<PAGE>

          UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                      Washington, DC   20549

                            FORM 10Q

     (X)  Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
          Exchange Act of 1934

          For the quarterly period ended March 31, 1999

                                or

     ( )  Transition Report Pursuant to Section 13 or 15(d)
          of the Securities Exchange Act of 1934

                  Commission File Number 0-12194

                         ZITEL CORPORATION
     (Exact name of Registrant as specified in its charter)



             California                          94-2566313
   (State or other jurisdiction of            (I.R.S. Employer
   incorporation or organization)            Identification No.)

         47211 Bayside Parkway                   94538-6517
          Fremont, California                    (Zip Code)
(Address of principal executive offices)


Registrant's telephone number, including area code:  (510) 440-9600


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 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 _____

The number of shares of the Registrant's Common Stock outstanding as of March
31, 1999 was 21,911,553.



<PAGE>
              ZITEL CORPORATION AND SUBSIDIARIES


                             INDEX
<TABLE>
<CAPTION>
                                                               Page
                                                              Number
<S>                                                           <C>
PART I.   Financial Information

  Item 1.  Financial Statements

     Condensed Consolidated Balance Sheets
       March 31, 1999 (unaudited) and September 30, 1998 .....  3

     Condensed Consolidated Statements of
       Operations (unaudited) - Three and Six Months
        Ended March 31, 1999 and 1998 ........................  4

     Condensed Consolidated Statements of
       Cash Flows (unaudited) - Six Months Ended
       March 31, 1999 and 1998 ...............................  5

     Notes to Condensed Consolidated
       Financial Statements ..................................  7

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

  Item 3.  Quantitative and Qualitative Disclosures
           about Market Risk ................................. 19

PART II.   Other Information

  Item 1.  Legal Proceedings ................................. 20

  Item 2.  Changes in Securities ............................. 20

  Item 3.  Defaults Upon Senior Securities ................... 20

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

  Item 5.  Other Information ................................. 21

  Item 6.  Exhibits and Reports on Form 8-K .................. 31
</TABLE>
                             Page 2
<PAGE>
                  ZITEL CORPORATION AND SUBSIDIARIES

                 CONDENSED CONSOLIDATED BALANCE SHEETS
                               ($000's)
<TABLE>
<CAPTION>
                                       March 31,  September 30,
                                         1999         1998
                                     (UNAUDITED)
<S>                                    <C>           <C>
     ASSETS
Current assets:
  Cash and cash equivalents            $ 6,254       $ 6,589
  Accounts receivable, net               4,202         3,579
  Refundable taxes                         213           208
  Other current assets                   1,528           749
                                       -------       -------
    Total current assets                12,197        11,125

Fixed assets, net                        1,027         1,311
Other assets, net                        5,352         5,634
                                       -------       -------
  Total assets                         $18,576       $18,070
                                       =======       =======

     LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable                     $ 2,299       $ 3,585
  Accrued liabilities                    1,449         1,527
  Deferred revenue                       2,835         2,139
                                       -------       -------
    Total current liabilities            6,583         7,251

Convertible subordinated debenture       4,892         4,585
                                       -------       -------
    Total liabilities                   11,475        11,836

Shareholders' equity:
  Common stock                          66,280        60,574
  Accumulated deficit                  (59,179)      (54,340)
                                       -------       -------
  Total shareholders' equity             7,101         6,234
                                       -------       -------
  Total liabilities and
    shareholders' equity               $18,576       $18,070
                                       =======       =======
</TABLE>
The accompanying notes are an integral part of these financial statements.

                             Page 3
<PAGE>
               ZITEL CORPORATION AND SUBSIDIARIES

         CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

                          (UNAUDITED)
                (In thousands except per share data)
<TABLE>
<CAPTION>
                           Three Months Ended   Six Months Ended
                                March 31,          March 31,
                           ------------------  -----------------
                              1999     1998      1999      1998
                            -------  -------   -------   -------
<S>                         <C>      <C>       <C>       <C>
Net sales                   $ 4,239  $ 4,183   $10,139   $11,546
Royalty revenue                   -      210         -       792
                            -------  -------   -------   -------
  Total revenue               4,239    4,393    10,139    12,338
Cost and expenses:
  Cost of goods sold          1,451    2,339     3,673     5,795
  Research and development
    expenses                    653    1,963     1,268     3,951
  Selling, general &
    administrative expenses   3,663    5,182     7,550    11,860
  Loss from unconsolidated
    company                       -        -     1,512         -
                            -------  -------   -------   -------
  Operating loss             (1,528)  (5,091)   (3,864)   (9,268)

Other expense                   535      399       975       719
                            -------  -------   -------   -------
Net loss                    $(2,063) $(5,490) $ (4,839)  $(9,987)
                            =======  =======   =======   =======

Basic and diluted net loss
  per share                 $  (.09) $  (.33)  $  (.22)  $  (.62)
                            =======  =======   =======   =======

Shares used in basic and
  diluted per share
  calculation                21,908   16,646    21,643    16,175
                            =======  =======   =======   =======
</TABLE>

The accompanying notes are an integral part of these financial statements.

                                Page 4
<PAGE>

              ZITEL CORPORATION AND SUBSIDIARIES
        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                            ($000's)
<TABLE>
<CAPTION>
                                                                (UNAUDITED)
                                                             Six Months Ended
                                                                 March 31,
                                                              1999       1998
                                                            --------   --------
<S>                                                         <C>        <C>
Cash flows provided by (used in) operating  activities:                                              
  Net loss                                                  $(4,839)   $(9,987)
  Adjustments to reconcile net loss to net cash           
   provided by (used in) operating activities:            
    Loss from unconsolidated company                          1,512          -
    Discount on subordinated debenture                          555          -
    Interest accrued on convertible                       
     subordinated debenture                                     347          -
    Amortization of capitalized financing costs                 308        482
    Depreciation and amortization                             1,040      1,530
    Provision for doubtful accounts                             (33)       102
    Provision for inventory allowances                            -        160
    Change in operating assets and liabilities:           
    Increase (decrease) in accounts receivable                 (590)     1,393
    Refundable income taxes                                      (5)        (6)
    Decrease in inventories                                       -        975
    Increase in other current assets                           (779)      (188)
    Decrease in accounts payable                             (1,286)    (1,971)
    Decrease in accrued liabilities                             (78)      (721)
    Deferred revenue                                            696        989
                                                            -------    -------
 Net cash used in operating activities                       (3,152)    (7,242)
                                                            -------    -------
Cash flows provided by (used in)                          
 investing activities:                                    
    Acquisition of fixed assets                                (109)      (477)
    Investment in unconsolidated company                     (1,512)    (1,495)
    Proceeds from sale of short-term investments                  -      9,596
    Capitalized software development costs                     (219)      (233)
    Purchased technology                                       (250)         -
    Decrease in (purchase of) other assets                       15       (629)
                                                            -------    -------
 Net cash provided by (used in)                           
  investing activities                                       (2,075)     6,762
                                                            -------    -------
</TABLE>

