<PAGE>


                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549

                                   FORM 10-Q

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

                  For the quarterly period ended June 30, 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 June
30, 1999 was 21,946,424.


<PAGE>


              ZITEL CORPORATION AND SUBSIDIARIES


                             INDEX

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

  Item 1.  Financial Statements

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

     Condensed Consolidated Statements of
       Operations (unaudited) - Three and Nine Months
        Ended June 30, 1999 and 1998 .........................  4

     Condensed Consolidated Statements of
       Cash Flows (unaudited) - Nine Months Ended
       June 30, 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 ................................. 20

  Item 6.  Exhibits and Reports on Form 8-K .................. 30
</TABLE>

                                     Page 2
<PAGE>


                       ZITEL CORPORATION AND SUBSIDIARIES

                      CONDENSED CONSOLIDATED BALANCE SHEETS
                                    ($000's)


<TABLE>
<CAPTION>
                                       June 30,   September 30,
                                         1999         1998
                                       --------   ------------
                                     (UNAUDITED)
<S>                                  <C>          <C>
     ASSETS
Current assets:
  Cash and cash equivalents            $ 3,268       $ 6,589
  Accounts receivable, net               5,559         3,579
  Refundable taxes                         212           208
  Other current assets                   1,550           749
                                       -------       -------
    Total current assets                10,589        11,125

Fixed assets, net                          870         1,311
Other assets, net                        4,906         5,634
                                       -------       -------
  Total assets                         $16,365       $18,070
                                       -------       -------
                                       -------       -------

     LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable                     $ 2,797       $ 3,585
  Accrued liabilities                    1,031         1,527
  Deferred revenue                       2,306         2,139
                                       -------       -------
    Total current liabilities            6,134         7,251

Convertible subordinated debenture       4,924         4,585
                                       -------       -------
    Total liabilities                   11,058        11,836

Shareholders' equity:
  Common stock                          66,326        60,574
  Accumulated deficit                  (61,019)      (54,340)
                                       -------       -------
  Total shareholders' equity             5,307         6,234
                                       -------       -------
  Total liabilities and
    shareholders' equity               $16,365       $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  Nine Months Ended
                                            June 30,            June 30,
                                       ------------------  ------------------
                                         1999      1998      1999      1998
                                       -------   --------  --------  --------
<S>                                    <C>       <C>       <C>       <C>
Net sales                              $ 6,318   $  4,591  $ 16,457  $ 16,137
Royalty revenue                              -        749         -     1,541
                                       -------   --------  --------  --------
  Total revenue                          6,318      5,340    16,457    17,678
Cost of goods sold                       3,427      4,445     7,100    10,240
Research and development expenses          749      1,616     2,017     5,567
Selling, general &
  administrative expenses                3,920      7,614    11,470    19,474
Loss on impairment of assets                 -      1,956         -     1,956
Loss from unconsolidated company             -          -     1,512         -
                                       -------   --------  --------  --------
  Operating loss                        (1,778)   (10,291)   (5,642)  (19,559)

Interest expense                           172      1,401     1,356     2,409
Other (income) expense                    (110)       288      (319)       (2)
                                       -------   --------  --------  --------
Loss before income taxes                (1,840)   (11,980)   (6,679)  (21,966)
Provision for income taxes                   -      6,547         -     6,547
                                       -------   --------  --------  --------
Net loss                               $(1,840)  $(18,527) $ (6,679) $(28,513)
                                       -------   --------  --------  --------
                                       -------   --------  --------  --------

Basic and diluted loss per share       $ (0.08)  $  (1.07) $  (0.31) $  (1.73)
                                       -------   --------  --------  --------
                                       -------   --------  --------  --------

