<PAGE>   1

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-K



                  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

        For the Fiscal Year Ended               Commission File Number:
            December 31, 1998                           0-21626



                                ELECTROGLAS, INC.

             (Exact Name of Registrant as Specified in its Charter)


                Delaware                              77-0336101
        (State of Incorporation)         (I.R.S. Employer Identification No.)


  2901 Coronado Drive, Santa Clara, California          (408) 727-6500
                    95054
    (Address of Principal Executive Offices)    (Registrant's Telephone Number
                  (Zip Code)                        Including Area Code)


        Securities registered pursuant to Section 12(b) of the Act: None
           Securities registered pursuant to Section 12(g) of the Act:
                          Common Stock, $0.01 par value
                                (Title of Class)

Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No[ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

As of January 31, 1999, the aggregate market value of the voting stock held by
non-affiliates of the Registrant was approximately $332,655,000, based on the
closing sale price as reported on the Nasdaq National Market on such date. This
calculation does not reflect a determination that certain persons are affiliates
of the Registrant for any other purposes.

As of January 31, 1999 the Registrant had outstanding 19,860,000 shares of 
Common Stock.

The Index to Exhibits is located beginning on Page 51.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement in connection with its 1998 Annual
Meeting of Stockholders are incorporated by reference into Part III of this Form
10-K Report.
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                                     PART I

                               ------------------

                                ITEM 1. BUSINESS

OVERVIEW

Electroglas, Inc. ("Electroglas" or "the Company") is a world-leading supplier
of process management tools to the global semiconductor industry. Semiconductor
manufacturers depend on the Company's wafer probers, inspection systems and
software to improve their productivity and control their processes, optimizing
manufacturing efficiency. Historically, the Company's primary product has been
automatic wafer probing equipment. Electroglas believes it is one of the largest
suppliers of wafer probers worldwide. The Company has sold over 10,000 wafer
probers from among its current product offerings and believes it supplies more
than half of the probers used in the United States and European market segments.
The Company's primary prober product offerings are its Horizon 4000 Series wafer
probers and its 2000 Series wafer probers. All of the Company's wafer probers
feature the Company's linear motor technology and offer advanced vision
processing, sophisticated system software and high throughput.

Today, the Company is also involved in the development, manufacture, marketing,
and servicing of semiconductor wafer inspection products and yield enhancement
software as part of its strategy to move from a supplier of wafer probers to a
process management tool provider. The move began with two acquisitions completed
in 1997. In May 1997, Electroglas acquired Sunnyvale, California-based Knights
Technology, Inc. ("Knights"). In December 1997, Electroglas acquired Albany,
Oregon-based Techne Systems, Inc. (doing business as "Electroglas Inspection
Products"). Knights' primary product offerings are their open architecture
Merlin's Framework CAD Navigation software and YieldManager yield management
system and their respective modules. Electroglas Inspection Products' primary
product offering is the QuickSilver line of automated wafer inspection systems.

Electroglas was formed on April 1, 1993 to succeed to the wafer prober business
conducted by the Electroglas division of General Signal Corporation (former
"Parent"). Immediately prior to the closing of the initial public offering of
its Common Stock ("the IPO") on July 1, 1993, the Company assumed the assets and
liabilities of the Electroglas division in the asset transfer and, following the
IPO, the Company commenced operations as an independent corporation. The
Company, through its predecessors, has been in the wafer prober business for
more than 30 years.

INDUSTRY BACKGROUND

Semiconductor devices are fabricated by repeating a complex series of process
steps on a wafer substrate, which is usually made of silicon and measures three
to eight inches in diameter. Wafers are typically sent through a series of 100
to 300 process steps. A finished wafer consists of many integrated circuits
(each referred to as a "device" or "die"), the number depending on the area of
the circuits and the size of the wafer. Manufacturers have increasingly utilized
larger diameter wafers to achieve more cost-effective production. The move to
larger 300mm (12 inch) wafers is expected to begin in 1999.

The management of these fabrication steps is Electroglas' latest focus. The
Company's wafer probers and inspection products collect data that is easily
accessed with their networking software and managed and analyzed by their yield
enhancement software products -- providing a way to manage the fabrication
process.



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WAFER PROBING

A wafer prober successively positions each integrated circuit on a wafer so that
the electrical contact points (or "pads") on the die align under and make
contact with the probe pins, which are located on a probe card mounted on the
wafer prober. The probe card, which is generally custom made by other suppliers
for the specific integrated circuit being tested, is connected to a test system,
also supplied by other suppliers, which performs the required parametric or
functional test. Parametric testing is performed during the wafer fabrication
process ("in-line testing") and at the completion of the wafer fabrication
process ("end-of-line testing") to measure electrical parameters which verify
the reliability of the wafer fabrication process. Functional testing is also
performed after the completion of wafer fabrication to identify devices which do
not conform to particular electrical specifications. This process is typically
called "wafer sort." Wafers sometimes go through several functional testing
steps.

POST-FAB WAFER INSPECTION

Before wafers are sent from the sort floor to final assembly, they typically
undergo an optical inspection step performed by human operators. This identifies
die with physical defects that have passed electrical test, but are at risk of
failure after the devices have been packaged. Sorting die both optically and
electrically improves product reliability while avoiding the cost of packaging
marginal die. Optical inspection on the sort floor is also used after wafer
probe to determine whether the probe tips caused bond-pad damage. Wafer
inspection tools automate this process of defect identification, defect
classification, and feedback control processes. The tools analyze each
individual die on each wafer for defects and process excursions, identify the
type of defect or pattern anomaly, measure the defect or anomaly, and pass the
quantitative results to both upstream and downstream production machines.

YIELD MANAGEMENT SOFTWARE

Yield enhancement software tools bring together fab data, inspection results,
electrical test data, and product test data to help determine which process
zones or tools are most significantly contributing to yield loss. They provide a
common location and format for presenting this data and doing cross-correlation
between data types for the purpose of yield enhancement analysis in the wafer
fab.

CAD NAVIGATION SOFTWARE

CAD Navigation software provides computerized interfaces and navigation
capabilities for IC design, failure analysis, defect review and debugging by
cross-mapping information from different design representations of specific
devices so that exact locations can be viewed in all three domains -- layout,
netlist, and schematic -- simultaneously.

WAFER PROBER MARKET

The automatic wafer probing market can be divided into the United States,
European and Asian market segments, into which the Company sells substantially
all of its products. Semiconductor manufacturers use automatic wafer probers
primarily during wafer sort, which occurs before the separation and packaging of
each individual device. Wafer probers have been increasingly used during in-line
and end-of-line testing and are also used for research and development, and
quality and process control applications. In-line testing requires special
equipment features such as cleanroom compatibility, as tests are carried out
during the manufacturing process. This testing is done to verify the
manufacturing process while wafers are in an unfinished state where corrective
action can occur. The Company estimates, based upon its experience, that wafer
sort applications represent approximately 80% of the market for automatic wafer
probers. The remaining 20% is divided between in-line and end-of-line testing
and laboratory applications.




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A semiconductor manufacturer typically purchases wafer probers when outfitting a
new wafer fabrication facility or expanding an existing facility. Wafer probers
are also purchased to replace equipment in response to major changes in
technology, such as larger wafer sizes and greater device complexity. A
semiconductor fabrication facility typically requires 20 to 80 probers to meet
testing requirements on a timely basis. The purchase of semiconductor
manufacturing equipment and spare parts, the integration of such equipment into
production lines and the training of employees on a particular supplier's
equipment require significant expenditures by semiconductor manufacturers. To
maximize the benefits of their investment in machinery, parts, production line
integration and training, semiconductor manufacturers generally are reluctant to
replace existing equipment with equipment from another supplier.

WAFER INSPECTION MARKET

The strong demand for lightweight, portable electronic devices is driving the
growth of new flip chip packaging technologies. Unlike conventional packaging
that uses fine gold wires to electrically connect the semiconductor chip to its
package, flip chips utilize gold or solder bumps that are deposited onto bonding
pads on the chip surface. The chips are then flipped into chip scale packages
(packages that are only slightly larger then the actual chip) or directly onto
printed circuit boards. Flip chips take up much less space then conventional
chips and, due to the elimination of the gold wires, flip chips can also operate
at higher speeds. The use of flip chip packaging is expected to grow rapidly as
memory, ASIC, and other device types are required to operate at high speed and
in tight spaces.

Wafer bumping is an expensive process, and the cost of flip chip packaging can
be very high. Bumps that are deformed, missing, and over or under sized will
cause the failure of flip chip devices. To avoid the cost of packaging defective
chips, semiconductor manufacturers are turning to automated wafer inspection
systems. Electroglas inspection systems are designed to inspect every bump on
every wafer providing the tools necessary for semiconductor manufacturers to
control their wafer bumping processes and to screen out defective chips prior to
probing and packaging.

YIELD ENHANCEMENT MARKET

Yield, or the percentage of good die that can be realized from a wafer, is a
critical factor in determining the profitability of a production line, and often
the semiconductor company as a whole. Therefore, efforts to maximize the yield
of each product line have become a key engineering priority at these companies.
This has led to a growing need for tools that monitor and analyze defects and
cause yield loss. Also, as defect problems are brought under control, there has
been an increased emphasis on finding and solving non-defect related problems.

Historically, much of the software used in this market was developed in-house by
the engineer, or through a dedicated development group. This created some highly
customized, but also inflexible and expensive to maintain, solutions to problems
related to data storage and analysis. However, many organizations are now
looking to out-source this work in an effort to lower their support costs,
maximize their engineers' productivity and increase the overall functionality of
their analysis tools.

CAD NAVIGATION MARKET

CAD Navigation software is typically used in design debug, low yield analysis
and failure analysis (FA). Engineers use CAD NAV software to move their probing,
measurement, or diagnostic equipment to a chip's internal locations, or to
locate on screen the faults on a chip. In recent years, new technologies have
made design debug and failure analysis increasingly difficult. For example, the
decreasing feature sizes make visualization difficult; rising device count makes
data handling difficult; multiple interconnect layers make device access
difficult; flip chip technology makes both device access and visualization
difficult. CAD Navigation software helps engineers simplify the process.




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In the US market, most major semiconductor manufacturers use multiple copies of
CAD NAV software in their failure analysis labs. The software helps integrate
their debug and FA functions. In the European market, a few leading major
manufacturers have started using CAD NAV in the past two years. Also single
license installations have been reaching most of the major manufacturers. In the
Japanese market, the economy is slower, but manufacturers are still using CAD
Navigation software.

COMPANY STRATEGY

Electroglas has become a leader in the wafer probing market through a
combination of strengths, including advanced technical capabilities, close
relationships with the leading manufacturers of integrated circuits, a broad
line of high quality products and a well established, highly qualified
distribution organization. Building on these strengths, Electroglas' strategy is
comprised of the following key elements:

o       Focus on Technological Innovation. The Company has invested heavily in
        research and development to add features and functionality to its
        products. The Company was the first to introduce automatic wafer probers
        using a linear motor positioning system for precise motion control and
        digital pattern recognition processors for automatic alignment and was
        the first to introduce automatic wafer probers for use with eight-inch
        wafers. The Company expects to continue its emphasis on research and
        development in an effort to anticipate and address technological
        advances in semiconductor processing.

o       Maintain Strong Customer Relationships. The Company has long-standing
        relationships with its customers. The Company's development of products
        and product enhancements is market driven. Engineering, sales and
        management personnel collaborate with customer counterparts to determine
        customers' needs and specifications. The Company expects to continue to
        strengthen its existing customer relationships by continuing to provide
        high levels of service and support.

o       Emphasize Quality Products. The Company believes it has developed a
        reputation as a leader in providing high quality products. The Company
        was chosen as one of the "Ten-Best" test and measurement equipment
        manufacturers for seven years in a row in an annual customer survey
        conducted by VLSI Research, Inc. The Company has received quality awards
        from its customers and the SEMATECH Partnering for Total Quality award.
        The Company has a company-wide quality program and received ISO 9002
        Certification in 1997. The Company's quality training program emphasizes
        continuous improvement, data driven decisions and close collaboration
        among the Company's employees, customers and suppliers. The Company
        trains all of its employees in basic quality skills. The Company also
        regularly participates in quality sharing meetings with other equipment
        manufacturers and customer quality audits of procedures and personnel.

o       Expand Product Lines and Applications. The Company intends to capitalize
        on its market position and technical skills to further broaden its
        product lines through internally developed products and from time to
        time through strategic alliances and acquisitions, such as the Knights
        and Techne acquisitions of 1997.




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PRODUCTS

WAFER PROBERS

Horizon 4000 Series: The Horizon 4090, and the Horizon 4090 (micro) are
the Company's primary offerings in the Horizon 4000 Series of wafer probers.
This product line is positioned to satisfy high volume semiconductor
manufacturing applications. The Horizon 4000 Series provides many advanced
automation capabilities including automatic probe-to-pad-alignment, in-process
inspection and optical character recognition (OCR). Optional for Horizon Series
probers is a temperature controlled chuck top, providing the ability to maintain
precisely a customer-selected wafer temperature during testing. The Horizon
4090(micro) prober also offers an integrated mini-environment and clean air
system to provide a class 1 probing environment. The Horizon 4090, and Horizon
4090(micro) utilize the Company's EGCommander system software. This software
was developed by the Company and allows significant application and customer
driven customization of the wafer prober and compatibility with the standard
MS-DOS operating system. The user interface features color graphics, touchscreen
programming, probing recipes, control maps and real-time maps. The Horizon 4000
Series probers feature a distributed multiple processor architecture to maximize
productivity and expandability.

The Company recently introduced thin wafer capabilities to its Horizon
4090(micro) prober. The enhanced 4090(micro) prober utilizes Electroglas'
patented Smart Mapping wafer map system. Smart Mapping uses fiber optic
through-beam sensing to detect and compensate for thin wafer irregularities such
as bowing, warping, and sagging. The system dynamically adjusts wafer transfer
arm entry and exit points on the cassette based on wafer position. The Horizon
4090(micro) prober also incorporates Electroglas' High Force Z stage and
advanced alignment algorithms. The complete system handles both thin and
standard wafers automatically and allows customers to use standard wafer
carriers, eliminating the need for special cassettes or extra transfer steps.

NETWORK PRODUCTS

Electroglas' SORTnet solution is a system of software products that allows
the integration of the Company's prober products into standard local area
networks found in semiconductor manufacturing operations. The network products
help allow manufacturers to monitor the entire probing operation, collect test
data on a real-time basis, centrally control prober setup and facilitate key
manufacturing advancements, including offline inking and inkless probing, in
order to improve overall productivity.

YIELD MANAGEMENT

YieldManager, introduced in 1994, is an integrated enterprise-wide,
client-server yield enhancement system for sub-micron semiconductor fabrication
facilities. YieldManager takes the output from testers, probers and inspection
equipment used at various points in the semiconductor fabrication process,
correlates it and manages it in a manner that enables the operator of the fab to
maximize its manufacturing yield. YieldManager provides an encompassing and
integrated approach to yield management and automates processes previously
managed separately and often manually.

YieldManager links to the following Knights' products: MegaLab(R) and Merlin's
Framework(TM) software for defect review; SpaR (Spatial Pattern Recognition) to
group defects into signatures that can be classified into process events;
Q-YIELD(TM) for data-mining and LogicMap, yield enhancement/analysis software
solution for logic devices.



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CAD NAVIGATION

Merlin's Framework is Knights' principal CAD NAV product that uses semiconductor
CAD data to locate physical attributes of the semiconductor itself. Merlin's
Framework provides visual representations of circuits that can be manipulated,
rotated, exploded, searched, and linked with ease. With the application tools,
features, and options available through Merlin's Framework, users can convert
layout, netlist, and schematic data and establish cross-mapping links between
these data -- with a single tool in just a few steps. A complete Merlin's
Framework system speeds problem solving by providing cross-mapping between
design representations of specific device nodes so that those exact locations
can be viewed in all three domains simultaneously. Merlin's Framework has been
used in the semiconductor industry for failure analysis and process diagnostics
and is a leading CAD NAV product.