                                Page 5
<PAGE>

              ZITEL CORPORATION AND SUBSIDIARIES
        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                          (continued)
                            ($000's)
<TABLE>
<CAPTION>
                                                      (UNAUDITED)
                                                   Six Months Ended
                                                       March 31,
                                                    1999       1998
                                                  --------   -------
<S>                                               <C>        <C>
Cash flows provided by financing activities:
   Issuance of common stock                        $   110   $   671
   Issuance of subordinated debentures               4,782         -
                                                   -------   -------
 Net cash provided by financing activities           4,892       671
                                                   -------   -------
 Net increase (decrease) in cash                      (335)      191
Cash and cash equivalents, beginning of year         6,589     4,224
                                                   -------   -------
Cash and cash equivalents, end of period           $ 6,254   $ 4,415
                                                   =======   =======

Supplemental non-cash investing and 
 financing activities:
  Capitalized financing costs                      $   218   $     -
                                                   =======   =======
  Common stock purchase warrants                   $   128   $     -
                                                   =======   =======
  Conversion of subordinated debentures
    and accrued interest                           $ 4,912   $15,313
                                                   =======   =======
</TABLE>

The accompanying notes are an integral part of these financial statements.

                             Page 6
<PAGE>
               ZITEL CORPORATION AND SUBSIDIARIES

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

                           (UNAUDITED)
            (Amounts in thousands except per share data)

1.  The condensed consolidated financial statements included herein have been
prepared by the Company, without audit, pursuant to the rules and regulations of
the Securities and Exchange Commission and should be read in conjunction with
the audited financial statements of the Company. Certain information and
footnote disclosures, normally included in financial statements prepared in
accordance with generally accepted accounting principles, have been condensed or
omitted although the Company believes the disclosures which are made are
adequate to make the information presented not misleading. Further, the
condensed consolidated financial statements reflect, in the opinion of
management, all adjustments necessary to present fairly the financial position
and results of operations as of and for the periods indicated. The results of
operations for the period ended March 31, 1999 are not necessarily indicative of
the results expected for the full year.

2.  Recent Accounting Pronouncements:
    In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income". SFAS No. 130 establishes standards for the reporting and
display of comprehensive income and its components in a full set of general
purpose financial statements. Comprehensive income is defined as the change in
equity of a business enterprise during a period from transactions and other
events and circumstances from non-owner sources. The Company adopted SFAS No.
130 at the beginning of fiscal year 1999. There was no difference between the
Company's net loss and its total comprehensive loss for the three and six months
ended March 31, 1999 and 1998.

    In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information". SFAS No. 131 requires publicly-held
companies to report financial and other information about key revenue-producing
segments of the entity for which such information is available and is utilized
by the chief operations decision maker. Specific information to be reported for
individual segments includes profit or loss, certain revenue and expense items
and total assets. A reconciliation of segment financial information to amounts
reported in the

                             Page 7
<PAGE>

financial  statements  would be provided.  The Company is evaluating  the impact
SFAS No. 131 will have on its disclosure  requirements  for the fiscal year 1999
annual financial statements.

    In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". SFAS No. 133 establishes accounting and
reporting standards requiring that every derivative instrument, including
certain derivative instruments embedded in other contracts, be recorded in the
balance sheet as either an asset or liability measured at its fair value. SFAS
No. 133 requires that changes in the derivative's fair value be recognized
currently in earnings unless specific hedge accounting criteria are met. Special
accounting for qualifying hedges allows a derivative's gains and losses to
offset related results on the hedged item in the income statement, and requires
that a company must formally document, designate and assess the effectiveness of
transactions that receive hedge accounting. SFAS No. 133 is effective for the
Company in fiscal year 2000 and will not require retroactive restatement of
prior period financial statements. The Company has not yet quantified the impact
of adopting SFAS No. 133 on its financial statements, but the Company believes
there will not be a significant impact.

    On October 27, 1997, the American Institute of Certified Public Accountants
(AICPA) issued Statement of Position (SOP) 97-2, "Software Revenue Recognition".
SOP 97-2, as amended by SOP 98-4, "Deferral of the Effective Date of Certain
Provisions of SOP 97-2", effective January 1, 1998, establishes the standard for
the appropriate recognition of software revenue. The Company has adopted SOP
97-2, as amended, effective October 1, 1998 and it has been determined that
there was no material impact to the adoption.

    In December 1998, The Accounting Standards Executive Committee (AcSEC)
released SOP 98-9, "Modification of SOP 97-2, "Software Revenue Recognition",
with Respect to Certain Transactions". SOP 98-9 amends SOP 97-2 to require that
an entity recognize revenue for multiple element arrangements by means of the
"residual method" when (1) there is vendor-specific objective evidence (VSOE) of
the fair values of all the undelivered elements that are not accounted for by
means of long-term contract accounting, (2) VSOE of fair value does not exist
for one or more of the delivered elements, and (3) all revenue recognition
criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of
each delivered element) are satisfied.

                             Page 8
<PAGE>

    The provisions of SOP 98-9 that extend the deferral of certain passages of
SOP 97-2 became effective December 15, 1998. All other provisions of SOP 98-9
will be effective for transactions that are entered into in fiscal years
beginning after March 15, 1999. Retroactive application is prohibited. The
Company is evaluating the requirements of SOP 98-9 and the effects, if any, on
the Company's current revenue recognition policies.

    AICPA SOP 98-1, "Accounting for Costs of Computer Software Developed or
Obtained for Internal Use", issued on March 4,1998, is effective for the Company
in fiscal year 1999. There has not been a significant impact upon adoption.