Number of shares used in basic and
  diluted loss per share calculations   21,930     17,235    21,739    16,528
                                       -------   --------  --------  --------
                                       -------   --------  --------  --------
</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)
                                                   Nine Months Ended
                                                       June 30,
                                                    1999      1998
                                                  --------   -------
<S>                                               <C>        <C>
Cash flows provided by (used in)
  operating activities:
  Net loss                                        $ (6,679)  $(28,513)
  Adjustments to reconcile net loss to net cash
   provided by (used in) operating activities:
    Loss on impairment of assets                         -      1,956
    Writedown of inventory                               -      1,655
    Writedown of patents                                 -        387
    Adjustment of goodwill and purchased
      technology                                         -        658
    Loss from unconsolidated company                 1,512        410
    Discount on subordinated debenture                 555      1,111
    Interest accrued on convertible
      subordinated debenture                           379        584
    Amortization of capitalized financing costs        362        672
    Depreciation and amortization                    1,673      2,338
    Provision for doubtful accounts                    166        155
    Provision for inventory allowances                   -        160
    Change in operating assets and liabilities:
    (Increase) decrease in accounts receivable      (2,146)     2,630
    (Increase) decrease in deferred
      and refundable taxes                              (4)     6,509
    Decrease in inventories                              -      1,028
    Increase in other current assets                  (801)      (942)
    Decrease in accounts payable                      (788)      (568)
    Decrease in accrued liabilities                   (496)      (282)
    Deferred revenue                                   167      1,001
                                                  --------    -------
 Net cash used in operating activities              (6,100)    (9,051)
                                                  --------    -------
Cash flows provided by (used in)
  investing activities:
    Purchase of fixed assets                          (144)      (549)
    Investment in unconsolidated company            (1,512)    (1,510)
    Proceeds from sale of marketable securities          -      9,596
    Capitalized software development costs            (260)      (349)
    Purchased technology                              (250)      (550)
    Decrease in (purchase of) other assets               7       (865)
                                                  --------    -------
 Net cash provided by (used in)
   investing activities                             (2,159)     5,773
                                                  --------    -------
</TABLE>


                                     Page 5
<PAGE>


              ZITEL CORPORATION AND SUBSIDIARIES

        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                          (continued)
                            ($000's)

<TABLE>
<CAPTION>
                                                      (UNAUDITED)
                                                   Nine Months Ended
                                                       June 30,
                                                    1999      1998
                                                  --------   -------
<S>                                               <C>        <C>
Cash flows provided by financing activities:
   Issuance of common stock                       $    156   $  1,238
   Issuance of subordinated debentures               4,782      9,567
                                                  --------   --------
 Net cash provided by financing activities           4,938     10,805
                                                  --------   --------
 Net increase (decrease) in cash                    (3,321)     7,527
Cash and cash equivalents, beginning of year         6,589      4,224
                                                  --------   --------
Cash and cash equivalents, end of period          $  3,268   $ 11,751
                                                  --------   --------
                                                  --------   --------
Supplemental non-cash investing and
 financing activities:
  Capitalized financing costs                     $    218   $    558
                                                  --------   --------
                                                  --------   --------
  Common stock purchase warrants                  $    128   $    614
                                                  --------   --------
                                                  --------   --------
  Conversion of subordinated debentures
    and accrued interest                          $  4,912   $ 18,791
                                                  --------   --------
                                                  --------   --------
</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 June 30, 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 nine months ended June 30, 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 2001 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>
                                        June 30,    September 30,
                                         1999            1998
                                        --------    -------------
    <S>                                 <C>         <C>
    Goodwill                            $ 2,754        $ 2,768
    Purchased technology                  2,588          2,588
    Other assets                          2,263          1,890
    Less accumulated amortization        (2,699)        (1,612)
                                        -------        -------
                                        $ 4,906        $ 5,634
                                        -------        -------
                                        -------        -------
</TABLE>

4.  Investment in Unconsolidated Company:
    The following is a summary of financial information with respect to
MatriDigm for the three and nine months ended June 30, 1999 and 1998,
respectively:

<TABLE>
<CAPTION>
                                        Three months ended     Nine months ended
                                            June 30,               June 30,
                                        1999        1998        1999      1998
                                       ------     -------      -------  --------
    <S>                                <C>        <C>          <C>      <C>
    Net sales                          $2,120     $ 2,085      $ 3,727  $  3,975
    Gross profit                        1,562       1,217        2,130     1,478
    Loss before one-time merger costs    (855)     (3,059)      (5,418)  (10,484)
    Net loss                             (855)     (3,059)      (6,118)  (10,484)
</TABLE>

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


                                     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
convert 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 $1.70.

    For the nine months ended June 30,1999, a charge to interest expense in
the amount of $124 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 June 30, 1999, there have
been no conversions of the Debentures.