LabManager, the latest feature of Merlin's Framework, was recently introduced as
a tool that enables automated transfer of information between failure analysis
and reliability labs. Merlin also links to LogicMap.

WAFER INSPECTION PRODUCTS

The QuickSilver series of products feature sophisticated technologies, such as
Time Delay Integration (TDI) for high-speed acquisition of complex images. There
are four products distinguished by their software packages. The QuickSilver 100
is primarily for microstructure inspection applications, the QuickSilver 200
focuses on defect inspection and the QuickSilver 300 and 330 are targeted at
bump inspection applications.

ENGINEERING, RESEARCH AND DEVELOPMENT

The market for wafer probing equipment is characterized by continuous
technological development and product innovation. The Company believes that
continued and timely development of new products and enhancements to existing
products is necessary to maintain its competitive position. Accordingly, the
Company devotes a significant portion of its personnel and financial resources
to engineering, research and development programs. The Company uses its close
relationships with key customers to make improvements on its products, which
respond to such customers' needs.

The Company's ongoing engineering, research and development efforts generally
can be classified into three categories: feature enhancements, such as features
to improve accuracy, speed or automation; new products; and customer driven
product enhancements. Engineering, research and development expenses were $30.5
million, $21.9 million and $18.7 million in 1998, 1997 and 1996, respectively,
or 30.1%, 14.6% and 12.3% of net sales, respectively. Engineering, research and
development expenses consist primarily of salaries, project materials and other
costs associated with the Company's ongoing efforts.




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MARKETING, SALES AND SERVICE

The Company primarily sells its products directly to end-users. The Company
believes that using a direct sales force provides it with a significant
competitive advantage in communicating with customers and responding to market
demands.

The Company generally sells product on net 30-day terms to most customers.
Other, primarily foreign, customers are required to deliver a letter of credit
typically payable upon product delivery. The Company generally warrants its
products for a period of up to 12 months from shipment for material and labor to
repair the product. Installation is customarily included in the price of the
product. The Company's field engineers provide customers with call out repair
and maintenance services for a fee. Customers may enter into repair and
maintenance service contracts covering the Company's products. The Company
trains customer employees to perform routine service for a fee and provides
telephone consultation services generally free of charge.

In the United States, Electroglas maintains sales and service offices in
Arizona, California, Oregon, Massachusetts and Texas. In Europe, the Company
maintains sales and service locations in France, Germany and the United Kingdom.
In Asia, the Company maintains direct sales and service locations in Japan, Hong
Kong, Korea, People's Republic of China, Singapore and Taiwan. As of December
31, 1998, the Company employed approximately 177 people worldwide in sales,
service, applications, logistics, technical support and customer service.

CUSTOMERS

Electroglas sells its products to leading semiconductor manufacturers throughout
the world. In 1998 and 1997, no single customer accounted for more than 10% of
net sales. In 1996, sales to Intel represented 13% of net sales. No other
customer exceeded 10% of net sales in 1996.

International sales represented 43%, 43% and 45% of the Company's net sales in
1998, 1997 and 1996, respectively. These sales represent the combined total of
export sales made by United States operations and all sales made by foreign
operations.

MANUFACTURING AND SUPPLIERS

The Company's principal manufacturing activities take place in Santa Clara,
California and consist primarily of assembling and testing complete probing
systems that meet specific customer requirements. The Company manufactures most
of the subassemblies used in the probing systems; however, some are standard
products purchased from third parties. While the Company uses standard
components wherever possible, most mechanical parts, metal fabrications and
castings are made to Company specifications. The Company schedules production
based on firm customer commitments and anticipated orders during the planning
cycle.

Electroglas maintains manufacturing capability for certain components. This
capacity has proven useful for certain short-run and small lot size components
where economic third party supply is not available. This capacity has also been
used for product development and prototypes. The Company maintains in-house
control of the critical manufacturing processes for its linear motor positioning
system.




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Quality control is maintained through incoming inspection of components,
in-process inspection during equipment assembly and final inspection and
operation of all manufactured equipment prior to shipment. Electroglas has a
company-wide quality training program emphasizing continuous improvement, data
driven decisions and close collaboration among the Company's employees and its
customers and suppliers. The Company trains all of its employees in basic
quality skills and regularly participates in quality sharing meetings with other
equipment manufacturers and customer quality audits of procedures and personnel.

Certain of the components and subassemblies included in the Company's products
are obtained from a single source. However, the Company believes that
alternative sources exist or can be developed, if necessary.

BACKLOG

At December 31, 1998, the Company's backlog was approximately $10.2 million as
compared to approximately $36.6 million at December 31, 1997. The Company
generally ships orders within 10 weeks after receipt of a customer's purchase
order. Due to possible changes in product delivery schedules and cancellation of
product orders and because the Company's sales will often reflect orders shipped
in the same quarter received, the Company's backlog at any particular date is
not necessarily indicative of actual sales for any succeeding period.

COMPETITION

The semiconductor equipment industry is highly competitive. The principal
competitive factors in the industry are product performance, reliability,
service and technical support, product improvements, price, established
relationships with customers and product familiarity. The Company believes that
its products compete favorably with respect to each of these factors in the
non-Japanese market segment. The Company's major competitors are Tokyo Electron
Limited ("TEL") and Tokyo Seimitsu ("TSK"). Some of the Company's competitors
have greater financial, engineering and manufacturing resources than the Company
and larger service organizations and long-standing customer relationships. There
can be no assurance that levels of competition in the Company's particular
product market will not intensify or that the Company's technological advantages
may not be reduced or lost as a result of technological advances by competitors
or changes in semiconductor processing technology. See "Factors that May Affect
Results and Financial Condition -- Highly Competitive Industry, and Japanese
Market Segment and Japanese Competition."

PATENTS, TRADEMARKS, COPYRIGHTS AND OTHER INTELLECTUAL PROPERTY

The Company believes that the success of its business depends more on the
technical competence, creativity and marketing abilities of its employees,
rather than on patents, trademarks and copyrights. Nevertheless, the Company has
a policy of seeking patents when appropriate on inventions concerning new
products and improvements as part of its ongoing research, development and
manufacturing activities. The Company owns various patents and has applied for
additional patent protection in the United States and abroad for the technology
in its products. The Company also has several registered United States and
international trademarks. The Company maintains unregistered copyrights on its
software and typically maintains the source code for its products as trade
secrets.




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<PAGE>   10

The Company also relies upon trade secret protection for its confidential and
proprietary information. The Company routinely enters into confidentiality
agreements with its employees. There can be no assurance, however, that others
will not independently gain information and techniques or otherwise gain access
to the Company's trade secrets or that the Company can meaningfully protect its
trade secrets. See "Factors that May Affect Results and Financial Condition --
Patents and Other Intellectual Property."

EMPLOYEES

As of December 31, 1998, the Company employed approximately 593 persons. Many of
the Company's employees are highly skilled, and the Company's success will
depend in part upon its ability to attract and retain such employees, who are in
great demand. The Company has never had a work stoppage or strike and no
employees are represented by a labor union or covered by a collective bargaining
agreement. The Company considers its employee relations to be good.

FACTORS THAT MAY AFFECT RESULTS AND FINANCIAL CONDITION

The statements contained in this Form 10-K which are not purely historical are
forward-looking statements, including statements regarding the Company's
beliefs, expectations, hopes, plans or intentions regarding the future.
Forward-looking statements in this document include statements under the
headings "Overview" regarding the Company's strategy to move to become a process
management tool provider; "Industry Background" regarding the move to larger 300
mm wafers in 1999, the growth of new flip chip technologies and the growing need
for tools that monitor and analyze defects that cause yield loss; and "Company
Strategy" with respect to the Company's expectations regarding continued
emphasis on research and development, and strengthening of customer
relationships, intentions regarding broadening existing product lines, among
others, including those identified under the heading "Management's Discussion
and Analysis of Financial Condition and Results of Operations." All
forward-looking statements included in this document are made as of the date
hereof, based on information available to the Company as of the date hereof, and
Electroglas assumes no obligation to update any forward-looking statement or
statements. It is important to note that the Company's actual results could
differ materially from those in such forward-looking statements. The following
important factors, among others, in some cases have affected, and in the future
could affect, the Company's actual operating results and could cause the
Company's actual consolidated operating results to differ materially from those
expressed in any forward-looking statement made by, or on behalf of, the
Company.

Semiconductor Industry Downturns Adversely Affect Electroglas Revenues and
Operating Results. The Company's business largely depends on capital
expenditures by semiconductor manufacturers, which in turn depend on the current
and anticipated market demand for integrated circuits and products that use
integrated circuits. The semiconductor industry is highly cyclical and has
historically experienced periods of oversupply resulting in significantly
reduced demand for capital equipment. The semiconductor industry is currently
experiencing a downturn, which has led many semiconductor manufacturers to delay
or cancel capital expenditures. These delays and cancellations have adversely
affected the Company's revenues, gross profit, gross margin and operating
results. There can be no assurance that this downturn will not continue and that
the semiconductor industry will not experience further downturns or slowdowns in
the future, which may materially and adversely affect the Company's business and
operating results. In addition, the need to invest in the engineering, research
and development and marketing required to penetrate targeted foreign markets and
maintain extensive customer service and support capabilities limits the
Company's ability to reduce expenses during such downturns.



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Variability and Uncertainty of Quarterly Operating Results. The Company has
experienced and expects to continue to experience significant fluctuations in
its quarterly results. The Company's backlog at the beginning of each quarter
does not necessarily determine actual sales for any succeeding period. The
Company's sales will often reflect orders shipped in the same quarter that they
are received. Moreover, customers may cancel or reschedule shipments, and
production difficulties could delay shipments. Other factors which may influence
the Company's operating results in a particular quarter include the timing of
the receipt of orders from major customers, product mix, competitive pricing
pressures, continued or worsened financial markets or economic instability in
Asia, the relative proportions of domestic and international sales, the
Company's ability to design, manufacture and introduce new products on a
cost-effective and timely basis, the delay between expenses to further develop
marketing and service capabilities and the realization of benefits from those
improved capabilities, and the introduction of new products by the Company's
competitors. Accordingly, the Company's results of operations are subject to
significant variability and uncertainty from quarter to quarter.

Dependence on New Products and Processes. Electroglas believes that its future
success will depend in part upon its ability to continue to enhance its existing
products and to develop and manufacture new products, particularly those related
to implementation of the Company's strategy to become a process management tool
provider. As a result, the Company expects to continue to make a significant
investment in engineering, research and development. There can be no assurance
that the Company will be successful in the introduction, marketing and cost
effective manufacture of any of its new products, that the Company will be able
to timely develop and introduce new products and enhance its existing products
and processes to satisfy customer needs or achieve market acceptance; or that
the new markets for which the Company is developing new products or expects to
sell current products, such as the market for 300 mm wafer probers and markets
related to the growth in the use of flip chips, will develop sufficiently if the
current industry downturn continues. To develop new products successfully, the
Company depends on close relationships with its customers and the willingness of
those customers to share information with the Company. The failure to develop
products and introduce them successfully and in a timely manner could adversely
affect the Company's competitive position and results of operations.

Dependence on Principal Customers. For the years ended December 31, 1998, 1997
and 1996, five of the Company's customers accounted for 38%, 33% and 37%,
respectively, of its net sales. No single customer accounted for more than 10%
of net sales in 1998 and 1997. Intel Corporation accounted for 13% of net sales
in the year ended December 31, 1996. If one or more of the Company's major
customers ceased or significantly curtailed its purchases, a material adverse
effect on the Company's results of operations could result.

Highly Competitive Industry. The semiconductor equipment industry is highly
competitive. Electroglas faces substantial competition from established
competitors, some of which, in particular Tokyo Electron Limited, are part of
larger companies that have greater financial, engineering and manufacturing
resources than the Company and have larger service organizations and
long-standing customer relationships. The Company's competitors can be expected
to continue to improve the design and performance of their products and to
introduce new products with competitive price/performance characteristics.
Competitive pressures may force price reductions that could adversely affect the
Company results of operations. Although the Company believes it has certain
technological and other advantages over its competitors, maintaining and
capitalizing on these advantages will require the Company to continue a high
level of investment in engineering, research and development, marketing and
customer service and support. There can be no assurance that the Company will
have sufficient resources to continue to make these investments or that the
Company will be able to make the technological advances necessary to maintain
such competitive advantages. See "Business -- Competition."



                                       11

<PAGE>   12

Japanese Market Segment and Japanese Competition. Electroglas believes that
competing Japanese companies have a competitive advantage because they dominate
the Japanese market segment (comprised of semiconductor fabrication facilities
located in Japan and those located outside Japan which are controlled by
Japanese companies). Electroglas has found it difficult to penetrate the large
and technically advanced Japanese market, which represents a substantial
percentage of the worldwide wafer prober market. In particular, TEL, a large
supplier of wafer probers and other semiconductor capital equipment in Japan,
dominates the Japanese market segment for wafer probers. TEL dominance of the
Japanese market segment and its position as a large supplier of wafer probers
worldwide provide it with a sales and technology base that enables it to compete
throughout the rest of the world. Another Japanese company, TSK, also a large
supplier of wafer probers in the Japanese market segment, has recently increased
its share of that market. See "Business -- Competition."

Although Electroglas believes it is the largest supplier of wafer probers in the
non-Japanese market segment, Electroglas has not yet established itself as a
significant participant in the Japanese market segment. While Japanese
semiconductor manufacturers in recent years have begun to build semiconductor
fabrication facilities outside Japan, Electroglas has not yet had significant
sales into such facilities. Further, Japanese semiconductor manufacturers have
extended their influence outside Japan by licensing products and process
technologies to non-Japanese semiconductor manufacturers; these licenses
typically include a recommendation to use wafer probers and other semiconductor
equipment manufactured by Japanese companies. In particular, Electroglas may be
at competitive disadvantage with respect to the Japanese semiconductor capital
equipment suppliers who have been engaged for some time in collaborative efforts
with Japanese semiconductor manufacturers. There can be no assurance that
Electroglas will be able to establish a significant presence in or ever compete
successfully in the Japanese market segment. In addition, to the extent that the
slowdown in the Japanese market segment, recently exacerbated by the recent
economic and currency turmoil in Japan and Asia generally, has left the
Company's Japanese competitors with excess inventory or excess capacity, they
may offer substantial discounts on their products, increasing pricing pressure
in both the Japanese market segment and elsewhere. Furthermore, any weakness of
the yen compared to the dollar may exacerbate this situation.

Patents and Other Intellectual Property. The Company's success depends in
significant part on its intellectual property. While the Company attempts to
protect its intellectual property through patents, copyrights and trade secrets,
it believes that its success will depend more upon innovation, technological
expertise and distribution strength. There can be no assurance that the Company
will successfully protect its technology or that competitors will not be able to
develop similar technology independently. No assurance can be given that the
claims allowed on any patents held by the Company will be sufficiently broad to
protect the Company's technology. In addition, no assurance can be given that
any patents issued to the Company will not be challenged, invalidated or
circumvented or that the rights granted thereunder will provide competitive
advantages to the Company.

Some customers using certain products of Electroglas have received a notice of
infringement from Technivison Corporation and Jerome H. Lemelson alleging that
the manufacture of semiconductor products infringes certain patents issued to
Mr. Lemelson. Certain of these customers have notified Electroglas that, in the
event it is subsequently determined that the customer infringes certain of the
Lemelson patents, they may seek reimbursement from Electroglas for some damages
or expenses resulting from this matter. Electroglas believes that its products
do not infringe the Lemelson patents. Certain of the Company's customers are
currently engaged in litigation with Mr. Lemelson involving 17 of his patents
and the validity of those patents has been placed in issue. In the future, it is
possible that the Company's participation in the litigation may be required.
Electroglas may incur costs with respect to such participation and cannot
predict the outcome of this or similar litigation or the effect of such
litigation upon Electroglas. To the best of the Company's knowledge, neither it
nor any of its products has been identified by Mr. Lemelson as infringing his
patents.