3.  Other Assets:
    Other assets consist of the following:
<TABLE>
<CAPTION>
                                       March 31,    September 30,
                                         1999            1998
                                     ------------   -------------
<S>                                  <C>            <C>
    Goodwill                            $2,754          $2,768
    Purchased technology                 2,588           2,588
    Other assets                         2,269           1,890
    Less accumulated amortization       (2,259)         (1,612)
                                        ------          ------
                                        $5,352          $5,634
                                        ======          ======
</TABLE>

4.  Investment in Unconsolidated Company:
    The following is a summary of financial information with respect to
MatriDigm for the three and six months ended March 31, 1999 and 1998,
respectively:
<TABLE>
<CAPTION>
                                       Three months ended   Six months ended
                                            March 31,           March 31,
                                         1999     1998        1999     1998
                                        ------   ------      ------   ------
<S>                                     <C>      <C>         <C>      <C>
    Net sales                           $  762   $  987      $1,607   $1,890
    Gross profit                           351       13         567      261
    Loss before one-time merger costs    1,802    3,795       4,562    7,425
    Net loss                             1,802    3,795       5,262    7,425
</TABLE>

5.  3% Convertible Subordinated Debentures dated June 16, 1998:
    For the six months ended March 31, 1999, approximately $4.9 million was
converted into 1.25 million shares of common stock at an average price of
$3.92625 per share. As of November 1998, the debentures had been fully
converted.


                             Page 9
<PAGE>

6.  3% Convertible Subordinated Debentures dated February 3, 1999:
    On February 3, 1999, the Company issued $5 million principal amount of 3%
Convertible Subordinated Debentures (the "Debentures") which automatically
converts on February 1, 2000, and five-year common stock purchase warrants
to acquire 75,000 shares of the Company's common stock. The Debentures accrue
interest at the rate of 3% per annum and principal and accrued interest are
convertible into Common Stock of the Company at a price of $2.25.

    The current quarter includes a charge to interest expense in the amount of
$78 thousand and $555 thousand, respectively, related to the amortization of the
debt issuance costs on the 3% convertible subordinated debentures and the
expense of the discount. As of March 31, 1999, there have been no conversions of
the debentures.

7.  Common Stock:

    Common stock activity for the period from September 30, 1998 through March
31, 1999 is as follows:
<TABLE>
<CAPTION>
                                             Common Stock     Common Stock
                                                Shares           Amount
                                             ------------     ------------
<S>                                          <C>              <C>
    Balance at September 30, 1998               20,601           $60,574
    Conversion of subordinated debentures        1,251             4,912
    Exercise of stock options                       60               110
    Common stock warrants and
      discount on subordinated debentures            -               684
                                                ------           -------
    Balance at March 31, 1999                   21,912           $66,280
                                                ======           =======
</TABLE>

8.  Income Taxes:
    The benefit for income taxes was fully offset by a valuation allowance due
to the uncertainty surrounding the realization of the favorable tax attributes.

9.  Earnings Per Share (EPS):
    The Company has adopted the provisions of SFAS No. 128, "Earnings Per
Share", effective December 31, 1997. SFAS No. 128 requires the presentation of
basic and diluted earnings per share. Basic EPS is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted EPS is computed giving effect to all
dilutive potential common shares that were outstanding during the period.
Dilutive potential common shares

                             Page 10
<PAGE>

consist of the incremental common shares issuable upon the conversion of
convertible subordinated debt (using the "if converted" method) and exercise of
stock options and warrants for all periods. All prior period earnings per share
amounts have been restated to comply with the SFAS No. 128.

    In accordance with the disclosure requirements of SFAS No. 128, a
reconciliation of the numerator and denominator of basic and diluted EPS is
provided as follow (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                      Three Months Ended Six Months Ended
                                           March 31,         March 31,
                                      ------------------ ----------------
                                        l999      1998     1999     1998
                                      -------   -------  -------  -------
                                          (unaudited)       (unaudited)
<S>                                   <C>       <C>      <C>      <C>
Numerator - Basic and Diluted EPS
  Net loss                            $(2,063)  $(5,490) $(4,839) $(9,987)
                                      =======   =======  =======  =======
Denominator - Basic EPS              
  Common stock outstanding             21,908    16,646   21,643   16,175
  Common equivalent stock                   -         -        -        -
                                      -------   -------  -------  -------
                                       21,908    16,646   21,643   16,175
                                      -------   -------  -------  -------
Basic loss per share                  $  (.09)  $  (.33) $  (.22) $  (.62)
                                      =======   =======  =======  =======
                                     
Denominator - Diluted EPS            
  Denominator - Basic EPS              21,908    16,646   21,643   16,175
  Effect of Dilutive Securities:
    Common stock options                    -         -        -        -
    Convertible preferred stock             -         -        -        -
                                      -------   -------  -------  -------
                                       21,908    16,646   21,643   16,175
                                      -------   -------  -------  -------
Diluted loss per share                $  (.09)  $  (.33) $  (.22) $  (.62)
                                      =======   =======  =======  =======
</TABLE>

    For the quarter and six-month period ended March 31, 1999, options to
purchase 92 thousand and 108 thousand shares, respectively, were not included in
the computation of diluted EPS because of the anti-dilutive effect of including
these shares in the calculation for both periods. For the quarter and six-month
period ended March 31, 1998, options to purchase 738 thousand and

                             Page 11
<PAGE>

744 thousand shares, respectively, were not included in the computation of
diluted EPS because of the anti-dilutive effect of including these shares in the
calculation for both periods. In addition, had the subordinated debt been
converted, it would have resulted in approximately 2,222 thousand for the three
and six months ended March 31, 1999. These shares were not included in the
computation due to their anti-dilutive effect.







                              Page 12
<PAGE>

       MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

              CONDITION AND RESULTS OF OPERATIONS

Result of Operations

The Company recorded a net loss of $2,063,000 ($0.09 per share) for the quarter
ended March 31, 1999 compared with a net loss of $5,490,000 ($0.33 per share)
for the same quarter of the prior year. Included in the current quarter are
costs related to the convertible subordinated debentures of $633,000. Weighted
average shares outstanding for the current quarter were 21,908,000 compared to
16,646,000 for the same quarter of the prior year. For the six months ended
March 31, 1999, the net loss was $4,839,000 ($0.22 per share) compared with a
net loss of $9,987,000 ($0.62 per share) for the same period a year earlier.
Year-to-date weighted average shares were 21,643,000 versus 16,175,000 in the
prior year.

Total revenue for the current quarter was $4,239,000 versus total revenue of
$4,393,000 for the same quarter of the prior year, a decrease of $154,000. The
prior year included revenue of $1,608,000 related to the storage business unit,
which was disposed of in the third quarter of fiscal year 1998, and royalties in
the amount of $210,000, which terminated in April 1998. Revenue from the
Datametrics business unit was $3,951,000 in the current quarter, an increase of
54% from the same quarter of the prior year. For the six months ended March 31,
1999, total revenue was $10,139,000 versus total revenue of $12,338,000 for the
same period of the prior year, a decrease of $2,199,000. Included in the prior
year was revenue and royalties related to the storage business unit of
$4,795,000 and $792,000, respectively. Revenue from the Datametrics business
unit was $9,372,000 for the six months just ended, an increase of 39% from the
same period in the prior year.

