company and its  competitors;  the mix of sales by  products,  services  and
distribution   channels;   levels  of  international   sales;   acquisitions  by
competitors;  changes in foreign currency exchange rates including EURO exchange
rates  beginning  in 1999;  the ability of the Company to develop and market new
products and control costs; and general domestic and international  economic and
political  conditions.

As a result of these factors, revenues and operating results for any quarter are
subject to variation  and are not  predictable  with any  significant  degree of
accuracy.  Therefore, the Company believes that period-to-period  comparisons of
its  results of  operations  are not  necessarily  meaningful  and should not be
relied upon as indications of future performance.  Moreover,  such factors could
cause  the  Company's  operating  results  in a given  quarter  to be below  the
expectations of public market analysts and investors.  In either case, the price
of the Company's common stock could be materially adversely affected.

Competition:  The document imaging, workflow,  computer output to laser disk and
electronic  document  management  software markets are highly  competitive,  and
there are certain  competitors of the Company with substantially  greater sales,
marketing,  development and financial  resources.  The Company believes that the
competitive  factors  affecting the market for its products and services include
vendor and product  reputation;  product  quality,  performance  and price;  the
availability of products on multiple  platforms;  product  scalability;  product
integration  with  other  enterprise  applications;  product  functionality  and
features;  product ease of use; and the quality of customer support services and
training.  The relative  importance  of each of these  factors  depends upon the
specific customer involved.  While the Company believes it competes favorably in
each of these areas,  there can be no assurance  that it will continue to do so.
Moreover,  the Company's  present or future  competitors  may be able to develop
products  comparable  or superior to those  offered by the Company,  offer lower
price  products or adapt more  quickly than the Company to new  technologies  or
evolving customer requirements.  Competition is expected to intensify.  In order
to be  successful  in the future,  the  Company  must  respond to  technological
change, customer requirements and competitors' current products and innovations.
There can be no  assurance  that the Company will be able to continue to compete
effectively  in its market or that future  competition  will not have a material
adverse effect on its business, financial condition or results of operations. In
addition,  current and potential  competitors  have established or may establish
cooperative relationships among themselves or with third parties to increase the
ability of their  products  to address  the needs of the  markets  served by the
Company.  Accordingly,  it is possible that new  competitors or alliances  among
competitors may emerge and rapidly acquire  significant market share.  Increased
competition  may result in price  reductions,  reduced gross margins and loss of
market share, any of which could have a material adverse effect on the Company's
business, financial condition or results of operations.

Intellectual Property and Other Proprietary Rights:    The   Company's   success
depends,  in part,  on its  ability to  protect  its  proprietary  rights to the
technologies used in its principal products. The Company relies on a combination
of  copyrights,   trademarks,  trade  secrets,  confidentiality  procedures  and
contractual  provisions  to  protect  its  proprietary  rights.  There can be no
assurance that the Company's  existing or future copyrights,  trademarks,  trade
secrets or other  intellectual  property  rights will be of sufficient  scope or
strength to provide  meaningful  protection  or a  commercial  advantage  to the
Company.  The Company has no software  patents.  Also, in selling certain of its
products,  the Company  relies on "shrink wrap"  licenses that are not signed by
licensees  and,  therefore,  may be  unenforceable  under  the  laws of  certain
jurisdictions.  In addition,  the laws of some foreign  countries do not protect
the Company's proprietary rights to the same extent as do the laws of the United
States.  There can be no assurance  that such factors  would not have a material
adverse  effect on the  Company's  business,  financial  condition or results of
operations.  In addition,  the Company also relies on certain  software  that it
licenses  from  third  parties,  including  software  that  is  integrated  with
                                       24
<PAGE>
internally  developed  software  used in the  Company's  products to perform key
functions.  There can be no  assurance  that such third  parties  will remain in
business, that they will continue to support their products, that their products
are, or will be, year 2000  compliant,  or that their  products  will  otherwise
continue to be available to the Company on commercially  reasonable  terms.  The
loss or inability to maintain any of theses  software  licenses  could result in
delays or  reductions  in product  shipments  until  equivalent  software can be
developed, identified, licensed and integrated, which could adversely affect the
Company's business, financial condition or results of operations.