                                       12
<PAGE>   13

Dependence on Certain Suppliers. Electroglas obtains certain of the components
and subassemblies for its systems from a single source or a limited group of
suppliers, most notably all of the vision processor systems used in the
Company's products are supplied by Cognex Corporation ("Cognex"). Although
Electroglas seeks to reduce dependence on its sole and limited source suppliers,
the partial or complete loss of Cognex as a supplier of vision processor
systems, and the loss of certain other limited source suppliers could at least
temporarily adversely affect the Company's results of operations and damage
customer relationships. Further, a significant increase in the price of one or
more of these components could adversely affect the Company's results of
operations.

International Operations. International sales accounted for 43%, 43% and 45% of
the Company's net sales for 1998, 1997 and 1996, respectively. The Company
expects international sales to continue to represent a significant percentage of
net sales. A number of factors may adversely affect the Company's international
sales and operations, including the imposition of governmental controls,
fluctuations in the U.S. dollar, which could increase the foreign sales prices
of the Company's products in local currencies, export license requirements,
restrictions on the export of technology, political instability, trade
restrictions, changes in tariffs and difficulties in staffing and managing
international operations. Currently, many Asian countries are experiencing
banking and currency difficulties that have led to economic recession in those
countries. Among other things, the decline in value of Asian currencies,
together with difficulties obtaining credit, have resulted in a decline in the
purchasing power of the Company's Asian customers. This in turn has resulted in
the cancellation and delay of certain new orders for the Company's products from
Asian customers, thus adversely affecting the Company's business, financial
condition and results of operations. These and similar geopolitical and global
economic factors have had an adverse effect on the Company's operations. There
can be no assurance that such factors will not continue to adversely impact the
Company's operations in the future or require the Company to modify its current 
business practices. In addition, the laws of certain foreign countries may not 
protect the Company's intellectual property rights to the same extent as do the 
laws of the United States.

Dependence on Key Employees. The future success of Electroglas partly depends on
its ability to retain key personnel. The Company also needs to attract
additional skilled personnel in all areas of its business to grow. While many of
the Company's current employees have years of service with Electroglas, there
can be no assurance that the Company will be able to retain its existing
personnel or attract additional qualified employees in the future.

Acquisitions. The Company may pursue acquisitions of complementary product
lines, technologies or businesses, such as the acquisitions of Knights and
Techne in May and December 1997, respectively. Acquisitions by the Company may
result in potentially dilutive issuances of equity securities, the incurrence
of debt and contingent liabilities and amortization expenses related to goodwill
and other intangible assets, which could materially adversely affect the
Company's profitability. In the fourth quarter of 1998, the Company recorded
asset impairment charges of $9.6 million. The charges relate principally to
acquired goodwill and other intangible assets in connection with the Knights and
Techne acquisitions. To the extent future events result in further impairment of
the long-lived assets of Techne or Knights, expenses may occur sooner than the
Company expects. In addition, current or future acquisitions involve numerous
risks, including difficulties in the assimilation of the operations,
technologies and products of the acquired companies, the diversion of
management's attention from other business concerns, risks of entering markets
in which the Company has no or limited direct prior experience, and the
potential loss of key employees of the acquired company. There can be no
assurances as to the effect thereof of these, or future, acquisitions on the
Company's business or operating results.




                                       13
<PAGE>   14

Possible Volatility of Common Stock Price. The market price of Electroglas
Common Stock could fluctuate significantly in response to variations in
quarterly operating results and other factors, such as announcements of
technological innovations or new products by the Company or by the Company's
competitors, government regulations, developments in patent or other property
rights, and developments in the Company's relationships with its customers. In
addition, the stock market has in recent years experienced significant price
fluctuations. These fluctuations often have been unrelated to the operating
performance of the specific companies whose stock is traded. Broad market
fluctuations, general economic conditions and specific conditions in the
semiconductor industry may adversely affect the market price of the Company's
Common Stock.

Antitakeover Provisions. The recently adopted Shareholders Rights Plan, certain
provisions of the Company's Certificate of Incorporation and Delaware law could
discourage potential acquisition proposals and could delay or prevent a change
in control of Electroglas. Such provisions could diminish the opportunities for
a stockholder to participate in tender offers, including tender offers at a
price above the then current market value of Electroglas Common Stock. Such
provisions may also inhibit fluctuations in the market price of Electroglas
Common Stock that could result from takeover attempts. In addition, the Board of
Directors, without further stockholder approval, may issue additional series of
preferred stock that could have the effect of delaying, deterring or preventing
a change in control of Electroglas. The issuance of additional series of
preferred stock could also adversely affect the voting power of the holders of
Common Stock, including the loss of voting control to others. The Company has no
current plans to issue any Preferred Stock.



                                       14
<PAGE>   15

                               ITEM 2. PROPERTIES

The Company's executive office and manufacturing, engineering, research and
development operations are located primarily in four buildings in Santa Clara,
California totaling approximately 150,000 square feet, occupied under leases
expiring in March 2000. The Company owns substantially all of the machinery and
equipment used in its facilities. The Knights subsidiary is headquartered in a
21,410 square foot leased facility in Sunnyvale, California and also leases
office space in Mumbai, India where it maintains an engineering and quality
assurance operation. The Techne subsidiary's manufacturing, engineering and
administrative operations are housed in a leased 15,500 square foot facility in
Albany, Oregon.

The Company also leases sales and service offices in Arizona, California,
Oregon, Massachusetts and Texas. In Europe, the Company leases sales and service
locations in France, Germany and the United Kingdom. In Asia, the Company leases
direct sales and service locations in Japan, Hong Kong, Korea, People's Republic
of China, Singapore and Taiwan.

In March 1997, the Company entered into a $12.0 million five-year operating
lease for approximately 21.5 acres of land in San Jose, California. On July 1,
1998, the lease agreement was amended to provide a construction allowance of
$43.0 million for certain buildings currently under construction on the land.
The monthly payments are based on the London Interbank Offering Rate (LIBOR). At
current interest rates and based on the lease amount of $17.7 million at
December 31, 1998, the annual lease payments currently represent approximately
$1.2 million, which will increase as the construction funding increases
throughout the construction period of 18 to 24 months. At the end of the lease,
the Company has the option to purchase the land and buildings at approximately
$55.0 million. The guaranteed residual payment on the lease is approximately
$55.0 million.

The lease contains certain restrictive covenants. At December 31, 1998, the
Company was in compliance with these covenants. In connection with the lease
collateral requirements, the Company was required to collateralize the lease. At
December 31, 1998, the Company collateralized $17.7 million, which is included
in other assets as restricted cash. The amount of collateralization will
increase as funding increases over the construction period.

The Company has been performing environmental remediation activities on its
leased property in Santa Clara, California, in cooperation with the California
Regional Water Quality Board. In 1997, the Company accrued $1.6 million, which
was the Company's best estimate of its obligation. The Company has since
incurred actual costs of $0.8 million and expects that its remaining liability
to be in the range of $0.5 million to $0.8 million. It is possible that the
Company's recorded estimate of its obligations may change in the near term due
to changes in cost estimates.

The Company, like all manufacturing companies, is subject to various federal,
state and local environmental statutory requirements. Except for the
aforementioned remediation activities, the Company believes that it is in
material compliance with existing applicable environmental laws and regulations.
Although the Company has undertaken an extensive investigation related to the
aforementioned environmental remediation activities, there can be no assurance
that adverse developments related to its investigation and such remediation
activities will not result in the need for the Company to expend additional
resources to remedy environmental problems in order to comply with current or
future environmental regulations. Management considers the above facilities
suitable and adequate to meet the Company's requirements for the next twelve
months and that suitable additional or substitute space will be available as
needed.



                                       15
<PAGE>   16

                            ITEM 3. LEGAL PROCEEDINGS

The Company is not currently involved in any legal actions that it believes are
material. From time to time, however, the Company may be subject to various
claims and lawsuits by customers and competitors arising in the normal course of
business, including suits charging infringement or violations of antitrust laws.
Such suits may seek substantial damages and, in certain instances, any damages
awarded would be trebled.

           ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the security holders of the Company
during the fourth quarter ended December 31, 1998.




                                       16

<PAGE>   17

                                    PART II

                                ---------------

               ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY
                        AND RELATED STOCKHOLDER MATTERS

MARKET PRICES FOR COMMON STOCK

The Company's common stock is traded on the Nasdaq National Market under the
symbol "EGLS." The following table sets forth for the periods indicated the
actual high and low sales prices per share of common stock as reported on the
Nasdaq National Market System:


<TABLE>
<CAPTION>
FISCAL YEAR                                    1998                 1997
                                         HIGH        LOW       HIGH       LOW
-------------------------------------------------------------------------------
<S>                                       <C>        <C>        <C>       <C> 
1st Quarter                             19 5/8      12 5/8     22 3/8    15 7/8
2nd Quarter                             17 13/16    12 1/4     27 3/4    15 1/4
3rd Quarter                             13 7/16     8 1/8      35 7/8    23 1/2
4th Quarter                             16 3/8      7 3/4      34        14 3/8
</TABLE>


The Company has never declared or paid cash dividends on the shares of common
stock and does not anticipate paying any cash dividends on the shares of common
stock in the foreseeable future. The Company currently intends to retain future
earnings to fund the development and growth of its business.

As of January 31, 1999, the Company had approximately 10,350 stockholders of
record and holders in street name.

                         ITEM 6. SELECTED FINANCIAL DATA

SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,                         1998           1997           1996          1995          1994
-----------------------------------------------------------------------------------------------------------------
<S>                                           <C>            <C>            <C>           <C>           <C>      
Net sales                                     $ 101,599      $ 150,035      $ 151,950     $ 169,240     $ 112,319
                                              -------------------------------------------------------------------
Gross profit                                     33,724         63,626         72,284        92,634        61,921
Engineering, research and development            30,538         21,897         18,672        13,560        10,149
Selling, general and administrative              33,334         32,532         24,758        25,771        19,272
In-process research and development                  --         27,029             --            --            --
Impairment of long-lived assets                   9,578             --             --            --            --
                                              -------------------------------------------------------------------
Operating income (loss)                         (39,726)       (17,832)        28,854        53,303        32,500
Interest and other income, net                    5,527          4,844          4,847         4,211         2,876
                                              -------------------------------------------------------------------
Income (loss) before income taxes               (34,199)       (12,988)        33,701        57,514        35,376
Provision (benefit) for income taxes             (2,614)         2,949          9,242        20,417        13,042
                                              -------------------------------------------------------------------
Net income (loss)(1)(2)                       $ (31,585)     $ (15,937)     $  24,459     $  37,097     $  22,334
                                              ===================================================================
Basic net income (loss) per share(1)(2) .     $   (1.62)     $   (0.86)     $    1.38     $    2.09     $    1.34
                                              ===================================================================
Diluted net income (loss) per share(1)(2)     $   (1.62)     $   (0.86)     $    1.36     $    2.05     $    1.31
                                              ===================================================================
Working capital                               $ 136,643      $ 172,423      $ 159,376     $ 146,849     $  96,482
Total assets                                    184,241        228,919        197,866       191,741       131,901
Short-term borrowings                               566          1,160          1,790         1,952            --
Total equity                                    167,667        199,734        173,651       157,394       110,755
</TABLE>




                                       17

<PAGE>   18


UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA


<TABLE>
<CAPTION>
                                             FIRST        SECOND         THIRD         FOURTH
(IN THOUSANDS, EXCEPT PER SHARE DATA)       QUARTER       QUARTER       QUARTER       QUARTER
----------------------------------------------------------------------------------------------
<S>                                         <C>           <C>           <C>           <C>     
1998:
Net sales                                   $ 36,865      $ 27,538      $ 22,497      $ 14,699
Gross profit                                  15,687         6,886         7,341         3,810
Net loss(2)                                     (416)       (5,147)       (5,746)      (20,276)
Basic net loss per share(2)                    (0.02)        (0.26)        (0.30)        (1.04)
Diluted net loss per share(2)                  (0.02)        (0.26)        (0.30)        (1.04)

1997:
Net sales                                   $ 25,551      $ 36,075      $ 44,263      $ 44,146
Gross profit                                   9,884        15,864        19,707        18,171
Net income (loss)(1)                              26       (20,715)        5,687          (935)
Basic net income (loss) per share(1)            0.00         (1.14)         0.30         (0.05)
Diluted net income (loss) per share(1)          0.00         (1.14)         0.29         (0.05)
</TABLE>


(1)     Net loss for the second and fourth quarters of 1997 includes pretax
        in-process research and development charges of $23.5 million and $3.5
        million resulting from the acquisitions of Knights Technology, Inc. and
        Techne Systems, Inc., respectively. In addition, the Company incurred a
        $1.6 million pretax charge in the fourth quarter of 1997 for
        environmental remediation costs.

(2)     Net loss for the fourth quarter of 1998 includes a $9.6 million pretax
        charge for impaired technology and intangibles related to previous
        acquisitions, and an $8.1 million charge related to the revaluation of
        the Company's deferred tax assets.

                 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The statements contained in this Form 10-K which are not purely historical are
forward-looking statements, including statements regarding the Company's
beliefs, expectations, hopes, plans or intentions regarding the future.
Forward-looking statements include, but are not limited to, statements in this
item about international sales as a portion of net sales and gross profits, the
Company's environmental remediation efforts, the impact of Year 2000 issues and
the Company's Year 2000 readiness, current levels of taxable income, liquidity,
anticipated cash needs and availability and the impact of the introduction of
the Euro and costs related thereto. All forward-looking statements included in
this document are made as of the date hereof, based on information available to
the Company as of the date hereof, and Electroglas assumes no obligation to
update any forward-looking statement. It is important to note that the Company's
actual results could differ materially from those in such forward looking
statements. You should consult the risk factors described from time to time in
the Company's reports on SEC form 10-Q, as well as those disclosed in the
discussion above, under the heading "Factors That May Affect Results and
Financial Condition" and below, under the heading "Year 2000 Update" and
"Additional Factors That May Affect Results and Financial Condition."



                                       18

<PAGE>   19

The components of the Company's statements of operations, expressed as a
percentage of net sales, are as follows:


<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,                       1998        1997       1996
-----------------------------------------------------------------------------
<S>                                            <C>         <C>         <C>   
Net sales                                      100.0%      100.0%      100.0%
Cost of sales                                   66.8        57.6        52.4
                                               -----------------------------
Gross profit                                    33.2        42.4        47.6
Operating expenses:
   Engineering, research and development        30.1        14.6        12.3
   Selling, general and administrative          32.8        21.7        16.3
   In-process research and development            --        18.0          --
   Impairment of long-lived assets               9.4          --          --
                                               -----------------------------
Total operating expenses                        72.3        54.3        28.6
                                               -----------------------------
Operating income (loss)                        (39.1)      (11.9)       19.0
Interest income                                  5.5         3.5         3.1
Other income (expense), net                     (0.1)       (0.3)        0.1
                                               -----------------------------
Income (loss) before income taxes              (33.7)       (8.7)       22.2
Provision (benefit) for income taxes            (2.6)        1.9         6.1
                                               -----------------------------
Net income (loss)                              (31.1)%     (10.6)%      16.1
                                               =============================
</TABLE>

RESULTS OF OPERATIONS

Years ended December 31, 1998, 1997 and 1996

NET SALES

The Company, along with the semiconductor equipment industry in general, is
currently experiencing a downturn caused by a number of factors, including
economic conditions in Asia, excess capacity in the fabrication process,
semiconductor pricing pressures, and the growth of the sub-$1000 PC. These
factors, among others, have all combined to reduce customer spending on new
capital equipment which has affected the Company's sales over the last two and a
half years except for a brief upturn in the latter part of 1997.

Net sales were $101.6 million in 1998, as compared to $150.0 million in 1997, a
decrease of 32.3%. The decrease was due to lower prober unit sales resulting
from the industry downturn that has been affecting the Company's sales
throughout 1998. The decrease in net sales in 1998 was offset partially by
incremental revenues generated from the yield management and inspection system
businesses that were acquired in May 1997 and December 1997, respectively.

Net sales were $150.0 million in 1997, as compared to $152.0 million in 1996.
Excluding Knights software sales, prober sales decreased 3.9% in 1997 due to
lower system sales resulting from the industry downturn that negatively impacted
the Company's sales from the third quarter of 1996 through the second quarter of
1997.