Gross margin as a percent of net sales was 66% for the quarter ended March
31,1999 compared to 44% for the same quarter of the prior year. For the
six-month period ended March 31, 1999, gross margin was 64% versus 50% for the
same period of the prior year. The improvement in the gross margin percentage
during the current quarter and six-month period is primarily attributable to
product mix as a result of net sales generated by the software business unit.
Future gross margins may be affected by several factors including the mix of
products sold, the price of products sold, and price competition.


                              Page 13
<PAGE>

Research and development expenses for the quarter ended March 31, 1999, were 15%
of total revenue compared with 45% for the same quarter of the prior year.
Actual spending decreased $1,310,000. For the six-month period just ended,
research and development expenses were 13% of total revenue compared with 32%
for the same period of the prior year. Actual spending decreased $2,683,000. The
decrease in spending during both periods is the result of the sale of the
storage business unit in July 1998.

Selling, general and administrative (SG&A) expenses were 86% of total revenue
for the current quarter versus 118% for the same quarter of the prior year.
Actual spending decreased $1,519,000. For the six-month period just ended, SG&A
expenses were 74% of total revenue compared with 96% for the same period a year
earlier. Actual spending decreased $4,310,000. The decrease in spending in both
periods is the result of the sale of the storage business unit in the prior
year.

During the six months ended March 31, 1999, the Company charged $1,512,000 to
expense as a loss from unconsolidated company. Because of the uncertainties in
MatriDigm's future and its ability to generate sufficient operating cash flows,
the Company reserved 100% of the funds advanced to MatriDigm during the
six-month period.

Other expense was $535,000 for the quarter just ended versus $399,000 in the
same quarter of the prior year. For the current quarter, other expense included
$633,000 expense related to the 3% convertible subordinated debentures,
partially offset by interest income of $155,000. For the comparable quarter of
the prior year, other expense included interest related to the 5% convertible
subordinated debentures of $482,000, which was partially offset by interest
income of $126,000.

Liquidity and Capital Resources

During the six-month period ended March 31, 1999, working capital increased
$1,740,000 and cash flow utilized by operating activities was $3,152,000. The
utilization of cash in operating activities resulted primarily from the net loss
of $4,839,000, an increase in accounts receivable of $590,000, an increase in
other current assets of $779,000, and a decrease in accounts payable of
$1,286,000. This was partially offset by the loss from unconsolidated company of
$1,512,000, depreciation and amortization of $1,040,000, an increase in deferred
revenue of $696,000, and the discount on subordinated debentures of $555,000.

                              Page 14
<PAGE>

During the current year, net cash utilized by investing activities was
$2,075,000. The Company invested an additional $1,512,000 in an unconsolidated
company, purchased technology in the amount of $250,000 and capitalized software
development costs in the amount of $219,000.

Net cash provided by financing activities was $4,892,000, which included
$4,782,000 (net) from the issuance of convertible subordinated debentures and
$110,000 from the exercise of employee stock options.

Management believes that the Company will be able to meet its cash requirement
needs for the next twelve months from cash on hand, other working capital, and
cash flow from operations.

Recent Accounting Pronouncements

In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income". SFAS No. 130 establishes standards for the reporting and display of
comprehensive income and its components in a full set of general purpose
financial statements. Comprehensive income is defined as the change in equity of
a business enterprise during a period from transactions and other events and
circumstances from non-owner sources. The Company adopted SFAS No. 130 at the
beginning of fiscal year 1999. There was no difference between the Company's net
loss and its total comprehensive loss for the three and six months ended March
31, 1999 and 1998.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information". SFAS No. 131 requires publicly-held
companies to report financial and other information about key revenue-producing
segments of the entity for which such information is available and is utilized
by the chief operations decision maker. Specific information to be reported for
individual segments includes profit or loss, certain revenue and expense items
and total assets. A reconciliation of segment financial information to amounts
reported in the financial statements would be provided. The Company is
evaluating the impact SFAS No. 131 will have on its disclosure requirements for
the fiscal year 1999 annual financial statements.

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative 
Instruments and Hedging Activities".  SFAS No. 133 establishes accounting and 
reporting standards requiring that

                              Page 15
<PAGE>

every derivative instrument, including certain derivative instruments embedded
in other contracts, be recorded in the balance sheet as either an asset or
liability measured at its fair value. SFAS No. 133 requires that changes in the
derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met. Special accounting for qualifying hedges
allows a derivative's gains and losses to offset related results on the hedged
item in the income statement, and requires that a company must formally
document, designate and assess the effectiveness of transactions that receive
hedge accounting. SFAS No. 133 is effective for the Company in fiscal year 2000
and will not require retroactive restatement of prior period financial
statements. The Company has not yet quantified the impact of adopting SFAS No.
133 on its financial statements, but the Company believes there will not be a
significant impact.

On October 27, 1997, the American Institute of Certified Public Accountants
(AICPA) issued Statement of Position (SOP) 97-2, "Software Revenue Recognition".
SOP 97-2, as amended by SOP 98-4, "Deferral of the Effective Date of Certain
Provisions of SOP 97-2", effective January 1, 1998, establishes the standard for
the appropriate recognition of software revenue. The Company has adopted SOP
97-2, as amended, effective October 1, 1998 and it has been determined that
there was no material impact to the adoption.

In December 1998, The Accounting Standards Executive Committee (AcSEC) released
SOP 98-9, "Modification of SOP 97-2, 'Software Revenue Recognition', with
Respect to Certain Transactions". SOP 98-9 amends SOP 97-2 to require that an
entity recognize revenue for multiple element arrangements by means of the
"residual method" when (1) there is vendor-specific objective evidence (VSOE) of
the fair values of all the undelivered elements that are not accounted for by
means of long-term contract accounting, (2) VSOE of fair value does not exist
for one or more of the delivered elements, and (3) all revenue recognition
criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of
each delivered element) are satisfied.

The provisions of SOP 98-9 that extend the referral of certain passages of SOP
97-2 became effective December 15, 1998. All other provisions of SOP 98-9 will
be effective for transactions that are entered into in fiscal years beginning
after March 15, 1999. Retroactive application is prohibited. The Company is
evaluating the requirements of SOP 98-9 and the effects, if any, on the
Company's current revenue recognition policies.

                              Page 16
<PAGE>

AICPA SOP 98-1, "Accounting for Costs of Computer Software Developed or Obtained
for Internal Use", issued on March 4,1998, is effective for the Company in
fiscal year 1999. There has not been a significant impact upon adoption.