7.  Common Stock:
    Common stock activity for the period from September 30, 1998 through June
30, 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                       94               156
    Common stock warrants and
      discount on subordinated debentures            -               684
                                                ------           -------
    Balance at June 30, 1999                    21,946           $66,326
                                                ------           -------
                                                ------           -------
</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):
    A reconciliation of the numerator and denominator of basic and diluted
EPS is provided as follow (in thousands, except per share amounts):


                                     Page 10
<PAGE>


<TABLE>
<CAPTION>
                                      Three Months Ended     Nine Months Ended
                                            June 30,              June 30,
                                      ------------------     -----------------
                                        l999     1998          1999     1998
                                      -------  --------      -------  --------
                                          (unaudited)           (unaudited)
<S>                                   <C>      <C>           <C>      <C>
Numerator - Basic and Diluted EPS
  Net loss                            $(1,840) $(18,527)     $(6,679) $(28,513)
                                      -------  --------      -------  --------
                                      -------  --------      -------  --------
Denominator - Basic EPS
  Common stock outstanding             21,930    17,235       21,739    16,528
  Common equivalent stock                   0         0            0         0
                                      -------  --------      -------  --------
                                       21,930    17,235       21,739    16,528
                                      -------  --------      -------  --------
Basic loss per share                  $ (0.08) $  (1.07)     $ (0.31) $  (1.73)
                                      -------  --------      -------  --------
                                      -------  --------      -------  --------
Denominator - Diluted EPS
  Denominator - Basic EPS              21,930    17,235       21,739    16,528
  Effect of Dilutive Securities:
    Common stock options                    0         0            0         0
    Convertible preferred stock             0         0            0         0
                                      -------  --------      -------  --------
                                       21,930    17,235       21,739    16,528
                                      -------  --------      -------  --------
Diluted loss per share                $ (0.08) $  (1.07)     $ (0.31) $  (1.73)
                                      -------  --------      -------  --------
                                      -------  --------      -------  --------
</TABLE>

    For the quarter and nine-month period ended June 30, 1999, options to
purchase 3 thousand and 73 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 nine-month period ended June 30, 1998, options to purchase 459 thousand
and 649 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 2,941 thousand and
2,582 thousand for the three and nine months ended June 30, 1999,
respectively. These shares were not included in the computation due to their
anti-dilutive effect.


                                     Page 11
<PAGE>


10. Loss on Sublease of Facility:
    In July 1999, the Company subleased approximately 40% of its facility in
Fremont, CA. Included in the current quarter is a loss associated with the
sublease arrangement in the amount of $387 thousand.

11. Subsequent Events:
    In July 1999, $2,490,000 of the Company's outstanding Debentures, together
with accrued interest, were converted into 1,470,149 shares of common stock of
the Company.

    On August 9, 1999, the Company entered into an agreement with MatriDigm
Corporation to acquire the outstanding shares of MatriDigm not owned by the
Company. The Company will issue approximately 2.2 million shares of common stock
upon closing of the merger. The transaction will be accounted for as a purchase
and is expected to occur in approximately 60 days, subject to regulatory
approval and other conditions.


                                     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 $1,840,000 ($0.08 per share) for the
quarter ended June 30, 1999 compared with a net loss of $18,527,000 ($1.07
per share) for the same quarter of the prior year. Weighted average shares
outstanding for the current quarter were 21,930,000 compared to 17,235,000
for the same quarter of the prior year. For the nine months ended June 30,
1999, the net loss was $6,679,000 ($0.31 per share) compared with a net loss
of $28,513,000 ($1.73 per share) for the same period a year earlier.
Year-to-date weighted average shares were 21,739,000 versus 16,528,000 in the
prior year.

Total revenue for the current quarter was $6,318,000 versus total revenue of
$5,340,000 for the same quarter of the prior year, an increase of $978,000.
The prior year included revenue of $855,000 related to the storage business
unit, which was disposed of in the third quarter of fiscal year 1998, and
royalties in the amount of $749,000, which terminated in April 1998. Revenue
from the Datametrics business unit was $3,662,000 in the current quarter, an
increase of 7% from the same quarter of the prior year. Revenue from the sale
of Year 2000 services in the current quarter was $2,656,000; there was
minimal revenue from the sale of such services in the prior quarter of the
prior year. For the nine months ended June 30, 1999, total revenue was
$16,457,000 versus total revenue of $17,678,000 for the same period of the
prior year, a decrease of $1,221,000. Included in the prior year was revenue
and royalties related to the storage business unit of $5,649,000 and
$1,541,000, respectively. Revenue from the Datametrics business unit was
$13,035,000 for the nine months just ended, an increase of 29% from the same
period in the prior year.

Gross margin as a percent of net sales was 46% for the quarter ended June
30,1999 compared to 3% for the same quarter of the prior year. For the
nine-month period ended June 30, 1999, the gross margin was 57% versus 37%
for the same period of the prior year. The improvement in the gross margin
percentage during the current quarter and nine-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 June 30, 1999, were
12% of total revenue compared with 30% for the same quarter of the prior
year. Actual spending decreased $867,000. For the nine-month period just
ended, research and development expenses were 12% of total revenue compared
with 31% for the same period of the prior year. Actual spending decreased
$3,550,000. The decrease in spending during both periods is primarily the
result of the sale of the storage business unit in July 1998.