Net sales were comprised of prober systems ($71.3 million, $123.2 million and
$128.4 million for 1998, 1997 and 1996, respectively), aftermarket sales,
consisting primarily of service, spare parts and upgrades in support of the
prober business ($18.0 million, $22.8 million and $23.6 million for 1998, 1997
and 1996, respectively) and Knights software and Techne inspection systems
($12.3 million and $4.0 million for 1998 and 1997, respectively).



                                       19

<PAGE>   20

International sales represented 43%, 43% and 45% of net sales for the years
1998, 1997 and 1996, respectively. The Company's international sales will
continue to account for a significant portion of net sales in 1999. However,
Asian economic conditions may continue to have a significant adverse impact on
international revenues in 1999.

GROSS PROFIT

Gross profit was 33.2%, 42.4% and 47.6% as a percentage of sales for 1998, 1997
and 1996, respectively. The decrease in gross profit in 1998 as compared to 1997
primarily reflects the impact of the Company's under-absorbed manufacturing
overhead resulting from lower net sales. Additionally, gross profit in 1998 was
negatively impacted by approximately $3.9 million of charges to write-down
manufacturing inventory resulting from rapid product transition from the older
Horizon 4000 models to the newer 4090. Furthermore, gross profit was impacted by
lower gross margins on inspection systems as a result of $1.2 million of
capitalized profit in inventory arising from the acquisition of Techne that was
recorded in cost of sales in the second quarter of 1998 when the systems were
shipped.

The decrease in gross profit in 1997 as compared to 1996, was primarily
attributable to a change in sales mix from higher margin, more mature products
to the Horizon 4090, which has lower margins due to higher material costs. Lower
warranty costs in 1997 partially offset the negative impact of the change in
sales mix.

The Company believes that its gross profit will continue to be affected by a
number of factors, including competitive pressures, changes in demand for
semiconductors, changes in product mix, level of software sales, and excess
manufacturing capacity costs.

ENGINEERING, RESEARCH AND DEVELOPMENT

The Company's engineering, research and development expenses consist primarily
of salaries, project materials, consultant fees and other costs associated with
the Company's research and development efforts. Engineering, research and
development expenses were 30.1%, 14.6% and 12.3% as a percentage of sales for
1998, 1997 and 1996, respectively. The increase in 1998 was due mainly to
continuing investment in the Horizon 4090(micro) and 300mm programs,
and incremental research and development costs related to the yield management
software and inspection products businesses acquired in 1997. The Company
believes that in order to remain competitive it must continue to invest
substantially in research and development through the downturn. The increase in
1997 compared to 1996 was due primarily to the addition of Knights expenses
associated with the development of yield management software.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative (SG&A) expenses were 32.8%, 21.7% and 16.3%
as a percentage of sales for 1998, 1997 and 1996, respectively. The increase in
1998 compared to 1997 was due primarily to higher incremental operational
expenses and goodwill amortization related to the software and inspection
products businesses acquired in 1997 on lower sales. In addition, $0.6 million
of costs associated with severance compensation and facilities consolidation
were charged during 1998.

The increase in SG&A expenses in 1997 compared to 1996 was due primarily to the
addition of Knights operations and intangible amortization related to the
Knights acquisition in 1997. In addition, the Company accrued $1.6 million for
environmental remediation costs related to the clean-up of its leased property
in Santa Clara, California in 1997. The remaining increase in 1997 was due to
additional marketing support and higher worldwide sales expenses.



                                       20

<PAGE>   21

INTEREST INCOME

Interest income was $5.6 million, $5.2 million and $4.8 million in 1998, 1997
and 1996, respectively. The increase in interest income in each year was
principally the result of increasing average cash balances and a shift to higher
yielding taxable instruments during 1998.

IN-PROCESS RESEARCH AND DEVELOPMENT

In connection with the acquisitions of Knights Technology, Inc., and Techne
Systems, Inc., the Company wrote-off in-process research and development
totaling $23.5 million and $3.5 million, respectively. See Note 2 under "Notes
to Consolidated Financial Statements." These amounts were expensed on the
acquisition dates because the acquired technology had not yet reached
technological feasibility and had no alternative future uses. The Company is
using the in-process research and development to create new process management
tools.

KNIGHTS

At the date of acquisition, Knights' in-process research and development related
to two primary research and development programs that were expected to reach
completion between late 1997 and 2002. These projects related to various stages
of development of Knights' yield management and CAD Navigation software. At the
acquisition date, total estimated cost to complete was approximately $6.0
million. At December 31, 1998, the Company estimates that it has spent $4.1
million and will spend an additional $4.4 million in research and development
over the next three years to complete the acquired in-process research and
development. These estimates are subject to change, given the uncertainties of
the development process, and no assurance can be given that deviations from
these estimates will not occur. Additionally, these projects will require
maintenance expenditures when and if they reach a state of technological and
commercial feasibility. To date, the Company has not had the expected success in
commercializing the in-process research and development and has significantly
revised downwards its forecasts of future cash flows since the acquisition date.

TECHNE

At the date of acquisition, Techne's in-process research and development related
to two primary research and development programs that were expected to reach
completion between late 1998 and 2000. These projects related to various stages
of development of Techne's microstructure, bump and sort wafer inspection tools.
At the acquisition date, total estimated cost to complete was approximately $3.2
million. At December 31, 1998, the Company estimates that it has spent $1.7
million and will spend an additional $2.3 million in research and development
over the next year to complete the acquired in-process research and development.
These estimates are subject to change, given the uncertainties of the
development process, and no assurance can be given that deviations from these
estimates will not occur. Additionally, these projects will require maintenance
expenditures when and if they reach a state of technological and commercial
feasibility. To date, the Company has not had the expected success in
commercializing the in-process research and development and has significantly
revised downwards its forecasts of future cash flows since the acquisition date.

VALUE ASSIGNED TO IN-PROCESS RESEARCH AND DEVELOPMENT

The value assigned to in-process research and development was determined by
estimating the costs to develop Knights' and Techne's purchased in-process
research and development into commercially viable products, estimating the
resulting net cash flows from the projects and discounting the net cash flows to
their present value. The revenue estimates used to value the in-process research
and development were based on estimates of relevant market sizes and growth
factors, expected trends in technology and the nature and expected timing of new
product introductions by the 



                                       21

<PAGE>   22

company and its competitors.

The rates utilized to discount the net cash flows to their present value are
based on Knights' and Techne's weighted average cost of capital. Given the
nature of the risks associated with the estimated growth, profitability and
developmental projects, Knights' and Techne's weighted average cost of capital
was adjusted. A discount rate of 25.0% was deemed appropriate for Knights, while
a discount rate of 35.0% was deemed appropriate for Techne. These discount rates
are intended to be commensurate with each company's corporate maturity and the
uncertainties in the economic estimates described above.

The estimates used by the Company in valuing in-process research and development
were based upon assumptions the Company believes to be reasonable but which are
inherently uncertain and unpredictable. The Company's assumptions may be
incomplete or inaccurate, and no assurance can be given that unanticipated
events and circumstances will not occur. Accordingly, actual results may vary
from the projected results. Any such variance may result in a material adverse
effect on the financial condition and results of operations of the Company.

IMPAIRMENT OF LONG-LIVED ASSETS

In the fourth quarter of 1998, the Company recorded asset impairment charges of
$9.6 million. The charge principally relates to long-lived assets, including
goodwill acquired in connection with the 1997 acquisitions of Techne Systems,
Inc. and Knights Technology, Inc. The charges were recorded in accordance with
Statement of Financial Accounting Standards 121, "Accounting for the Impairment
of Long Lived Assets." Standard 121 requires that the Company analyze whether
the cash flows attributable to an asset support the value assigned to that asset
in the financial statements. Where estimated cash flow is not sufficient to
recover the asset's net carrying value, a fair value approach is taken towards
reassigning a carrying value to the asset.

During the second half of 1998, the Company did not receive any orders for a new
Techne inspection product being developed. Consequently, there were no
inspection products in backlog at the end of the year and there is significant
uncertainty as to future orders. In light of this, the Company re-evaluated its
forecast for such products. The Company expects that it will not be able to
recover the carrying value of the long-lived assets related to Techne, and
recorded an impairment loss in the fourth quarter of 1998.

In addition, the Company experienced lower than expected sales of Knights'
products, which resulted in an operating loss for Knights in 1998. In light of
this, the Company reevaluated its forecast for Knights products. The Company
expects that it will not be able to recover the carrying value of the long-lived
assets related to Knights, and recorded an impairment loss in the fourth quarter
of 1998.

INCOME TAXES

The income tax benefit as a percentage of income was 7.6% in 1998. Income taxes
as a percentage of income before income taxes exclusive of the non-deductible
in-process research and development expenses were 21.0% and 27.4% in 1997 and
1996, respectively. The decrease in the effective tax rate (benefit) in 1998
compared to 1997 was primarily due to the lower percentage impact of tax exempt
investment income and the valuation allowance recorded against the net deferred
tax assets. The decrease in the effective tax rate in 1997 compared to 1996 was
primarily due to increased benefits of tax exempt investment income and the
research and development tax credit. The Company has provided a 



                                       22

<PAGE>   23

full valuation allowance of $16.9 million against its net deferred tax assets at
December 31, 1998 due to uncertainties surrounding their realization.

LIQUIDITY AND CAPITAL RESOURCES

The Company's cash, cash equivalents, short-term investments and restricted cash
were $131.5 million at December 31, 1998, an increase of $6.5 million from
$125.0 million at December 31, 1997.

Cash generated from operations was $12.3 million, which resulted primarily from
changes in working capital accounts partially offset by the net loss. Accounts
receivable generated $23.9 million as a result of improved asset management and
lower revenues. Inventories decreased by $11.6 million due primarily to lower
sales volume in the later half of 1998 compared to the same period in 1997 and
the $3.9 million write-down of inventory resulting from rapid product
transition. These cash generating assets were partially offset by a decrease in
accrued liabilities and accounts payable of $4.9 million and $4.7 million,
respectively. The decrease in accounts payables and accrued liabilities was due
to lower production levels and headcount reflecting lower anticipated business
volumes. In addition, an increase in taxes receivable consumed $7.3 million of
cash.

Cash used by investing activities was $18.0 million due primarily from the
transfer of $17.7 million of cash to restricted cash, as a requirement of the
lease agreement for the construction of the Company's San Jose campus (See below
and Note 12 under "Notes to the Consolidated Financial Statements". The
Company's net maturities of investments of $3.1 million was offset by capital
expenditures of $3.0 million for engineering design and test equipment,
manufacturing leasehold improvements, and enhancement of the Company's
information technology infrastructure.

Cash used by financing activities was $1.3 million. The cash used by financing
activities resulted from the net payment of short-term borrowings of $0.6
million by the Company's Japanese subsidiary, the repurchase of an additional
262,000 shares of the Company's common stock at a cost of $4.1 million,
partially offset by the sale of Common Stock of $3.4 million under employee
stock plans.

At December 31, 1998, the Company's Japanese subsidiary had lines of credit with
Japanese banks with a total borrowing capacity of approximately $5.1 million
(denominated in Yen). Amounts outstanding under these facilities at December 31,
1998 were $0.6 million. These facilities enable the Company's Japanese
subsidiary to finance its working capital requirements locally.

In March 1997, the Company entered into a $12.0 million five-year operating
lease for approximately 21.5 acres of land in San Jose, California. On July 1,
1998, the lease agreement was amended to provide a construction allowance of
$43.0 million for certain buildings currently under construction on the land.
The monthly payments are based on the London Interbank Offering Rate (LIBOR). At
current interest rates and based on the lease amount of $17.7 million at
December 31, 1998, the annual lease payments currently represent approximately
$1.2 million, which will increase as the construction funding increases
throughout the construction period of 18 to 24 months. At the end of the lease,
the Company has the option to purchase the land and buildings at approximately
$55.0 million. The guaranteed residual payment on the lease is approximately
$55.0 million.

The lease contains certain restrictive covenants. At December 31, 1998, the
Company was in compliance with these 




                                       23

<PAGE>   24

covenants. In connection with the lease collateral requirements, the Company was
required to collateralize the lease. At December 31, 1998, the Company
collateralized $17.7 million, which is included in other assets as restricted
cash. The amount of collateralization will increase as funding increases over
the construction period.

Historically, the Company has generated cash in an amount sufficient to fund its
operations. The Company anticipates that its existing capital resources and cash
flow generated from future operations will enable it to maintain its current
level of operations and its planned operations including capital expenditures
for the foreseeable future.

YEAR 2000 UPDATE

The Company is aware of the issues associated with the programming code in
computer systems as the Year 2000 approaches. The Year 2000 problem is pervasive
and complex, as virtually every computer operation will be affected in some way
by the rollover of the two-digit year value to 00. Systems that do not properly
recognize date-sensitive information when the year changes to 2000 could
generate erroneous data or cause a system to fail. Significant uncertainty
exists in the software industry concerning the potential effects associated with
the Year 2000 problem.

The Company currently is in the process of auditing its own information
technology infrastructure for Year 2000 readiness, including reviewing what
actions are required to make all software systems Year 2000 ready as well as
actions needed to mitigate the risks of Year 2000. Such actions include a review
of vendors' contracts, attention to Year 2000 issues in future contracts with
vendors, and formal communications with suppliers requesting that they certify
that their products are Year 2000 ready.

STATE OF READINESS

The Company has been actively addressing the Year 2000 issues. The following
sections broadly address Year 2000 matters with respect to the Company's (a)
information technology systems, (b) suppliers, (c) products, and (d) facilities
and infrastructure for Year 2000 readiness assessment.

INFORMATION TECHNOLOGY SYSTEMS

The Company has upgraded, or is in the process of upgrading or replacing, many
of its core business applications systems. A Year 2000 ready upgrade to the
Company's enterprise resource planning system was completed in the third quarter
of 1998. Year 2000 ready upgrades exist for most of the Company's remaining core
applications systems, and the Company plans on upgrading these systems by June
1999. The Company's wide-area network requirements are provided by major
national and international carriers, and the Company expects these carriers to
be Year 2000 ready. During fiscal 1997 and 1998, the Company invested in a
desktop upgrade program. The standard personal computers, servers and laptop
computers installed during this period are Year 2000 ready to the extent the
vendors have affirmed. Although not every desktop application has been fully
tested as of the filing date, the Company believes that the number of non-ready
systems is small. The Company expects it will complete its assessment and
replacement of these systems by June 1999. Over the past several years, the
Company has replaced or upgraded its local PBX and voice mail systems to Year
2000 ready systems. The Company is in the process of verifying Year 2000
readiness of these systems in the Company's domestic and international sales
offices, and intends to complete its assessment by June 1999.

SUPPLIERS



                                       24

<PAGE>   25

During fiscal 1998, the Company sent Year 2000 Readiness Questionnaires to its
suppliers. To date, the Company has received responses from over 90% of its
major suppliers, most stating that they will be Year 2000 ready. The Company
expects to initiate follow up communications in the first quarter of 1999 with
the suppliers that did not respond to the Year 2000 Readiness Questionnaire.
Supplier responses to the Questionnaire will be closely monitored. In some
cases, alternate suppliers may need to be identified by the Company. There can
be no assurance that the Company will be able to find suitable alternate
suppliers and contract with them on reasonable terms, or at all, and such
inability could have a material and adverse impact on the Company's business and
results of operations.

PRODUCTS

The Company's Year 2000 product testing is ongoing. The Company is using two
nationally-and industry-recognized test procedures to verify that the Company's
products are Year 2000 ready. They are the YMARK2000 program (NSTL), for
PC-based products, and the SEMATECH Year 2000 Readiness Test Scenarios for all
products. The Company notified its customers of known risk areas and proposed
remediation plans during the fourth quarter of 1998. The Company plans to make
Year 2000 upgrades available to customers during the first quarter of 1999, and
to have upgrades installed in the field in 1999. There can be no assurance that
the Company's products will contain all necessary date code changes. Any failure
of the Company's products to perform, including system malfunctions due to the
onset of Year 2000, could result in claims against the Company, which could have
a material adverse effect on the Company's business, financial condition and
results of operations. Moreover, the Company's customers could choose to convert
to other Year 2000 ready products in order to avoid such malfunctions, either of
which could have a material adverse effect on the Company's business, financial
condition and results of operations.