Impact of the Year 2000 Issue

The costs of the planned Year 2000 modifications and the dates by which the
Company expects to complete its plans are based on Management's best estimates,
which were derived utilizing numerous assumptions of future events, including
the continued availability of certain resources, third-party modification plans
and other factors. Specific factors that might cause differences between the
estimates and actual results include, but are not limited to, the availability
and cost of personnel trained in these areas, the ability to locate and correct
all relevant computer codes, changes in consulting fees and costs to remediate
or replace hardware and software as well as non-incremental costs resulting from
redeployment of internal resources, timely responses to and corrections by third
parties such as significant customers and suppliers, and similar uncertainties.

The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. The issue arises if
date-sensitive software recognizes a date using "00" as the year 1900 rather
than the year 2000. This could result in a system failure or miscalculations
causing disruptions of operations, including, among other things, a temporary
inability to process transactions, send invoices, or engage in similar normal
business activities.

The Company's information technology systems consist primarily of hardware and
software purchased from outside parties. The vendor for the Company's
enterprise-wide software has informed the Company that the version of its
software that the Company is currently utilizing is Year 2000 compliant and the
Company is currently testing to ensure that this is the case. This testing phase
is expected to be complete by mid-1999. The Company is in the process of
addressing the Year 2000 compliance of other software and hardware. The Company
is utilizing a seven step process in addressing compliance of these other
systems: (1) awareness; (2) inventory of all systems and documentation; (3)
assessment to identify any areas of noncompliance; (4) remediation/renovation of
any noncompliant systems; (5) verification of compliance through testing and/or
vendor certification; (6) implementation of any necessary changes

                              Page 17
<PAGE>

revealed during verifications; and (7) monitoring of the results of
implementation. The Company is in the process of identifying areas of
non-compliance. The Company expects to have completed the entire process for its
non-enterprise software and hardware by the end of third quarter 1999.

The Company has begun the process of identifying and making inquiries of its
significant suppliers and large public and private sector customers to determine
the extent to which the Company is vulnerable to those third parties' failure to
solve their own Year 2000 issues. The Company expects that the process of making
inquiries to these significant suppliers and customers will be ongoing through
the end of 1999. However, there can be no guarantee that the systems of other
companies or public agencies with which the Company does business will be timely
converted, or that failure to convert by another company or public agency would
not have a material adverse effect on the Company.

The Company's most likely worst case Year 2000 scenario would be an interruption
in work or cash flow resulting from unanticipated problems encountered with the
information systems of the Company, or of any of the significant third parties
with whom the company does business. The Company believes that the risk of
significant business interruption due to unanticipated problems with its own
systems is low based on the progress of the Year 2000 project to date. If
unforeseen internal disruptions occur, the Company believes that its existing
disaster recovery program, which includes the manual processing of certain key
transactions, would significantly mitigate the impact. The Company's highest
risk relates to significant suppliers or customers failing to remediate their
Year 2000 issues in a timely manner. Relating to its suppliers, the Company has
identified and will continue to identify alternative suppliers. The Company's
suppliers are generally locally or regionally based, which tends to lessen the
Company's exposure from the lack of readiness of any single supplier. The risk
relating to the Company's customers relates primarily to any delay in receipt of
payment due to a customer's unresolved Year 2000 issue. The Company's existing
financial resources will help to mitigate such an impact and the Company will
continue to assess this risk as it receives communications about the Year 2000
status of its customers.

The Company estimates that costs to address the Year 2000 issue will total
approximately $275,000, including costs already incurred. These estimated costs
include consulting fees and costs to remediate or replace hardware and software
as well as

                             Page 18
<PAGE>

non-incremental costs resulting from redeployment of internal resources. To
date, an insignificant amount has been incurred and expensed related to the Year
2000 issue. The Company's Year 2000 costs will be funded from its operating cash
flows.

  Item 3.  Quantitative and Qualitative Disclosures about
           Market Risk

The Company considered the provision of Financial Reporting Release No. 48,
"Disclosure of Accounting Policies for Derivative Financial Instruments and
Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative
Information about Market Risk Inherent in Derivative Financial Instruments,
Other Financial Instruments and Derivative Commodity Instruments". The Company
had no holdings of derivative financial or commodity instruments at March 31,
1999. A review of the Company's other financial instruments and risk exposures
at that date revealed that the Company had exposure to interest rate risk. At
March 31, 1999, the Company performed sensitivity analyses to assess the
potential effect of this risk and concluded that near-term changes in interest
rates should not materially adversely affect the Company's financial position,
results of operations or cash flow.




=============================================================
This Report on Form 10-Q contains forward-looking statements which are made in
reliance on the Safe Harbor provisions of the Private Securities Litigation
Reform Act. Readers are cautioned that such forward-looking statements are
subject to risks and uncertainties and actual results could differ materially.
Certain of these risks and uncertainties are discussed herein under the section
"Risk Factors" and elsewhere in this Report as well in the Company's other
filings with the Securities and Exchange Commission.

-------------------------------------------------------------
Zitel is a registered trademark of Zitel Corporation.
All other product names and brand names are trademarks or 
registered trademarks of their respective holders.



                             Page 19
<PAGE>

PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings

On December 14, 1998, the Company commenced a suit against VLSI Technology, Inc.
in the Superior Court of the State of California in and for the County of Santa
Clara. The complaint alleges that the defendant promised to design and develop
certain application specific integrated circuits (ASICs) critical to the
Company's planned third-generation data storage system product (CASD-III), that
VLSI failed to design or develop the promised ASICs, and that the Company was
forced to abandon the CASD-III project and dispose of its Intelligent Storage
Systems business unit. The suit seeks damages with respect to CASD-III
development costs and loss of profits.

Item 2.  Changes in Securities

         None

Item 3.  Defaults Upon Senior Securities

         None

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

An annual meeting of shareholders of the Company was held on March 11, 1999. A
total of 19,390,869 shares of the Company's Common Stock out of a total
21,907,553 shares outstanding on the record date for the meeting were
represented and voted in person or by proxy.

The Company has a six-person Board of Directors. At the annual meeting, all six
directors were nominated and re-elected to the Board of Directors by a vote of
at least 18,333,595 shares in favor and at least 555,774 shares withholding
authority to vote.