The Company may, from time to time,  be notified  that it is infringing  certain
patent or  intellectual  property  rights of others.  Combinations of technology
acquired through past or future  acquisitions and the Company's  technology will
create new products and technology that may give rise to claims of infringement.
While no actions other than those discussed below are currently  pending against
the  Company for  infringement  of patent or other  proprietary  rights of third
parties,  there  can be no  assurance  that  third  parties  will  not  initiate
infringement actions against the Company in the future. Infringement actions can
result in substantial  cost to, and diversion of,  resources of the Company.  If
the Company were found to infringe  upon the rights of others,  no assurance can
be given that licenses  would be obtainable on acceptable  terms or at all, that
significant  damages for past infringement would not be assessed or that further
litigation  relative to any such licenses or usage would not occur.  The failure
to successfully  defend any claims or obtain necessary licenses or other rights,
the ultimate  disposition of any claims or the advent of litigation  arising out
of any  claims of  infringement,  could have a  material  adverse  effect on the
Company's business, financial condition or results of operations.

In October 1994, Wang Laboratories,  Inc. (Wang) filed a complaint in the United
States  District  Court for the  District  of  Massachusetts  alleging  that the
Company is infringing  five patents held by Wang (the FileNET Case). On June 23,
1995,  Wang amended its complaint to include an additional  related  patent.  On
July 2, 1996,  Wang filed a complaint in the same court  alleging that Watermark
Software  Inc.,  formerly a wholly  owned  subsidiary  that was merged  into the
Company,  is  infringing  three  of the same  patents  asserted  in the  initial
complaint (the Watermark  Case).  On October 9, 1996, Wang withdrew its claim in
the FileNET Case that one of the patents it  initially  asserted is infringed by
certain of the Company's products,  which were commercialized before the initial
complaint was filed.  Wang reserved the right to assert that patent  against the
Company's products commercialized after that date in a separate lawsuit.

In March 1997, Eastman Kodak Company (Kodak) purchased the Wang imaging business
unit that has responsibility  for this litigation.  The patents in the suit have
been  transferred to a Kodak  subsidiary,  Kodak Limited of England,  which,  in
turn,  has  exclusively  licensed  them to  another  Kodak  subsidiary,  Eastman
Software,  Inc. in the United  States  (Eastman).  On July 30,  1997,  the Court
permitted  Eastman  and  Kodak  Limited  of  England  to be  substituted  in the
litigation in place of Wang.

The Company has moved for summary judgement on noninfringement as to each of the
five patents in the suit,  and for summary  judgment of  invalidity as to one of
the  patents.   Eastman   moved  for  summary   judgment  as  to  the  Company's
unenforceability  defense on one of the patents.  In July 1998,  the  Magistrate
Judge  assigned to the case,  heard oral  arguments on the Company's  motion for
summary  judgement that U.S.  Patent  4,918,588 is not infringed and is invalid.
The  Magistrate  Judge has not yet decided these motions.  The Company  believes
that after he has ruled on these  motions,  he will hear oral  arguments  in the
remaining motions in the sequence in which they were filed. A trial date has not
been set.

If it should be determined that the patents at issue in the litigation are valid
and  are  infringed  by any  of  the  Company's  products,  including  Watermark
products,  the Company will,  depending on the product,  redesign the infringing
products  or seek to obtain a license  to market the  products.  There can be no
assurance  that the Company will be able to obtain such a license on  acceptable
terms.  Based on the  Company's  analysis  of these  Eastman  patents  and their
respective file histories, the Company believes that it has meritorious defenses
to Eastman's claims;  however,  the ultimate outcome or any resulting  potential
loss cannot be determined at this time.