FACILITIES AND INFRASTRUCTURE

The Company is in the process of assessing its Year 2000 risk with respect to
building automation, electronic security, water and utility systems. The Company
plans to send formal queries to landlords, local fire departments, and water and
utility providers in the first quarter of 1999.

The Company is primarily an assemble-to-order manufacturing operation. There is
no significant automated assembly equipment on its manufacturing shop floor. The
Company is in the process of reviewing its manufacturing operations for
potential Year 2000 issues and plans to complete such assessment by the end of
March 1999.

COSTS TO ADDRESS YEAR 2000 ISSUES

The Company is in the process of identifying for its customers the corrective
measures necessary to ensure that its installed products are Year 2000 ready. In
this regard, the Company is incurring, and will continue to incur throughout
1999, various costs to provide customer support regarding Year 2000 issues, and
certain of such costs are expected to be borne not by the Company but, instead,
to be passed on to the customers. The full cost of these activities, including
corrective measures, is not fully known. However, costs incurred to date have
not been material and the Company believes that the potential future financial
impact of assuring such Year 2000 readiness will not be material. The Company is
continuing its assessments and developing alternatives that will necessitate
refinement of this estimate over time. There can be no assurance, however, that
there will not be a delay in, or increased costs associated with, the efforts
described in this section. Since the efforts described in this section are
ongoing, all potential Year 2000 complications have not yet been identified.
Therefore, the potential impact of these complications on the Company's
financial condition and results of operations cannot be determined at this time.
If computer systems used by the Company or its 



                                       25

<PAGE>   26


suppliers, the product integrity of products provided to the Company by
suppliers, or the software applications used in systems manufactured and sold by
the Company, fail or experience significant difficulties related to the Year
2000, the Company's results of operations and financial condition could be
materially affected.

CONTINGENCY PLANS

The Company currently is in the process of preparing contingency plans for the
Year 2000 readiness issues noted above and the Company anticipates completing
those plans by December 1999. There can be no assurance that such measures will
prevent the occurrence of Year 2000 problems, which could have a material
adverse effect upon the Company's business, operating results and financial
condition.

EURO

The Company has established a team to address issues raised by the introduction
of the Single European Currency ("Euro") for initial implementation as of
January 1, 1999, and through the transition period to January 1, 2002. The
Company expects to be able to meet related legal requirements by January 1,
1999, and through the transition period. The Company does not expect the cost of
system modifications to be material and does not currently expect that
introduction and use of the Euro will materially affect its foreign exchange
activities or will result in a material increase in transaction costs. The
Company will continue to evaluate the impact over time of the introduction of
the Euro; however, based on currently available information, management does not
believe that the introduction of the Euro will have a material adverse impact on
the Company's financial condition or the overall trends in results of
operations.

ADDITIONAL FACTORS THAT MAY AFFECT RESULTS AND FINANCIAL CONDITION

The Company's future operating results may be affected by inherent uncertainties
that exist in the worldwide semiconductor equipment industry. Such uncertainties
include, but are not limited to, unexpected additional environmental remediation
expenses in the event the current remediation efforts need to be expanded or
ongoing investigation reveals additional contamination, timely availability and
acceptance of new hardware and software products, capital expenditures of
semiconductor manufacturers, changes in demand for semiconductor products,
competitive pricing pressures, product volume and mix, development of new
products, enhancement of existing products, global economic conditions,
availability of needed components, availability of skilled employees, timing of
orders received, fluctuations in foreign exchange rates, financial instability
in Asian markets, introduction of competitors products having technological
and/or pricing advantages, and the integration of the businesses of Knights and
Techne into the Company. In addition, the Company has experienced, and may in
the future experience, significant fluctuations in its quarterly financial
results. Accordingly, recent historical operating results should only be one
source of information when evaluating the future financial performance of the
Company.




                                       26
<PAGE>   27


       ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS

INTEREST RATE RISK

At December 31, 1998, the Company's cash equivalents and short-term investments
consisted primarily of fixed income securities. The Company maintains a strict
investment policy which ensures the safety and preservation of its invested
funds by limiting default risk, market risk, and reinvestment risk. The
portfolio includes only marketable securities with active secondary or resale
markets. These securities are subject to interest rate risk and may decline in
value when interest rates change. The table below presents notional amounts and
related weighted-average interest rates by year of maturity for the Company's
investment portfolio.


<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)                  1999          2000         TOTAL      FAIR VALUE
----------------------------------------------------------------------------------------
<S>                                   <C>           <C>          <C>           <C>     
Cash equivalents
   Fixed rate                         $  9,281      $    --      $  9,281      $  9,281
   Average rate                           3.74%          --          3.74%           --
Short-term investments
   Fixed rate                         $ 67,455      $16,367      $ 83,822      $ 84,108
   Average rate                           4.66%        3.94%         4.52%           --
Preferred stock
   Fixed rate                         $ 16,750      $    --      $ 16,750      $ 16,750
   Average rate                           5.56%          --          5.56%           --
Restricted cash
   Variable rate                      $ 17,712      $    --      $ 17,712      $ 17,712
   Average rate                           5.55%          --          5.55%           --
Total Investment Securities           $111,198      $16,367      $127,565      $127,851
   Average rate                           4.86%        3.94%         4.74%           --
</TABLE>

FOREIGN CURRENCY EXCHANGE RATE RISK

The current foreign exchange exposure in all international operations is deemed
to be immaterial. The Company believes the impact of a 10% change in exchange
rates would not be material to the Company's financial condition and results of
operations. Accordingly, the Company does not use derivative financial
instruments to hedge its current foreign exchange exposure. See Note 1 --
Summary of Significant Accounting Policies, foreign currency accounting.



                                       27

<PAGE>   28

              ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

<TABLE>
<CAPTION>
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE                   PAGES
--------------------------------------------------------------------------------------
<S>                                                                               <C>
Consolidated Financial Statements:

    Consolidated Statements of Operations -- Years Ended 
    December 31, 1998, 1997 and 1996...............................................29

    Consolidated Balance Sheets -- December 31, 1998 and 1997......................30

    Consolidated Statements of Stockholders' Equity --
    Years Ended December 31, 1998, 1997 and 1996...................................31

    Consolidated Statements of Cash Flows -- Years Ended 
    December 31, 1998, 1997 and 1996...............................................32

    Notes to Consolidated Financial Statements.....................................33

    Report of Ernst & Young LLP, Independent Auditors..............................48

Financial Statement Schedule:

    Schedule II -- Consolidated Valuation and Qualifying Accounts --
    Years Ended December 31, 1998, 1997 and 1996...................................49
</TABLE>



                                       28


<PAGE>   29

CONSOLIDATED STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,                        1998           1997           1996
------------------------------------------------------------------------------------
<S>                                          <C>            <C>            <C>      
Net sales                                    $ 101,599      $ 150,035      $ 151,950
Cost of sales                                   67,875         86,409         79,666
                                             ---------------------------------------
Gross profit                                    33,724         63,626         72,284
                                             ---------------------------------------
Operating expenses:
   Engineering, research and development        30,538         21,897         18,672
   Selling, general and administrative          33,334         32,532         24,758
   In-process research and development              --         27,029             --
   Impairment of long-lived assets               9,578             --             --
                                             ---------------------------------------
Total operating expenses                        73,450         81,458         43,430
                                             ---------------------------------------
Operating income (loss)                        (39,726)       (17,832)        28,854
Interest income                                  5,580          5,207          4,771
Other income (expense), net                        (53)          (363)            76
                                             ---------------------------------------
Income (loss) before income taxes              (34,199)       (12,988)        33,701
Provision (benefit) for income taxes            (2,614)         2,949          9,242
                                             =======================================
Net income (loss)                            $ (31,585)     $ (15,937)     $  24,459
                                             =======================================
Basic net income (loss) per share            $   (1.62)     $   (0.86)     $    1.38
                                             =======================================
Diluted net income (loss) per share          $   (1.62)     $   (0.86)     $    1.36
                                             =======================================
Shares used in basic calculations               19,437         18,460         17,779
                                             =======================================
Shares used in diluted calculations             19,437         18,460         17,967
                                             =======================================
</TABLE>



See the accompanying notes to consolidated financial statements.



                                       29


<PAGE>   30


CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,                                         1998          1997
--------------------------------------------------------------------------------------
<S>                                                           <C>            <C>      
Assets
Current assets:
   Cash and cash equivalents                                  $  12,966      $  20,259
   Short-term investments                                       100,858        104,719
   Accounts receivable, net of allowance for
     doubtful accounts of $448 in 1998 and $465 in 1997          11,945         35,852
   Inventories                                                   14,428         26,032
   Prepaid expenses and other assets                              2,050            999
   Income taxes receivable                                       10,860          3,578
   Deferred income taxes                                             --          7,613
                                                              ------------------------
     Total current assets                                       153,107        199,052
Restricted cash                                                  17,712             --
Equipment and leasehold improvements, net                        11,768         16,392
Intangible assets, net of accumulated amortization
   of $1,018 in 1998 and $1,639 in 1997                             923         12,525
Other assets                                                        731            950
                                                              ------------------------
Total assets                                                  $ 184,241      $ 228,919
                                                              ========================


Liabilities and stockholders' equity 
Current liabilities:
   Short-term borrowings                                      $     566      $   1,160
   Accounts payable                                               2,738          7,424
   Accrued liabilities                                           13,160         18,045
                                                              ------------------------
     Total current liabilities                                   16,464         26,629
Deferred income taxes                                               110          2,556
Commitments and contingencies (Note 12)
Stockholders' equity:
   Preferred stock, $0.01 par value;
     authorized 1,000; none outstanding                              --             --
   Common stock, $0.01 par value; authorized 40,000;
     19,860 issued and outstanding at December 31, 1998,
     and 20,543 at December 31, 1997                                199            205
   Additional paid-in capital                                   130,927        133,600
   Deferred stock compensation                                     (688)          (983)
   Retained earnings                                             38,178         78,736
   Accumulated other comprehensive loss                            (128)           (32)
                                                              ------------------------
                                                                168,488        211,526
   Less cost of common stock in treasury;
     62 shares at December 31, 1998 and
     800 shares at December 31, 1997                                821         11,792
                                                              ------------------------
     Total stockholders' equity                                 167,667        199,734
                                                              ------------------------
Total liabilities and stockholders' equity                    $ 184,241      $ 228,919
                                                              ========================
</TABLE>



See the accompanying notes to consolidated financial statements.



                                       30
<PAGE>   31



CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY


<TABLE>
<CAPTION>
                                                                              ADDITIONAL      DEFERRED    
                                                       COMMON STOCK            PAID-IN         STOCK      
(IN THOUSANDS)                                     SHARES        AMOUNT        CAPITAL      COMPENSATION  
----------------------------------------------------------------------------------------------------------
<S>                                                <C>         <C>            <C>                  <C>    
Balance at January 1, 1996                         18,011      $     180      $  87,102            $--    
Net income                                             --             --             --             --    
Net unrealized gains on investments                    --             --             --             --    
Net translation adjustments                            --             --             --             --    
                                                                                                          
Total comprehensive income                         

Deferred compensation related
   to grant of restricted stock                       100              1          1,424         (1,425)   
Amortization of deferred compensation                  --             --             --            147    
Issuance of common stock under
   employee stock plans                                92              1          1,314             --    
Purchase of treasury stock                             --             --             --             --    
Tax benefit of stock option exercises                  --             --             83             --    
                                                  --------------------------------------------------------
Balance at December 31, 1996                       18,203            182         89,923         (1,278)   
Net loss                                               --             --             --             --    
Net unrealized losses on investments                   --             --             --             --    
Net translation adjustments                            --             --             --             --    
                                                                                                          
Total comprehensive loss

Amortization of deferred compensation                  --             --             --            295    
Issuance of common stock under
    employee stock plans                              588              6          6,286             --    
Purchase of treasury stock                             --             --             --             --    
Tax benefit of stock option exercises                  --             --          3,337             --    
Common stock issued for businesses acquired         1,752             17         34,054             --    
                                                  --------------------------------------------------------
Balance at December 31, 1997                       20,543            205        133,600           (983)   
Net loss                                               --             --             --             --    
Net unrealized gains on investments                    --             --             --             --    
Net translation adjustments                            --             --             --             --    
                                                                                                          
Total comprehensive loss

Amortization of deferred compensation                  --             --             --            295    
Issuance of common stock under
   employee stock plans                               317              4          3,407             --    
Purchase of treasury stock                             --             --             --             --    
Retirement of treasury stock                       (1,000)           (10)        (6,080)            --    
                                                  --------------------------------------------------------
Balance at December 31, 1998                       19,860      $     199      $ 130,927      $    (688)   
                                                  ========================================================
</TABLE>


<TABLE>
<CAPTION>
                                                             ACCUMULATED OTHER           TREASURY               TOTAL
                                                   RETAINED    COMPREHENSIVE              STOCK              STOCKHOLDERS'
(IN THOUSANDS)                                     EARNINGS    INCOME (LOSS)       SHARES        AMOUNT         EQUITY
--------------------------------------------------------------------------------------------------------------------------
<S>                                               <C>            <C>                <C>        <C>            <C>      
Balance at January 1, 1996                        $  70,214      $    (102)            --            $--      $ 157,394
Net income                                           24,459             --             --             --         24,459
Net unrealized gains on investments                      --             42             --             --             42
Net translation adjustments                              --            (38)            --             --            (38)
                                                                                                              ---------
Total comprehensive income                                                                                       24,463
                                                                                                              ---------
Deferred compensation related
   to grant of restricted stock                          --             --             --             --             --
Amortization of deferred compensation                    --             --             --             --            147
Issuance of common stock under
   employee stock plans                                  --             --             --             --          1,315
Purchase of treasury stock                               --             --           (674)        (9,751)        (9,751)
Tax benefit of stock option exercises                    --             --             --             --             83
                                                  ---------------------------------------------------------------------
Balance at December 31, 1996                         94,673            (98)          (674)        (9,751)       173,651
Net loss                                            (15,937)            --             --             --        (15,937)
Net unrealized losses on investments                     --            (69)            --             --            (69)
Net translation adjustments                              --            135             --             --            135
                                                                                                              ---------
Total comprehensive loss                                                                                        (15,871)
                                                                                                              ---------
Amortization of deferred compensation                    --             --             --             --            295
Issuance of common stock under
    employee stock plans                                 --             --             --             --          6,292
Purchase of treasury stock                               --             --           (126)        (2,041)        (2,041)
Tax benefit of stock option exercises                    --             --             --             --          3,337
Common stock issued for businesses acquired              --             --             --             --         34,071
                                                  ---------------------------------------------------------------------
Balance at December 31, 1997                         78,736            (32)          (800)       (11,792)       199,734
Net loss                                            (31,585)            --             --             --        (31,585)
Net unrealized gains on investments                      --            217             --             --            217
Net translation adjustments                              --           (313)            --             --           (313)
                                                                                                              ---------
Total comprehensive loss                                                                                        (31,681)
                                                                                                              ---------
Amortization of deferred compensation                    --             --             --             --            295
Issuance of common stock under
   employee stock plans                                  --             --             --             --          3,411
Purchase of treasury stock                               --             --           (262)        (4,092)        (4,092)
Retirement of treasury stock                         (8,973)            --          1,000         15,063             --
                                                  ---------------------------------------------------------------------
Balance at December 31, 1998                      $  38,178      $    (128)           (62)     $    (821)     $ 167,667
                                                  =====================================================================
</TABLE>


See the accompanying notes to consolidated financial statements.