The shareholders approved the adoption of an amendment to the 1990 Stock Option
Plan, as amended, to provide that the number of shares of Common Stock reserved
for issuance under such Plan be increased by 500,000 shares, from 6,200,000
shares (including shares reserved or granted under the Company's prior Option
Plans) to 6,700,000 shares. The motion was carried by a vote of 17,996,907
shares voting for, 1,210,135 dissenting votes and 183,827 abstaining votes.

The shareholders approved the adoption of an amendment to the

                             Page 20
<PAGE>

1995 Non-Employee Directors' Stock Option Plan, as amended, to provide that the
number of shares of Common Stock reserved for issuance under such Plan be
increased by 200,000 shares, from 200,000 shares (including shares reserved or
granted under the Company's prior Option Plans) to 400,000 shares. The motion
was carried by a vote of 17,919,562 shares voting for, 1,283,075 dissenting
votes and 188,232 abstaining votes.

Item 5.  Other Information

                          Risk Factors

Recent Levels of Net Sales Have Been Insufficient

In recent years, Zitel has not generated net sales sufficient to produce an
operating profit and has relied on a stream of royalty payments under an
agreement with IBM Corporation and significant financings to support its
activities. In April 1998, Zitel and IBM entered into an agreement whereby IBM
stopped paying royalties to the Company in exchange for a lump sum payment
amounting to $740,000. Zitel sustained substantial operating losses and net
losses in fiscal 1997 and 1998 and in the first half of fiscal 1999. Zitel must
generate substantial additional net sales and gross margins on its products and
services and must continue to successfully implement programs to manage cost and
expense levels in order to remain a viable operating entity. There is no
assurance that Zitel can achieve these objectives.

Significant Losses

For the first half of fiscal year 1999, the Company reported a net loss of
$4,839,000. During the Company's 1998 fiscal year, the Company has reported a
total net loss of $43,205,000. The Company reported a total net loss of
$17,501,000 in fiscal 1997 and total net income of $4,049,000 in fiscal 1996.

While the Company has taken a number of steps to attempt to return to
profitability, there is no assurance that it will be successful. A significant
portion of the recent losses were caused by the operations of the Company's
former storage systems business unit; in July 1998, the Company sold that
business unit. The Company is in the process of attempting to sublease its
Fremont, California, headquarters and move to substantially smaller and less
costly premises.

The Company is taking other actions to reduce its costs in an effort to bring
costs into line with anticipated revenues.  There

                             Page 21
<PAGE>

can be no assurance that the Company will be successful in this effort and
remain a viable operating entity.

Nasdaq Listing Criteria

The Company's common stock is quoted on the Nasdaq National Market, which
requires the Company to meet the National Market maintenance criteria. If the
Company fails to meet the criteria and is not able to raise sufficient equity or
otherwise take action to meet such requirements, the Company may be delisted
from the National Market and the quotation of the Company's stock could be
included on the Nasdaq SmallCap Market or in the non-Nasdaq over-the-counter
market. As a result of any such delisting, an investor may find it more
difficult to trade in shares of the Company's Common Stock.

Change of Nature of Business

From its organization in 1979 until the acquisition of the Datametrics
businesses in June 1997, substantially all of the Company's net sales were
generated from the design, manufacture and sale of electronic data storage
systems. In June 1997, the Company acquired the business of Datametrics Systems
Corporation and certain related businesses which were engaged in the
development, marketing and sales of software products. In fiscal 1997, the
Company commenced offering Year 2000 conversion services; the first remediation
revenue from the Year 2000 business unit was recorded in the third quarter of
1998. With the sale of the Company's storage business unit, substantially all of
its operations are in businesses in which it has limited experience.
Accordingly, the Company must quickly develop increased management skills
necessary to survive and realize net income in these new businesses. There is no
assurance that it will be successful in developing these skills or realizing net
income in the future.

Fluctuations in Quarterly Results

Zitel's quarterly operating results have in the past varied and may in the
future vary significantly depending on a number of factors, including:

  - The level of competition, the size, timing, cancellation or rescheduling 
of significant orders;

  - Market acceptance of new products and product enhancements;


                             Page 22
<PAGE>

  - New product announcements or introductions by Zitel's competitors;

  - Deferrals of customer orders in anticipation of new products or product 
enhancements;

  - Changes in pricing by Zitel or its competitors;

  - The ability of Zitel to develop, introduce and market new products and 
product enhancements on a timely basis;

  - Zitel's success in expanding its sales and marketing programs;

  - Technological changes in the market for Zitel's products;

  - Product mix and the mix of sales among Zitel's sales channels;

  - Levels of expenditures on research and development;

  - Changes in Zitel's strategy; personnel changes; and,

  - General economic trends and other factors.

Due to all of the foregoing factors, Zitel believes that period-to-period
comparisons of its results of operations are not necessarily meaningful and
should not be relied upon as an indicator of future performance. It is possible
that in some future quarter the Company's operating results may be below the
expectations of public market analysts and investors.

Investment in MatriDigm Corporation

At September 30, 1998, the Company had invested approximately $7,400,000 to
acquire approximately 31% interest in MatriDigm, a private company organized to
provide COBOL software maintenance and re-engineering services for users of IBM
mainframe computer systems. In addition, the Company has demand notes in the
amount of $2,000,000 and has guaranteed a bank guarantee of $1,000,000. At
September 30, 1998, the Company has written off its investment and fully
reserved the demand notes and the bank guarantee. In the quarter ended December
31, 1998, the Company advanced an additional $1,500,000 and has fully reserved
the additional advance. In October 1998, the Company entered into an agreement
to acquire the balance of MatriDigm, which agreement has since been terminated.
The Company paid $250,000 on January 21, 1999 for a non-exclusive,
royalty-bearing license for the MatriDigm technology. The Company has continued
to explore possible

                             Page 23
<PAGE>

transactions to acquire the balance of MatriDigm but there is no assurance that
such a transaction will be consummated.

The initial focus of MatriDigm has been development of technology to automate
the conversion of legacy software code which could not recognize or utilize
dates after the year 1999 (the "Year 2000 Problem") into code which is able to
recognize and utilize dates into the next century. MatriDigm has devoted
substantially all of its engineering resources to development of such
technology. In May 1997, MatriDigm announced the commercial availability of its
MAP2000 windowing process for programs written in ANSI COBOL 85. MatriDigm has
subsequently extended the capability of MAP2000 to cover COBOL ANSI 68 and 74,
with support for CICS and IMS/DC transactions and VSAM, IMS/DB SQL and DB2
databases and file systems. MatriDigm's MARC2000, introduced June 1998, is a
tool which provides independent verification and validation (IV&V) to confirm
the accuracy and completeness of COBOL Year 2000 code conversions. It provides
extensive reports identifying faulty and potentially faulty code and helps the
customer to record the activities needed to demonstrate due diligence in
auditing COBOL Year 2000 renovation projects. MatriDigm intends to continue to
refine its current toolset and to extend its toolset.