Dependence  on Certain  Relationships:  The Company has entered into a number of
key relationships with other companies such as Microsoft Corporation, IBM Global
Services, SAP AG, Hewlett-Packard Company, and Sun Microsystems,  Inc. There can
be no  assurance  that  these  companies  will not reduce or  discontinue  their
relationships with, or support of, the Company and its products
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<PAGE>
Dependence  on Key  Management and Technical Personnel:   The Company's  success
depends to a  significant  degree upon the  continued  contributions  of its key
management,  marketing,  technical and operational  personnel.  In general,  the
Company does not utilize employment  agreements for its key employees.  The loss
of the  services  of one or more key  employees  could have a  material  adverse
effect on the Company's operating results.  The Company also believes its future
success  will  depend in large  part upon its  ability  to  attract  and  retain
additional highly skilled management,  technical, marketing, product development
and  operational  personnel.   Competition  for  such  personnel,   particularly
engineers  and other  technical  personnel,  is  intense,  and pay scales in the
software  industry are  increasing.  There can be no assurance  that the Company
will be successful in attracting and retaining such personnel.

International Sales:  Historically,   the  Company  has  derived   approximately
one-third of its total revenues from international sales. International business
is subject to certain risks including varying technical  standards;  tariffs and
trade  barriers;  political and economic  instability;  reduced  protection  for
intellectual property rights in certain countries;  difficulties in staffing and
maintaining foreign operations;  difficulties in managing foreign  distributors;
varying   requirements   for  localized   products;   potentially   adverse  tax
consequences; currency exchange fluctuations including those related to the EURO
beginning  in 1999;  the  burden of  complying  with a wide  variety  of complex
foreign laws,  regulations and treaties;  and the possibility of difficulties in
collecting accounts  receivable.  In particular,  the current economic crisis in
the Asia Pacific  region and Latin  America may limit  future  growth or cause a
decline in international  revenues.  There can be no assurance that any of these
factors  will not have a  material  adverse  effect on the  Company's  business,
financial condition or results of operations.

Product Liability:  Products  as  complex  as  those  sold  by the  Company  are
susceptible to errors or failures,  especially when first introduced or when new
versions are  released.  The  Company's  products are often  intended for use in
applications  that are  critical  to a  customer's  business.  As a result,  the
Company's  customers may rely on the effective  performance of the software to a
greater  extent than the market for  software  products  generally.  The Company
conducts  extensive  product  testing to ensure  that its  products  are free of
significant errors and defects. In addition, the Company has designed and tested
the most current  versions of its products to be year 2000  compliant.  However,
some of the Company's  customers are running earlier  products that are not year
2000  compliant.  Although the Company has been  encouraging  such  customers to
migrate to current product versions,  no assurance can be given that all of them
will do so in a timely fashion, if at all. Moreover,  the Company also relies on
certain software that it licenses from third parties, including software that is
integrated  with  internally  developed  software  and is used in the  Company's
products  to  perform  key  functions.  There  can  be no  assurance  that  such
third-party  software  will  be free  of  errors  and  defects  or be year  2000
compliant  in a timely  fashion.  Although the Company has not  experienced  any
material product liability claims to date, there can be no assurance that errors
or defects,  whether associated with year 2000 functions or otherwise,  will not
result in product  liability  claims  against  the  Company in the  future.  The
Company's  license  agreements  with  customers   typically  contain  provisions
designed to limit its exposure to potential product  liability claims.  However,
it is possible that such limitation of liability provisions may not be effective
under  the  laws  of  certain  jurisdictions.   Although  the  Company  has  not
experienced  any  product  liability  claims to date,  the sale and  support  of
products may entail the risk of such claims,  and there can be no assurance that
the  Company  will not be subject to such  claims in the  future.  A  successful
product  liability  claim  brought  against  the  Company  could have a material
adverse  effect upon the  Company's  business,  operating  results and financial
condition.

Stock Price  Volatility:  The Company  believes  that a variety of factors could
cause the trading price of its common stock to fluctuate, perhaps substantially,
including quarter-to-quarter  variations in operating results;  announcements of
developments related to its business;  fluctuations in its order levels; general
conditions in the technology sector or the worldwide  economy;  announcements of
technological  innovations,  new products or product enhancements by the Company
or its  competitors;  key  management  changes;  changes in joint  marketing and
development  programs;  developments  relating to patents or other  intellectual
property rights or disputes;  and  developments  in the Company's  relationships
with its customers, distributors and suppliers. In addition, in recent years the
stock market in general, and the market for shares of high-technology  stocks in
particular,  have experienced  extreme price  fluctuations  that have often been
unrelated to the operating performance of affected companies.  Such fluctuations
could adversely affect the trading price of the Company's common stock.
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