                                       31
<PAGE>   32


CONSOLIDATED STATEMENTS OF CASH FLOWS




<TABLE>
<CAPTION>
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,                                        1998           1997           1996
----------------------------------------------------------------------------------------------------
<S>                                                          <C>            <C>            <C>      
Cash flows from operating activities
Net income (loss)                                            $ (31,585)     $ (15,937)     $  24,459
Adjustments to reconcile net income (loss)
   to net cash provided by operating activities:
     Depreciation                                                6,920          5,165          2,885
     Amortization                                                3,903          2,813          1,208
     Write-off of in-process research and development               --         27,029             --
     Impairment of long-lived assets                             9,578             --             --
     Loss on disposal of fixed assets                              744             46              2
     Deferred income taxes                                       5,167          1,997          2,518
     Changes in current assets and liabilities
       net of effects from acquisitions:
        Accounts receivable                                     23,907        (17,953)        15,418
        Inventories                                             11,604           (973)          (144)
        Prepaid expenses and other current assets               (1,051)           336           (177)
        Accounts payable                                        (4,686)         2,092         (2,959)
        Accrued liabilities                                     (4,885)        (4,212)        (1,602)
        Income taxes receivable/payable                         (7,282)         5,981        (12,326)
                                                             ---------------------------------------
Cash provided by operating activities                           12,334          6,384         29,282
                                                             ---------------------------------------
Cash flows from investing activities
Capital expenditures                                            (2,989)       (10,697)        (8,010)
Purchases of investments, available-for-sale                  (299,989)      (193,692)      (233,171)
Maturities of investments, available-for-sale                  303,104        206,126        225,932
Acquisitions, net of cash acquired                                  --           (516)            --
Investment in restricted cash                                  (17,712)            --             --
Other assets                                                      (439)          (257)        (1,057)
                                                             ---------------------------------------
Cash provided by (used in) investing activities                (18,025)           964        (16,306)
                                                             ---------------------------------------
Cash flows from financing activities
Net payments from short-term borrowings                           (594)        (2,624)          (162)
Sales of common stock                                            3,411          6,292          1,315
Purchase of treasury stock                                      (4,092)        (2,041)        (9,751)
                                                             ---------------------------------------
Cash provided by (used in) financing activities                 (1,275)         1,627         (8,598)
                                                             ---------------------------------------
Effect of exchange rate changes                                   (327)           143            (33)
                                                             ---------------------------------------
Net increase (decrease) in cash and cash equivalent             (7,293)         9,118          4,345
Cash and cash equivalents at beginning of year                  20,259         11,141          6,796
                                                             ---------------------------------------
Cash and cash equivalents at end of year                     $  12,966      $  20,259      $  11,141
                                                             =======================================
Supplemental cash flow disclosure:
   Cash paid (received) during the year for income taxes     $    (530)     $  (5,062)     $  18,916
Other noncash changes:
   Income tax benefits from employee stock plans             $      --      $   3,337      $      83
</TABLE>





See the accompanying notes to consolidated financial statements.




                                       32
<PAGE>   33


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles Of Consolidation And Basis Of Presentation: The consolidated
financial statements include the accounts of the domestic and foreign business
operations of the Company for all periods. Intercompany transactions have been
eliminated.

Use Of Estimates: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements.
Actual results could differ from those estimates.

Cash And Cash Equivalents: The Company considers all highly liquid investments
with minimum yield risks and maturities of less than 90 days from the date of
purchase to be cash equivalents.

Investments: The Company invests its excess cash in high quality debt and equity
instruments. Management determines the appropriate classification of the debt
securities at the time of purchase as either held-to-maturity or
available-for-sale and re-evaluates such designation as of each balance sheet
date.

Available-for-sale securities are stated at fair market value, with unrealized
gains and losses reported in a separate component of stockholders' equity.
Held-to-maturity securities are stated at amortized cost, adjusted for
amortization of premiums and accretion of discounts to maturity. Such
amortization, as well as any interest on the securities, is included in interest
income.

Inventories: Inventories are stated at the lower of cost or market using the
first-in, first-out (FIFO) method.

Equipment and Leasehold Improvements: Equipment and leasehold improvements are
stated at cost less accumulated depreciation and amortization. Depreciation and
amortization are provided using the straight-line method over the estimated
useful lives (three to ten years) of assets. Leasehold improvements are
amortized over the life of the related assets or the life of the lease whichever
is shorter.

Revenue Recognition: Revenue related to the majority of the Company's products
is recognized as products are shipped and services rendered, except for newly
introduced products and for initial customer installments, which are recognized
upon the successful completion of an evaluation period.

The Company also derives revenue from software licenses and postcontract
customer support (PCS). Postcontract customer support includes telephone
support, bug fixes, and rights to upgrades on a when-and-if available basis. In
software arrangements that include rights to multiple software products,
specified upgrades and PCS, the Company allocates the total arrangement fee
among each deliverable based on the relative fair value of each of the
deliverables determined based on vendor-specific objective evidence.

Software Licenses: The Company recognizes the revenue allocable to software
licenses and specified upgrades upon delivery of the software product or upgrade
to the end user, unless the fee is not fixed or determinable or collectibility
is not probable. The Company considers all arrangements with payment terms
extending beyond twelve months and other arrangements with payment terms longer
than normal not to be fixed or determinable. If the fee is not fixed or
determinable, revenue is recognized as payments become due from the customer. If
collectibility is not considered probable, revenue is recognized when the fee is
collected.

Postcontract Customer Support: Revenue allocable to PCS is recognized on a
straight-line basis over the period the PCS is 




                                       33
<PAGE>   34

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


provided.

Warranty: The Company generally warrants its products for a period of up to 12
months from shipment for material and labor to repair the product; accordingly,
a provision for the estimated cost of the warranty is recorded upon shipment.

Engineering, Research and Development Expenses: The Company is actively engaged
in basic technology and applied research programs designed to develop new
products and product applications. In addition, substantial ongoing product and
process improvement engineering and support programs relating to existing
products are conducted within engineering departments. Engineering, research and
development costs are charged to operations as incurred.

Foreign Currency Accounting: The U.S. dollar is the functional currency for all
foreign operations, excluding Japan. Gains or losses that result from the
process of remeasuring foreign currency financial statements into U.S. dollars
were $0, $0.6 million and $0.3 million in 1998, 1997 and 1996, respectively, and
are included in operations.

The Japanese Yen is the functional currency for the Company's Japanese
subsidiary. Translation gains or losses related to the Japanese subsidiary are
included as a component of stockholders' equity and comprehensive income.

Net Income (Loss) Per Share: In 1997, the Financial Accounting Standards Board
issued Statement No. 128, "Earnings per Share." Statement 128 replaced the
calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants and convertible
securities. Diluted earnings per share is very similar to the previously
reported fully diluted earnings per share. All earnings per share amounts for
all periods have been presented, and where appropriate, restated to conform to
the Statement 128 requirement.

The following table sets forth the computation of basic and diluted net income
(loss) per share:


<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,                                                  1998          1997          1996
------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>           <C>           <C>     
Numerator:
   Net income (loss)                                                    $(31,585)     $(15,937)     $ 24,459

Denominator:
   Denominator for basic income (loss) per share --
     weighted average shares                                              19,437        18,460        17,779

   Effect of dilutive securities:
     Employee stock options                                                   --            --           138
     Restricted stock                                                         --            --            50
                                                                        ------------------------------------
   Dilutive potential common shares                                           --            --           188
     Denominator for diluted income (loss) per share--
        adjusted weighted average shares and assumed conversions          19,437        18,460        17,967
                                                                        ------------------------------------
Basic net income (loss) per share                                       $  (1.62)     $  (0.86)     $   1.38
Diluted net income (loss) per share                                     $  (1.62)     $  (0.86)     $   1.36
                                                                        ====================================
</TABLE>

Options to purchase 2,432,000 and 2,302,000 shares of common stock and 100,000
and 100,000 shares of restricted common stock were outstanding at December 31,
1998 and 1997, respectively, but were not included in the computa-



                                       34
<PAGE>   35

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

tion of diluted loss per share as the effect would be antidilutive.

In connection with the acquisition of Techne Systems, Inc., 120,000 shares of
common stock have been placed into escrow through December 1999 subject to
certain representations and warranties. Related to the Knights acquisition,
44,000 and 135,000 shares of common stock were in escrow as of December 31, 1998
and 1997, respectively. The escrow shares related to both acquisitions were not
included in the computation of diluted net loss per share as the effect would be
antidilutive.

Accounting For Long-Lived Assets: In accordance with Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived
Assets," the Company reviews long-lived assets held and used by the Company for
impairment whenever events or changes in circumstances indicate that assets may
be impaired and the undiscounted cash flows estimated to be generated by those
assets are less than the carrying amounts of those assets.

Comprehensive Income: As of January 1, 1998, the Company adopted Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income."
Statement 130 establishes new rules for the reporting and display of
comprehensive income (loss) and its components. Statement 130 requires
unrealized gains or losses on the Company's available-for-sale investments and
foreign currency translation adjustments, which prior to adoption were reported
separately in stockholders' equity, to be included in other comprehensive
income. Prior year financial statements have been reclassified to conform to the
requirements of Statement 130. The adoption of this Statement had no impact on
the Company's net income or stockholder's equity.

Effect of New Accounting Pronouncements: In June 1998, the Financial Accounting
Standards Board issued Statement No. 133," Accounting for Derivative Instruments
and Hedging Activities." It establishes accounting and reporting standards for
derivative instruments including stand alone instruments, such as forward
currency exchange contracts and interest note swaps or embedded derivatives,
such as conversion options contained in convertible debt investments and
requires that these instruments be marked-to-market on an ongoing basis. The
Company is required to adopt Statement 133 for the year ending December 2000.
Because of the Company's minimal use of derivatives, management does not expect
that the adoption of the new statement will have a significant effect on
earnings or the financial position of the Company.

Reclassification: During the year, the Company reclassified certain tax line
items to conform to current year presentations.




                                       35
<PAGE>   36

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. ACQUISITIONS

On May 19, 1997, the Company acquired Knights, a Sunnyvale, California based
developer of yield management software for the semiconductor industry, for the
following amounts:


<TABLE>
<CAPTION>
(IN THOUSANDS)
-------------------------------------------------
<S>                                       <C>    
Common stock issued, 1,352,000 shares     $27,720
Assumption of Knights stock options         2,295
Acquisition costs                           1,785
                                          -------
                                          $31,800
                                          =======
</TABLE>

On December 19, 1997, the Company acquired all of the outstanding shares of
common stock of Techne, an Albany, Oregon based manufacturer of back-end wafer
inspection equipment for the following amounts:


<TABLE>
<CAPTION>
(IN THOUSANDS)
-------------------------------------------------
<S>                                       <C>    
Cash                                       $1,500
Common stock issued, 400,000 shares         4,340
Acquisition costs                             400
                                           ------
                                           $6,240
                                           ======
</TABLE>

The Knights and Techne acquisitions were recorded under the purchase method of
accounting and accordingly, results of operations of Knights and Techne are
included in the accompanying consolidated financial statements subsequent to
acquisitions. The purchase prices have been allocated, based on independent
appraisals obtained by the Company, to the tangible and intangible assets
acquired and liabilities assumed based on their respective fair values on the
date of acquisition as follows:


<TABLE>
<CAPTION>
(IN THOUSANDS)                           KNIGHTS       TECHNE
--------------------------------------------------------------
<S>                                     <C>           <C>     
Cash                                    $    973      $     11
Other current assets                       1,220         3,685
Non-current assets                           712            49
Intangibles                                7,720         3,697
Liabilities                               (2,325)       (4,731)
In-process research and development       23,500         3,529
                                        ----------------------
                                        $ 31,800      $  6,240
                                        ======================
</TABLE>

To determine the value of in-process research and development of the acquired
businesses, the Company considered, among other factors, the stage of
development of each project, expected income, target markets, and associated
risks. Associated risks included inherent difficulties and uncertainties in
completing the project and, thereby, achieving technical feasibility and risks
related to the viability of and potential changes in future target markets. This
analysis resulted in a valuation for in-process research and development that
had not reached technical feasibility and did not have alternative future uses.
Therefore, in accordance with generally accepted accounting principles, $23.5
million and $3.5 million was expensed in 1997 related to the Knights and Techne
acquisitions, respectively.




                                       36
<PAGE>   37

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Intangible assets on the Knights acquisition relate primarily to developed
technology and goodwill. Intangible assets on the Techne acquisition relate
principally to developed technology. To determine the value of developed
technology, the expected future cash flows of each product was discounted,
taking into account risks related to the characteristics and applications of
each product, existing and future markets, and assessment of the life cycle
stage of each product. This analysis resulted in a valuation for completed
products that had reached technological feasibility and, therefore, was
capitalizable. Intangible assets will be amortized on a straight-line basis over
estimated useful lives ranging from three to five years.

In connection with the acquisition of Techne, 120,000 shares of common stock
have been placed in escrow through December 1999 subject to certain
representations and warranties. Related to the Knights acquisition, 44,000
shares of common stock remain in escrow at December 31, 1998.

The Company entered into an agreement to lease Techne's current manufacturing
facilities from Techne's President. Under the one year operating lease which
expired in December 1998, the Company made lease payments of approximately $0.2
million, plus payment of executory costs such as property taxes, maintenance and
insurance. The lease is currently on a month-to-month basis.

The following unaudited pro forma summary presents the consolidated results of
operations of the Company, excluding the charge for in-process research and
development, as if the acquisitions of Knights and Techne had occurred at the
beginning of 1996 and does not purport to be indicative of what would have
occurred had the acquisition been made as of the beginning of 1996 or of results
which may occur in the future:


<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,                               1997       1996
---------------------------------------------------------------------
<S>                                                <C>        <C>     
Net sales                                          $152,438   $159,175
Net income                                         $  8,959   $ 24,143
Basic net income per share                         $   0.49   $   1.36
Diluted net income per share                       $   0.47   $   1.34
----------------------------------------------------------------------
</TABLE>

NOTE 3. IMPAIRMENT OF LONG-LIVED ASSETS

In the fourth quarter of 1998, the Company recorded asset impairment charges of
$9.6 million. The charge related principally to long-lived assets, including
goodwill acquired in connection with the 1997 acquisitions of Techne and
Knights. The charges were recorded in accordance with Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long Lived
Assets." Statement 121 requires that the Company analyze whether the cash flows
attributable to an asset support the value assigned to that asset in the
financial statements. Where estimated cash flow is not sufficient to recover the
asset's net carrying value, a fair value approach is taken towards reassigning a
carrying value to the asset. The Company estimated fair value based on
management's estimate of discounted future cash flows. The charge consists of
$3.1 million related to goodwill, $6.3 million related to acquired intangible
assets, and $0.2 million related to other long-lived assets.

During the second half of 1998, the Company did not receive any orders for a new
Techne inspection product being developed. Consequently, there were no
inspection products in backlog at the end of the year and there is significant
uncertainty as to future orders. In light of this, the Company re-evaluated its
forecast for such products. The Company expects that it will not be able to
recover the carrying value of the long-lived assets related to Techne, and
recorded an impairment loss in the fourth quarter of 1998.




                                       37
<PAGE>   38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In addition, the Company experienced lower than expected sales of Knights'
products which resulted in an operating loss for Knights in 1998. In light of
this, the Company re-evaluated its forecast for Knights products. The Company
expects that it will not be able to recover the carrying value of the long-lived
assets related to Knights, and recorded an impairment loss in the fourth quarter
of 1998.

NOTE 4. FINANCIAL INSTRUMENTS

Concentration Of Credit Risk: Financial instruments that potentially subject the
Company to concentration of credit risk consist principally of cash equivalents,
investments and trade receivables.

The Company places its cash equivalents and investments with high credit-quality
financial institutions. The Company invests its excess cash in commercial paper,
readily marketable debt and equity instruments and collateralized funds of U.S.
and state government entities. The Company has established guidelines relative
to credit ratings, diversification and maturities that seek to maintain safety
and liquidity.

The Company sells its systems to semiconductor manufacturers throughout the
world. The Company performs ongoing credit evaluations of its customers'
financial condition and requires collateral, such as letters of credit, whenever
deemed necessary. The write-off of uncollectable amounts has been insignificant.
Accounts receivable from customers in Asia were $2.5 million and $7.1 million at
December 31, 1998 and 1997, respectively.