Substantially all software programs written assume that the first two digits of
any date are "19" and cannot recognize or utilize dates commencing with the year
2000. Estimates of the cost and available market for conversion of existing code
to eliminate this problem are substantial and vary widely. The alternative
solutions available to a company with a Year 2000 Problem include migration to
new programs, elimination of code with a Year 2000 Problem, use of internal
resources to convert existing code, or procurement of conversion services from
outside providers such as the Company and MatriDigm.

A large number of companies, many of which have substantially greater resources
than MatriDigm, are offering conversion services or are developing systems to
provide such services, and competition is intense among the providers of such
services. However, the demand for Year 2000 conversion services has emerged at a
slower pace than originally anticipated and there is no assurance that it can
successfully market its automated toolset, develop extensions for other computer
languages or generate substantial revenue and profits. MatriDigm's customers
have begun to recognize the value of their product and services and request that
they have continued use of the products and services. These quality assurance,
management change control and

                             Page 24
<PAGE>

audit trail capabilities are the basis for MatriDigm's markets following the
year 2000. While larger and more sophisticated users are requesting this
capability now, there is no assurance that a significant enough volume of
business will emerge in the future to sustain the company. During the course of
development, the Company has made additional investments in MatriDigm and
continues to make additional investments. To the extent other investors are
unable or unwilling to continue to make investments in MatriDigm, the Company
may be required to make a disproportionate share of such investments. These
investments could have a material adverse effect on the Company's business
results of operations and financial condition.

Zitel Stock Price Has Been Volatile

The price of Zitel's Common Stock has been subject to extreme volatility during
fiscal 1997 and 1998, as the closing bid price has ranged between a low of 10
7/8 and a high of 61 1/4 and a low of 2 7/32 and a high of 23 5/8, respectively.
In the first half of fiscal 1999, such price ranged between a low of 2 1/16 and
a high of 6 29/64. Zitel believes that one of the reasons for this volatility is
rumored progress of and rumored problems in the product development program and
marketing efforts of MatriDigm.

Competition

The market for system management tools in which the Company's software products
business unit competes is intensely competitive. Many of the companies with
which the Company competes, such as Computer Associates International, Inc.,
Hewlett-Packard Company, and BMC Software, Inc. have substantially larger
installed bases and greater financial resources than the Company. There can be
no assurance that the Company's competitors will not develop products comparable
or superior to those developed by the Company or adapt more quickly than the
Company to new technologies, evolving industry standards, new product
introductions, or changing customer requirements.

The market for Year 2000 conversion services is highly competitive, with
services being provided by a number of international, national, regional and
local firms, many of which have existing relationships and contractual
arrangements with customers. Many of these competitors have substantially
greater financial, technical and marketing resources than the Company. The
ability of the Company to compete in the IBM COBOL segment of this market will
depend primarily on the ability of MatriDigm to

                             Page 25
<PAGE>

achieve market acceptance of its automated solution and as yet there can be no
assurance that MatriDigm will be successful in this effort. In addition, the
Company must achieve general credibility as a provider of Year 2000 conversion
services by generating substantial net sales.

Dependence on New Products; Rapid Technological Change

The markets in which the Company operates are characterized by rapid
technological change, changing customer needs, frequent new product
introductions and evolving industry standards. The introduction of products
embodying new technologies and/or the emergence of new industry standards could
render the Company's existing products and services obsolete and unmarketable.
The Company's future success will depend upon its ability to develop and to
introduce new products and services on a timely basis that keep pace with
technological developments and emerging industry standards and address the
increasingly sophisticated needs of its customers. There can be no assurance
that the Company will be successful in developing and marketing products or
services that respond to technological changes or evolving industry standards,
that the Company will not experience difficulties that could delay or prevent
the successful development, introduction and marketing of new products or
services, or that its new products or services will adequately meet the
requirements of the marketplace and achieve market acceptance. If the Company is
unable, for technological or other reasons, to develop and introduce new
products or services in a timely manner in response to changing market
conditions or customer requirements, the Company's business, operating results
and financial condition will be materially and adversely affected.

Product Liability

The Company's agreements with its customers typically contain provisions
intended to limit the Company's exposure to potential product liability claims.
It is possible that the limitation of liability provisions contained in the
Company's agreements may not be effective. Although the Company has not received
any product liability claims to date, the sale and support of products by the
Company and the incorporation of products from other companies may entail the
risk of such claims. A successful product liability claim against the Company
could have a material adverse effect on the Company's business, operating
results and financial condition.

The extent to which the solution services business unit must

                             Page 26
<PAGE>

provide warranty protection to its customers in order to be competitive remains
uncertain. To the extent that future warranty obligations shift risks to the
Company that are in excess of the warranty protection provided to the Company by
MatriDigm and other toolset providers, a successful claim against the Company
could have a material adverse effect on the Company's business, operating
results and financial condition.

Dependence on Proprietary Technology

The Company's success depends significantly upon its proprietary technology. The
Company currently relies on a combination of patent, copyright and trademark
laws, trade secrets, confidentiality agreements and contractual provisions to
protect its proprietary rights. The Company seeks to protect its software,
documentation and other written materials under trade secret and copyright laws,
which afford only limited protection. The Company has registered its Zitel and
Datametrics trademarks and will continue to evaluate the registration of
additional trademarks as appropriate. The Company generally enters into
confidentiality agreements with its employees and with key vendors and
suppliers. The Company currently holds a United States patent on one of its
software technologies. There can be no assurance that this patent will provide
the Company with any competitive advantages or will not be challenged by third
parties, or that the patents of others will not have a material adverse effect
on the Company's ability to do business. The Company believes that the rapidly
changing technology in the computer industry makes the Company's success depend
more on the technical competence and creative skills of its personnel than on
patents.

There has also been substantial litigation in the computer industry regarding
intellectual property rights, and litigation may be necessary to protect the
Company's proprietary technology. The Company has not received significant
claims that it is infringing third parties' intellectual property rights, but
there can be no assurance that third parties will not in the future claim
infringement by the Company with respect to current or future products,
trademarks or other proprietary rights.