Selling, general and administrative (SG&A) expenses were 62% of total revenue
for the current quarter versus 143% for the same quarter of the prior year.
Actual spending decreased $3,694,000. For the nine-month period just ended,
SG&A expenses were 70% of total revenue compared with 110% for the same
period a year earlier. Actual spending decreased $8,004,000. The decrease in
spending in both periods is primarily the result of the sale of the storage
business unit in the prior year.

During the nine months ended June 30, 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 nine-month period.

For the quarter just ended, interest expense related to the convertible
subordinated debentures was $172,000 versus $1,401,000 of interest expense
related to convertible subordinated debentures in the same quarter of the
prior year. For the nine months just ended, interest expense related to
convertible subordinated debentures was $1,356,000 compared to $2,409,000 of
interest expense related to convertible subordinated debentures for the same
period a year earlier.

Other income for the quarter just ended was $110,000 compared to other
expense of $288,000 for the same quarter of the prior year. Interest income
in the quarter was $81,000 compared to $100,000 in the prior year.

Liquidity and Capital Resources

During the nine-month period ended June 30, 1999, working capital increased
$581,000 and cash flow used in operating activities was $6,100,000. The
utilization of cash in operating activities resulted primarily from the net
loss of $6,679,000, an increase in accounts receivable of $2,146,000, an
increase in other current assets of $801,000, a decrease in accounts payable
of


                                     Page 14
<PAGE>


$788,000, and a decrease in accrued liabilities of $496,000. This was
partially offset by the loss from unconsolidated company of $1,512,000,
depreciation and amortization of $1,673,000, interest expense and related
costs in connection with the convertible subordinated debentures of
$1,296,000.

During the current year, net cash used in investing activities was
$2,159,000. The Company invested an additional $1,512,000 in an
unconsolidated company, purchased technology in the amount of $250,000, fixed
assets in the amount of $144,000, and capitalized software development costs
in the amount of $260,000.

Net cash provided by financing activities was $4,938,000, which included
$4,782,000 (net) from the issuance of convertible subordinated debentures and
$156,000 from the exercise of employee stock options and the employee stock
purchase plan.

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 nine months ended June 30, 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


                                     Page 15
<PAGE>


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 2001 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 16
<PAGE>


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.

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 late-1999. The Company is in


                                     Page 17
<PAGE>


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 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 the third calendar 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


                                     Page 18
<PAGE>


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 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 June 30, 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 June 30, 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

         None

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 nine months 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


                                     Page 20
<PAGE>


operating entity.  There is no assurance that Zitel can achieve these
objectives.

Significant Losses

For the first nine months of fiscal year 1999, the Company reported a net
loss of $6,679,000. 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. In July 1999, the Company subleased approximately
40% of its corporate headquarters in Fremont, CA, and will continue to
attempt to sublease the remainder of the facility 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 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


                                     Page 21
<PAGE>


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;

   - 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.


                                     Page 22
<PAGE>


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, guaranteed a bank guarantee of $1,000,000, and
has agreed to use the proceeds of a proposed sale of preferred stock to
secure the guarantee of an additional $2,000,000. 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. On August 9, 1999, the
Company entered into an agreement to acquire the balance of MatriDigm.
Consummation of the agreement is subject to regulatory approvals and other
conditions.

The initial focus of MatriDigm was 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 initially
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 has not generated
significant revenue from the sale of remediation services. 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


                                     Page 23
<PAGE>


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 emerged at a slower pace than originally anticipated and MatriDigm
was unable to successfully market its automated toolset for remediation of
code 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 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 and advances to MatriDigm and continues to make
additional advances. MatriDigm currently projects the need for additional
working capital advances at least through the end of calendar 1999 and the
Company will be required to provide those additional advances. These advances
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. During the first


                                     Page 24
<PAGE>


nine months of fiscal 1999, such price ranged between a low of 1 5/16 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 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


                                     Page 25
<PAGE>


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 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


                                     Page 26
<PAGE>


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
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


                                     Page 27
<PAGE>


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. 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.

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


                                     Page 28
<PAGE>


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 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


                                     Page 29
<PAGE>


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 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

              None


                                     Page 30
<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:  August 12, 1999            Anna M. McCann
                                  Anna M. McCann
                                  Chief Financial Officer


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