Fair Value Of Financial Instruments: The Company has evaluated the estimated
fair value of financial instruments. The amounts reported for cash and cash
equivalents, accounts receivable, short-term borrowings, accounts payable and
accrued expenses approximate the fair value due to their short maturities.
Investment securities are reported at their estimated fair value based on quoted
market prices.

Investments: The following is a summary of the Company's investments:


<TABLE>
<CAPTION>
                                                           GROSS       GROSS     ESTIMATED
(IN THOUSANDS)                              AMORTIZED UNREALIZED  UNREALIZED          FAIR
AVAILABLE-FOR-SALE AT DECEMBER 31, 1998          COST      GAINS      LOSSES         VALUE
------------------------------------------------------------------------------------------
<S>                                         <C>            <C>        <C>        <C>      
Municipal bonds                             $  54,548      $ 326      $  (41)    $  54,833
Preferred stock                                16,750         --          --        16,750
Floating rate notes                            29,274          4          (3)       29,275
                                            ----------------------------------------------
                                            $ 100,572      $ 330      $  (44)    $ 100,858
                                            ==============================================
</TABLE>



<TABLE>
<CAPTION>
                                                           GROSS       GROSS     ESTIMATED
(IN THOUSANDS)                              AMORTIZED UNREALIZED  UNREALIZED          FAIR
AVAILABLE-FOR-SALE AT DECEMBER 31, 1997          COST      GAINS      LOSSES         VALUE
------------------------------------------------------------------------------------------
<S>                                         <C>            <C>        <C>        <C>      
Municipal bonds                             $  87,768      $ 110      $  (35)    $  87,843
Floating rate notes                            16,882         --          (6)       16,876
                                            ----------------------------------------------
                                            $ 104,650      $ 110      $  (41)    $ 104,719
                                            ==============================================
</TABLE>



                                       38
<PAGE>   39

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following is a summary of amortized costs and estimated fair values of debt
securities by contractual maturity:


<TABLE>
<CAPTION>
                                                                               ESTIMATED
(IN THOUSANDS)                                                   AMORTIZED         FAIR
AVAILABLE-FOR-SALE AT DECEMBER 31, 1998                               COST        VALUE
---------------------------------------------------------------------------------------
<S>                                                               <C>          <C>     
Amounts maturing within one year                                  $ 46,024     $ 46,025
Amounts maturing after one year, within five years                  54,548       54,833
                                                                  --------------------
                                                                  $100,572     $100,858
                                                                  =====================
</TABLE>


Note 5. Inventories

The following is a summary of inventories by major category:


<TABLE>
<CAPTION>
(IN THOUSANDS)
AT DECEMBER 31,                                                        1998       1997
--------------------------------------------------------------------------------------
<S>                                                                <C>        <C>     
Raw materials                                                      $  4,502   $ 11,571
Work in process                                                       5,948      8,499
Finished goods                                                        3,978      5,962
                                                                   -------------------
                                                                   $ 14,428   $ 26,032
                                                                   ===================
</TABLE>


Note 6. Equipment and Leasehold Improvements

The following is a summary of equipment and leasehold improvements by major
category:


<TABLE>
<CAPTION>
(IN THOUSANDS)
AT DECEMBER 31,                                                        1998       1997
--------------------------------------------------------------------------------------
<S>                                                                <C>        <C>     
Equipment                                                          $ 17,241   $ 18,302
Leasehold improvements                                                8,303      8,425
Office furniture and equipment                                       10,731      9,415
                                                                   -------------------
                                                                     36,275     36,142
Accumulated depreciation and amortization                           (24,507)   (19,750)
                                                                   -------------------
                                                                   $ 11,768   $ 16,392
                                                                   ===================
</TABLE>


Note 7. Accrued Liabilities

The following is a summary of accrued liabilities:


<TABLE>
<CAPTION>
(IN THOUSANDS)
AT DECEMBER 31,                                                        1998       1997
--------------------------------------------------------------------------------------
<S>                                                                <C>        <C>     
Salaries and benefits                                              $  3,943   $  5,704
Warranty reserves                                                     2,991      3,325
Customer advance payments                                               519      2,249
Deferred revenue                                                      2,594      1,858
Environmental remediation costs (Note 12)                               785      1,468
Other                                                                 2,328      3,441
                                                                   -------------------
                                                                   $ 13,160   $ 18,045
                                                                   ===================
</TABLE>



                                       39


<PAGE>   40

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8. SHORT-TERM BORROWINGS

The Company's Japanese subsidiary has credit facilities with a total borrowing
capacity of approximately $5.1 million (denominated in Yen) with two Japanese
banks. One of the facilities is guaranteed by a $1.7 million standby letter of
credit issued by the Company. As of December 31, 1998, the amount outstanding
was $0.6 million (denominated in Yen), renewable quarterly at the current bank
interest rate plus .25% per annum (1.875% and 2.50% at December 31, 1998).

NOTE 9. STOCKHOLDERS' EQUITY

Preferred Stock: The Board of Directors has the authority, without any further
vote or action by the stockholders, to provide for the issuance of 1,000,000
shares of preferred stock from time to time in one or more series with such
designation, rights preferences and limitations as the Board of Directors may
determine, including the consideration received therefore, the number of shares
comprising each series, dividend rates, redemption provisions, liquidation
preferences, redemption fund provisions, conversion rights and voting rights,
all without the approval of the holders of common stock.

Rights Agreement: On November 19, 1997, the Company adopted a Shareholder Rights
Plan (Rights Agreement). Pursuant to the Rights Agreement, rights were
distributed at the rate of one right for each share of Common Stock owned by the
Company's stockholders of record on December 5, 1997. The rights expire on
December 4, 2007 unless extended or earlier redeemed or exchanged by the
Company.

Under the Rights Agreement, each right entitles the registered holder to
purchase one-hundredth of a Series A Preferred share of the Company at a price
of $140. The rights will become exercisable only if a person or group acquires
beneficial ownership of 15% or more of the Company's common stock or commences a
tender offer or exchange offer upon consummation of which such person or group
would beneficially own 15% or more of the Company's common stock.

Stock Repurchase Program: On March 14, 1996, the Board of Directors authorized
the repurchase of up to 1,000,000 shares of the Company's common stock on the
open market. The Company completed the repurchase program in early 1998 and
retired the 1,000,000 shares of its common stock held in treasury at a cost of
$15.1 million. On May 19, 1998, the Board of Directors authorized the repurchase
of an additional 1,000,000 shares of the Company's stock beyond the initial
program to reduce the dilution resulting from its employee stock option and
stock purchase plans. During September 1998, the Company repurchased 62,400
shares of its common stock at a cost of $0.8 million.

Stock Option Plans: In August 1997, the Company's stockholders approved the 1997
Stock Incentive Plan (1997 Plan). The 1997 Plan replaced the Company's 1993 Long
Term Stock Incentive Plan (1993 Plan), and as a result, no additional shares
will be issued from the 1993 Plan after 1998. Under the 1997 and 1993 Plans,
750,000 and 3,000,000 shares, respectively, have been reserved for issuance to
eligible employees and to provide for certain automatic grants of stock options
to non-employee directors. In May 1998, the Company's stockholders approved an
amendment to the 1997 Plan to increase the number of shares reserved for
issuance from 750,000 to 1,050,000. Options under these plans are granted at
fair market value, expire ten years from the date of grant, and generally vest
in quarterly installments, commencing one year from the date of grant.




                                       40

<PAGE>   41

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes option activity and related information:


<TABLE>
<CAPTION>
                                             1998                   1997                  1996
                                    ---------------------  ---------------------  --------------------
                                                 WEIGHTED               WEIGHTED              WEIGHTED
                                                  AVERAGE                AVERAGE              AVERAGE
(SHARE AMOUNTS IN THOUSANDS)                     EXERCISE               EXERCISE              EXERCISE
YEAR ENDED DECEMBER 31,             OPTIONS        PRICE   OPTIONS        PRICE   OPTIONS       PRICE
-------------------------------------------------------------------------------------------------------
<S>                                  <C>        <C>         <C>        <C>         <C>        <C>      
Outstanding-- beginning of year      2,302      $   15.70   1,710      $   13.69   1,210      $   19.53
Granted                                591          13.48   1,149          16.49   1,548          13.99
Exercised                             (142)         10.41    (482)         10.17     (38)         11.09
Cancelled                             (319)         18.12     (75)         17.60  (1,010)         22.60
                                     ------------------------------------------------------------------
Outstanding-- end of year            2,432      $   15.15   2,302      $   15.70   1,710      $   13.69
                                     ==================================================================
</TABLE>

The following table summarizes information about outstanding options at 
December 31, 1998:

<TABLE>
<CAPTION>
                                         OPTIONS OUTSTANDING         OPTIONS EXERCISABLE
                                 ---------------------------------- ----------------------
                                               WEIGHTED
                                                AVERAGE    WEIGHTED               WEIGHTED
(IN THOUSANDS,                                 REMAINING   AVERAGE                AVERAGE
EXCEPT PER SHARE DATA)                        CONTRACTUAL  EXERCISE               EXERCISE
RANGE OF EXERCISE PRICES         OUTSTANDING     LIFE       PRICE   EXERCISABLE    PRICE
----------------------------------------------------------------------------------------------
<S>                                   <C>        <C>       <C>          <C>       <C>    
 $1.03 -$14.00                        573        6.33      $ 11.99      113       $  9.98
$14.01 -$14.25                        823        6.81      $ 14.25      566       $ 14.25
$14.26 -$34.25                      1,036        6.63      $ 17.61      310       $ 18.29
                                    -----------------------------------------------------
                                    2,432                               989
                                    =====================================================
</TABLE>

In addition, the Company issued 100,000 shares of restricted stock under the
1993 Long Term Stock Incentive Plan. The Company has recorded a deferred
compensation charge equal to the fair value of the restricted stock at the time
of issuance of $1.4 million. The deferred compensation charge is being amortized
over the five-year vesting period.

On July 1, 1996, the Company repriced 932,000 employee stock options to $14.25,
the closing value at June 28, 1996.

Employee Stock Purchase Plan: In May 1998, the Company's stockholders approved
the 1998 Employee Stock Purchase Plan replacing the 1993 Employee Stock Purchase
Plan that expired in June 1998. Both plans provide that eligible employees may
purchase stock at 85% of its fair value on specified dates through payroll
deductions. Under the new plan, 500,000 shares were reserved for issuance. The
Company sold 175,000 shares, 106,000 shares and 55,000 shares to employees in
1998, 1997 and 1996, respectively.

Stock Based Compensation: As permitted under Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" (FAS No. 123), the
Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB 25), in accounting for
stock-based awards to employees. Under APB 25, the Company generally recognizes
no compensation expense with respect to such awards.



                                       41


<PAGE>   42

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Pro forma information regarding net income (loss) and net income (loss) per
share is required by FAS No. 123 for awards granted after December 31, 1995 as
if the Company had accounted for its stock-based awards to employees under the
fair value method of FAS No. 123. The fair value of the Company's stock-based
awards to employees was estimated using a Black-Scholes option pricing model.
The Black-Scholes option pricing model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility. Because
the Company's stock-based awards to employees have characteristics significantly
different from those of traded options, and because changes in subjective input
assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its stock-based awards to employees. The fair value
of the Company's stock-based awards to employees was estimated using the
following assumptions:


<TABLE>
<CAPTION>
                                          OPTIONS                       ESPP
                                 ------------------------    ------------------------
                                  1998     1997      1996     1998      1997     1996
-------------------------------------------------------------------------------------
<S>                               <C>       <C>      <C>      <C>        <C>      <C> 
Expected dividend yield           0.0%      0.0%     0.0%     0.0%       0.0%     0.0%
Expected stock price volatility  55.0%     51.0%    49.0%    55.0%      51.0%    49.0%
Risk-free interest rate           4.6%      5.6%     5.8%     4.6%       5.5%     5.6%
Expected life (years)             4.0       4.0      4.0      0.5        0.5      0.5
                                 ====================================================
</TABLE>

For pro forma purposes, the estimated fair value of the Company's stock-based
awards to employees is amortized over the options' vesting period (for options)
and the six-month purchase period (for stock purchases under the ESPP). The
Company's pro forma information follows:


<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE DATA)                       1998       1997       1996
---------------------------------------------------------------------------------------
<S>                                                      <C>        <C>         <C>    
Net income (loss)-- as reported                          $(31,585)  $(15,937)   $24,459
Net income (loss)-- pro forma                             (37,163)   (20,308)    20,655
                                                         ------------------------------
Basic net income (loss) per share-- as reported             (1.62)    (0.86)      1.38
Basic net income (loss) per share-- pro forma               (1.91)    (1.10)      1.16
                                                         ------------------------------
Diluted net income (loss) per share-- as reported           (1.62)    (0.86)      1.36
Diluted net income (loss) per share-- pro forma             (1.91)    (1.10)      1.15
                                                         ==============================
</TABLE>

For pro forma purposes in accordance with FAS No. 123, the repricing of employee
stock options during 1996 is treated as a modification of the stock-based award,
with the original options being repurchased and new options granted. Any
additional compensation arising from the modification is recognized over the
remaining vesting period of the new grant. FAS No. 123 is effective for
stock-based awards granted by the Company commencing January 1, 1995. All
stock-based awards granted before January 1, 1995 have not been valued and no
pro forma compensation expense has been recognized. However, any option granted
before January 1, 1995, that was repriced in 1996 is treated as new grant within
1996 and valued accordingly. In addition, because compensation expense is
recognized over the vesting period of the option, which is typically four years,
and pro forma disclosure is only required commencing with 1995, the initial
impact on pro forma income may not be representative of pro forma compensation
expense in future years.

The weighted average fair value of options and stock purchase rights granted
during 1998 was $6.49 and $4.42, respectively.




                                       42


<PAGE>   43

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Incentive Plans: The Company has adopted an Employee Incentive Plan and a
Savings Plan covering substantially all of its United States-resident employees.
The Board of Directors determines annually a formula for setting aside amounts
into a profit sharing pool based upon performance targets. The amounts set aside
are used to pay bonuses to employees. The charge to operations for these plans
during 1998, 1997 and 1996 was $0, $1.3 million and $1.2 million.

NOTE 10. INCOME TAXES

Significant components of the provision (benefit) for income taxes are as
follows:


<TABLE>
<CAPTION>
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,                                    1998       1997       1996
--------------------------------------------------------------------------------------
<S>                                                      <C>         <C>        <C>   
Federal:
   Current                                               $(7,808)    $  631     $5,012
   Deferred                                                3,097      1,053      1,602
                                                         -----------------------------
                                                          (4,711)     1,684      6,614
State:
   Current                                                   (39)       (92)       227
   Deferred                                                1,960        609        916
                                                         -----------------------------
                                                           1,921        517      1,143
Foreign:
   Current                                                    66        748      1,485
   Deferred                                                  110         --         --
                                                         -----------------------------
                                                             176        748      1,485
                                                         -----------------------------
Total provision (benefit) for income taxes.              $(2,614)    $2,949     $9,242
                                                         =============================
</TABLE>

The tax benefits associated with exercises of nonqualified stock options and
disqualifying dispositions of stock acquired through incentive stock options and
the employee stock purchase plan reduce taxes currently payable for 1998, 1997
and 1996, as shown above by $0, $3.3 million and $0.1 million, respectively.
Such benefits are credited to additional paid in capital when realized.