The Company expects that companies in its markets will increasingly be subject
to infringement claims as the number of products and competitors in the
Company's target markets grows. Any such claims or litigation may be
time-consuming and costly, cause product shipment delays, require the Company to
redesign its products or require the Company to enter into royalty or

                             Page 27
<PAGE>

licensing agreements, any of which could have a material adverse effect on the
Company's business, operating results or financial condition. Despite the
Company's efforts to protect its proprietary rights, unauthorized parties may
attempt to copy aspects of the Company's products or to obtain and use
information that the Company regards as proprietary. There can be no assurance
that the Company's means of protecting its proprietary rights will be adequate
or that the Company's competitors will not independently develop similar
technology, duplicate the Company's products or design around patents issued to
the Company or other intellectual property rights of the Company.

The Company's solution services business unit relies primarily on proprietary
technology developed and owned by MatriDigm and the prospects for the business
unit are dependent on the ability of MatriDigm to maintain and expand a toolset
which provides a relative advantage over competing Year 2000 conversion service
providers for IBM COBOL. In the event that the MatriDigm toolset does not
achieve significant market acceptance, the business of the solution services
business unit would be materially and adversely affected.

International Sales and Operations

Sales to customers outside the United States have accounted for significant
portions of the Company's net sales, and the Company expects that the
acquisition of companies headquartered and operating in the United Kingdom and
The Netherlands, respectively, will result in international sales representing
an increasingly significant portion of the Company's net sales. International
sales pose certain risks not faced by companies that limit themselves to
domestic sales. Fluctuations in the value of foreign currencies relative to the
U.S. dollar, for example, could make the Company's products less price
competitive. If the Company, in the future, denominates any of its sales in
foreign currencies, this could result in losses from foreign currency
transactions. International sales also could be adversely affected by factors
beyond the Company's control, including the imposition of government controls,
export license requirements, restrictions on technology exports, changes in
tariffs and taxes and general economic and political conditions. The laws of
some countries do not protect the Company's intellectual property rights to the
same extent as the laws of the United States. The Company does not believe these
additional risks are significant in the United Kingdom or in The Netherlands.

                             Page 28
<PAGE>

Dependence on Key Personnel

The Company's future performance depends in significant part upon the continued
service of its key technical and senior management personnel. The Company
provides incentives such as salary, benefits and option grants (which are
typically subject to vesting over four years) to attract and retain qualified
employees. The loss of the services of one or more of the Company's officers or
other key employees could have a material adverse effect on the Company's
business, operating results and financial condition. The Company's future
success also depends on its continuing ability to attract and retain highly
qualified technical and management personnel. Competition for such personnel is
intense, and there can be no assurance that the Company can retain its key
technical and management employees or that it can attract, assimilate and retain
other highly qualified technical and management personnel in the future.

The future success of the Company's solution services business unit in
particular will depend to a significant extent on its ability to attract, train,
motivate and retain highly skilled software development professionals,
particularly project managers, software engineers and other senior technical
personnel. The Company believes that in the United States and elsewhere there is
a shortage of, and significant competition for, software development
professionals with the advanced technological skills necessary to perform the
services offered by the solution services business unit. The increasing
recognition of the scope and significance of the Year 2000 problem has
materially increased the competition for personnel with appropriate skills and
salary requirements have increased as availability of such personnel has
declined precipitously. The Company's ability to maintain and renew existing
relationships and obtain new business depends, in large part, on its ability to
hire and retain technical personnel. An inability to hire such additional
qualified personnel could impair the ability of the solution services business
unit to manage and complete its existing projects and to bid for or obtain new
projects.

Anti-Takeover Provisions

Certain provisions of the Company's Certificate of Incorporation, as amended and
restated, and Bylaws, as amended, California law and the Company's
indemnification agreements with certain officers and directors of the Company
may be deemed to have an anti-takeover effect. Such provisions may delay, defer
or prevent a tender offer or takeover attempt that a stockholder

                             Page 29
<PAGE>

might consider to be in that stockholder's best interests, including attempts
that might result in a premium over the market price for the shares held by
stockholders.

The Company's Board of Directors may issue additional shares of Common Stock or
establish one or more classes or series of Preferred Stock, having the number of
shares designations, relative voting rights, dividend rates, liquidation and
other rights, preferences and limitations as determined by the Board of
Directors without stockholder approval.

The Board of Directors of the Company has approved the adoption of a Preferred
Share Purchase Rights Plan (the "Rights Plan"). Terms of the Rights Plan provide
for a dividend distribution of one preferred share purchase right (a "Right")
for each outstanding share of common stock, no par value per share (the "Common
Shares"), of the Company. Each Right entitles the registered holder to purchase
from the Company one one-hundredth of a share of Series A Junior Participating
Preferred Stock, no par value (the "Preferred Stock"), at an exercise price of
$69.50 per one one-hundredth of a Preferred Share (the "Purchase Price"),
subject to adjustment, and a redemption price of $.01 per Right. Each one
one-hundredth of a share of Preferred Stock has designations and the powers,
preferences and rights, and the qualifications, limitations and restrictions
which make its value approximately equal to the value of a Common Share.

The Rights are not exercisable until the earlier to occur of (i) 10 days
following a public announcement that a person, entity or group of affiliated or
associated persons (an "Acquiring Person") have acquired beneficial ownership of
15% or more of the outstanding Common Shares or (ii) 10 business days (or such
later date as may be determined by action of the Board of Directors prior to
such time as any person or entity becomes an Acquiring Person) following the
commencement of, or announcement of an intention to make, a tender offer or
exchange offer the consummation of which would result in the beneficial
ownership by a person or group of 15% or more of such outstanding Common Shares.

The Rights have certain anti-takeover effects, as they would cause substantial
dilution to a person or group that attempted to acquire the Company on terms not
approved by the Company's Board of Directors. The Rights should not interfere
with any merger or other business combination approved by the Board of
Directors, since the Rights may be redeemed by the Company at $.01 per Right
prior to the earliest of (i) the twentieth day following the time

                             Page 30
<PAGE>

that a person or group has acquired beneficial ownership of 15% or more of the
Common Shares (unless extended for one or more 10 day periods by the Board of
Directors), (ii) a change of control, or (iii) the final expiration date of the
rights.

Item 6.  Exhibits and Reports on Form 8-K

         (a)  Exhibits

              Exhibit 27 - Financial Data Schedule

         (b)  Reports on Form 8-K

              During the period from January 1, 1999 through March 31, 1999, the
              Company filed the following current report on Form 8-K:

              Date of Report   - Item(s) Reported:
              February 3, 1999 - Placement of 3% Convertible
                                 Subordinated Debentures







                             Page 31
<PAGE>
                            SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, Registrant
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.


                                  ZITEL CORPORATION


Date:  May 10, 1999               /s/ Henry C. Harris
                                  Henry C. Harris
                                  Chief Financial Officer






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