                                       43

<PAGE>   44

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The reconciliation of income tax computed at the U.S. federal statutory rates to
income tax expense (benefit) is as follows:


<TABLE>
<CAPTION>
                                                 1998                     1997                     1996
(IN THOUSANDS EXCEPT PERCENTAGES)       ----------------------   ---------------------    ---------------------
YEARS ENDED DECEMBER 31,                 AMOUNT        PERCENT     AMOUNT      PERCENT      AMOUNT      PERCENT
---------------------------------------------------------------------------------------------------------------
<S>                                     <C>            <C>       <C>            <C>       <C>             <C>  
Tax computed at U.S. statutory rate     $(11,969)      (35.0)%   $ (4,545)      (35.0)%   $ 11,795        35.0%
State income taxes
   (net of federal benefit)                1,249         3.7          335         2.6          743         2.2
Tax exempt investment income              (1,227)       (3.6)      (1,312)      (10.1)      (1,532)       (4.6)
Research and development credit               --          --       (1,646)      (12.6)      (1,564)       (4.6)
Foreign tax rates in excess
   of U.S. tax rates                         448         1.3          266         2.0          132         0.4
In-process research and development           --          --        9,460        72.8           --          --
Intangibles -- goodwill                    1,313         3.8          188         1.4           --          --
Valuation allowance                        8,070        23.6           --          --           --          --
Tax exempt foreign sales
   corporation                                --          --         (212)       (1.6)        (622)       (1.9)
Other, net                                  (498)       (1.4)         415         3.2          290         0.9
                                        ----------------------------------------------------------------------
Provision (benefit) for
   income taxes                         $ (2,614)       (7.6)%   $  2,949        22.7%    $  9,242        27.4%
                                        ======================================================================
</TABLE>

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes.

Significant components of the Company's deferred tax accounts are as follows:

<TABLE>
<CAPTION>
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,                          1998         1997
---------------------------------------------------------------------
<S>                                            <C>           <C>      
Deferred tax liabilities:
   Intangible assets                           $ (1,753)     $ (3,770)
                                               ----------------------
Deferred tax assets:
   Warranty reserve                               1,035         1,229
   Inventories                                    3,023         2,238
   Depreciable assets                             1,599         1,214
   Deferred revenue                                 738         1,942
   Net operating losses                           3,710           700
   Tax credit carryforwards                       5,758           590
   Other, including nondeductible accruals        2,707         2,204
                                               ----------------------
     Total deferred tax assets                 $ 18,570      $ 10,117
     Less:  Valuation allowance                 (16,927)       (1,290)
                                               ----------------------
Net deferred tax assets (liabilities)          $   (110)     $  5,057
                                               ======================
</TABLE>




                                       44

<PAGE>   45

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Realization of the deferred tax assets is dependent on future taxable income,
the timing and amount of which is uncertain. Accordingly, a valuation allowance
in an amount approximately equal to the net deferred tax assets at December 31,
1998 has been established to reflect these uncertainties. In connection with the
Knight's acquisition accounting, approximately $0.5 million of the valuation
allowance will be credited to non-current intangibles when realized.

As of December 31, 1998, the Company had federal net operating loss and tax
credit carryforwards of approximately $9.5 million and $4.4 million,
respectively. The federal loss and research and development credit carryforwards
will expire in 2018. The AMT credit carryforward has no expiration date. The
foreign tax credit carryforwards will expire in the years between 2001 and 2003.

For state tax purposes, as of December 31, 1998, the Company had net operating
loss and tax credit carryforwards of approximately $14.0 million and $2.1
million, respectively. The state net operating loss carryforward will expire in
2003 and the state tax credits, exclusive of the research and development credit
carryforwards, will expire in the years 2007 and 2008. The research and
development credit carryforwards have no expiration dates.

Pretax income (loss) from foreign operations was ($0.8) million, ($0.8) million
and $2.6 million for 1998, 1997 and 1996, respectively. Upon repatriation of
foreign earnings, residual U.S. taxes would be immaterial.

NOTE 11. SEGMENT INFORMATION

The Company has one reportable segment; prober products, the manufacture, sale
and servicing of wafer probers for use in the manufacture of semiconductor
devices. Revenue from segments below the quantitative threshold are attributable
to two operating segments of the Company, its yield management software and
wafer inspection businesses. Prior to the acquisitions of Knights and Techne in
1997, the Company only operated in the prober products segment. The Company's
management has determined the operating segments based upon how the business is
managed and operated. The Company evaluates performance and allocates resources
based on operating income (loss), excluding unusual or infrequent occurring
items. There are no significant intersegment sales or transfers. The Company's
principal markets are the North American, European and Asian based semiconductor
manufacturing companies.

The following is a summary of the Company's operating segments:


<TABLE>
<CAPTION>
                                             PROBER
(IN THOUSANDS)                              PRODUCTS       ALL OTHER   CONSOLIDATED
-----------------------------------------------------------------------------------
<S>                                         <C>            <C>          <C>      
1998
Sales to unaffiliated customers             $  89,296      $  12,303    $ 101,599
Operating loss                              $ (24,864)     $  (5,284)   $ (30,148)
Other significant non-cash items:
   Impairment of long-lived assets          $      --      $  (9,578)   $  (9,578)
Identifiable assets                         $ 178,219      $   6,022    $ 184,241

1997
Sales to unaffiliated customers             $ 145,996      $   4,039    $ 150,035
Operating income (loss)                     $  11,975      $  (2,778)   $   9,197
Other significant non-cash items:
   In-process research and development      $      --      $ (27,029)   $ (27,029)
Identifiable assets                         $ 209,545      $  19,374    $ 228,919
</TABLE>



                                       45
<PAGE>   46


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following is a summary of the Company's geographic operations:


<TABLE>
<CAPTION>
                                                                                    ADJUSTMENTS
                                            UNITED                                      AND
(IN THOUSANDS)                              STATES          ASIA         EUROPE     ELIMINATIONS   CONSOLIDATED
---------------------------------------------------------------------------------------------------------------
<S>                                       <C>            <C>            <C>                 <C>      <C>      
1998
Sales to unaffiliated customers           $  76,679      $   1,326      $  23,594     $      --      $ 101,599
Transfer between geographic locations        17,168            367             --       (17,535)            --
                                          --------------------------------------------------------------------
Total net sales                           $  93,847      $   1,693      $  23,594     $ (17,535)     $ 101,599
Operating income (loss)                   $ (35,547)     $  (5,925)     $   1,383     $     363      $ (39,726)
Identifiable assets                       $ 174,879      $   1,736      $   8,693     $  (1,067)     $ 184,241


1997
Sales to unaffiliated customers           $ 119,567      $   1,557      $  28,911     $      --      $ 150,035
Transfer between geographic locations        23,829            517             93       (24,439)            --
                                          --------------------------------------------------------------------
Total net sales                           $ 143,396      $   2,074      $  29,004     $ (24,439)     $ 150,035
Operating income (loss)                   $ (12,970)     $  (6,571)     $   2,531     $    (822)     $ (17,832)
Identifiable assets                       $ 211,898      $   2,311      $  16,140     $  (1,430)     $ 228,919


1996
Sales to unaffiliated customers           $ 112,216      $   7,844      $  31,890     $      --      $ 151,950
Transfer between geographic locations        27,057             87             --       (27,144)            --
                                          --------------------------------------------------------------------
Total net sales                           $ 139,273      $   7,931      $  31,890     $ (27,144)     $ 151,950
Operating income (loss)                   $  28,402      $  (4,582)     $   4,827     $     207      $  28,854
Identifiable assets                       $ 187,135      $   2,741      $   8,597     $    (607)     $ 197,866
</TABLE>

Sales between geographic areas are accounted for at prices that the Company
believes are at arm's length prices.

International sales represented 43%, 43% and 45% of the Company's net sales in
1998, 1997 and 1996, respectively. These sales represent the combined total of
export sales made by United States operations and all sales made by foreign
operations.

Export sales made by United States operations were 19% of net sales in 1998 (16%
to Asia, 3% to other), 23% of net sales in 1997 (21% to Asia, 2% to other) and
19% of net sales in 1996 (18% to Asia, 1% to other).

No single customer accounted for more than 10% of net sales in 1998 and 1997. In
1996, one customer comprised 13% of net sales. No other customer exceeded 10% of
net sales in 1996.



                                       46
<PAGE>   47

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12. COMMITMENTS AND CONTINGENCIES

The Company leases its facilities and certain equipment under noncancelable
operating leases. As of December 31, 1998, the minimum annual rental commitments
are as follows:


<TABLE>
<CAPTION>
(IN THOUSANDS)
--------------------------------------------------------------------------------------
<S>                                                                            <C>    
1999                                                                           $ 4,552
2000                                                                             3,329
2001                                                                             2,540
2002                                                                             1,266
2003                                                                               614
Thereafter                                                                         137
                                                                               -------
                                                                               $12,438
                                                                               =======
</TABLE>

Rent expense was approximately $3.7 million, $3.6 million and $2.6 million for
the years ended December 31, 1998, 1997 and 1996, respectively.

LEASE AGREEMENT

In March 1997, the Company entered into a $12.0 million five-year operating
lease for approximately 21.5 acres of land in San Jose, California. On July 1,
1998, the lease agreement was amended to provide a construction allowance of
$43.0 million for certain buildings currently under construction on the land.
The monthly payments are based on the London Interbank Offering Rate (LIBOR). At
current interest rates and based on the lease amount of $17.7 million at
December 31, 1998, the annual lease payments currently represent approximately
$1.2 million, which will increase as the construction funding increases
throughout the construction period of 18 to 24 months. At the end of the lease,
the Company has the option to purchase the land and buildings at approximately
$55.0 million. The guaranteed residual payment on the lease is approximately
$55.0 million.

The lease contains certain restrictive covenants. At December 31, 1998, the
Company was in compliance with these covenants. In connection with the lease
collateral requirements, the Company was required to collateralize the lease. At
December 31, 1998, the Company collateralized $17.7 million, which is included
in other assets as restricted cash. The amount of collateralization will
increase as funding increases over the construction period.

LEGAL MATTERS

In the ordinary course of business, various lawsuits and claims are filed
against the Company. While the outcome of these matters is currently not
determinable, management believes that the ultimate resolution of these matters
will not have a material adverse effect on the Company's financial statements.

ENVIRONMENTAL REMEDIATION

The Company has been performing environmental remediation activities on its
leased property in Santa Clara, California, in cooperation with the California
Regional Water Quality Board. In 1997, the Company accrued $1.6 million, which
was the Company's best estimate of its obligation. The Company has since
incurred actual costs of $0.8 million and expects that its remaining liability
to be in the range of $0.5 million to $0.8 million. It is possible that the
Company's recorded estimate of its obligations may change in the near term due
to unexpected additional environmental remediation expenses in the event the
current remediation efforts need to be expanded or ongoing investigation reveals
additional contamination.



                                       47

<PAGE>   48

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


THE BOARD OF DIRECTORS AND STOCKHOLDERS
ELECTROGLAS, INC.

We have audited the accompanying consolidated balance sheets of Electroglas,
Inc. as of December 31, 1998 and 1997, and the related consolidated statements
of operations, stockholders' equity, and cash flows for each of the three years
in the period ended December 31, 1998. Our audits also included the financial
statement schedule listed in the index at Item 14(a). These financial statements
and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Electroglas, Inc. at December 31, 1998 and 1997, and the consolidated results of
its operations and cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.
Also in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.





                                            /s/  Ernst & Young LLP





San Jose, California
January 26, 1999



                                       48

<PAGE>   49

SCHEDULE II -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
                                                          ALLOWANCE FOR
(IN THOUSANDS)                                          DOUBTFUL ACCOUNTS
-------------------------------------------------------------------------
<S>                                                        <C>   
Balance at January 1, 1996                                 $  243
   Charges to operations                                       --
   Deductions (a)                                             (38)
                                                           ------
Balance at December 31, 1996                                  205
   Charges to operations (b)                                  292
   Deductions (a)                                             (32)
                                                           ------
Balance at December 31, 1997                                  465
   Charges to operations                                       --
   Deductions (a)                                             (17)
                                                           ------
Balance at December 31, 1998                               $  448
                                                           ======
</TABLE>



(a)     Includes write-offs and reversals.

(b)     Additions in 1997 related to allowances acquired.




              ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
                     ON ACCOUNTING AND FINANCIAL DISCLOSURE


Not applicable.




                                       49
<PAGE>   50

                                    PART III

                               ------------------

           ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item is included under the heading "Election of
Directors" and "Other Matters" in the Company's Proxy Statement to be filed in
connection with its 1998 Annual Meeting of Stockholders and is incorporated
herein by reference.

                         ITEM 11. EXECUTIVE COMPENSATION

The information required by this item is included under the heading "Executive
Compensation and Other Information" in the Company's Proxy Statement to be filed
in connection with its 1998 Annual Meeting of Stockholders and is incorporated
herein by reference.

       ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS MANAGEMENT

The information required by this item is included under the heading "Security
Ownership of Certain Beneficial Owners and Management" in the Company's Proxy
Statement to be filed in connection with its 1998 Annual Meeting of Stockholders
and is incorporated herein by reference.

             ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is included under the heading "Certain
Relationships and Related Transactions" in the Company's Proxy Statement to be
filed in connection with its 1998 Annual Meeting of Stockholders and is
incorporated herein by reference.


                                     PART IV

                               ------------------

                ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
                             AND REPORTS ON FORM 8-K


(a)     Documents filed as a part of this Report:

        (1)     Index to Financial Statements

                The index to the financial statements included in Part II, Item
8 of this documents are filed as part of this Report.

        (2)     Financial Statement Schedules

                The financial statement schedule included in Part II, Item 8 of
this document is filed as part of this Report. All of the other schedules are
omitted as the required information is inapplicable or the information is
presented in the consolidated financial statements or related notes.





                                       50

<PAGE>   51

        (3)     Exhibits


<TABLE>
<CAPTION>
EXHIBIT
NUMBER  EXHIBITS
--------------------------------------------------------------------------------
<S>     <C>
 3.1    Certificate of Incorporation of Electroglas, Inc., as amended.(1)

 3.2    By-laws of Electroglas, Inc., as amended.

 3.3    Certificate of Designation for Electroglas, Inc.(15)

 4.1    Reference is made to Exhibits 3.1 and 3.2.

 4.2    Specimen Common Stock Certificate of Electroglas, Inc., a Delaware
        corporation.(1)

10.1    Asset Transfer Agreement by and among General Signal Corporation,
        General Signal Technology Corporation and Electroglas, Inc., dated June
        23, 1993, with schedules and exhibits thereto.(2)

10.2    Foreign Units Management Service Agreement by and among General Signal
        Corporation, General Signal Technology Corporation and Electroglas,
        Inc., dated June 23, 1993.(2)

10.3    Registration Rights Agreement by and between General Signal Corporation
        and Electroglas, Inc., dated June 23, 1993.(2)

10.4*   Electroglas, Inc. 1993 Long-Term Incentive Plan.(2)

10.5*   Electroglas, Inc. Amended and Restated 1993 Employee Stock Purchase
        Plan.(3)

10.6    Lease between RREEF USA FUND-III, a California Group Trust, and
        Electroglas, Inc. dated as of December 20, 1993.(4)

10.7*   Change of Control Agreement between Electroglas, Inc. and Neil R. Bonke
        dated as of June 9, 1995.(5)

10.8*   Change of Control Agreement between Electroglas, Inc. and William J.
        Cornwell dated as of June 9, 1995.(5)

10.9*   Change of Control Agreement between Electroglas, Inc. and Armand J.
        Stegall dated as of June 9, 1995.(5)

10.10*  Electroglas, Inc. Restricted Stock Bonus Agreement Between Electroglas,
        Inc. and Curtis S. Wozniak.(6)

10.11*  Change of Control Agreement between Electroglas, Inc. and Curtis S.
        Wozniak dated as of April 4, 1996.(6)

10.12*  Employment and Consulting Agreement Between Electroglas, Inc. and Neil
        R. Bonke.(7)

10.13*  Electroglas Officers' Retirement Medical and Dental Coverage Policy.(8)

10.14*  Severance Agreement between Electroglas, Inc. and William J. Cornwell
        dated as of April 1, 1996.(9)

10.15   Lease Agreement between BNP Leasing Corporation and Electroglas, Inc.
        dated March 31, 1997.(10)

10.16   Agreement and Plan of Reorganization among Knights Technology, Inc.,
        certain shareholders of Knights Technology, Inc., and Electroglas, Inc.
        dated March 12, 1997.(11)

10.17   Rights Agreement between Electroglas, Inc., and BankBoston, N.A., as
        rights agent dated as of November 18, 1997.(12)

10.18*  Electroglas, Inc. 1997 Stock Incentive Plan.(15)
</TABLE>



                                       51
<PAGE>   52


<TABLE>
<CAPTION>
EXHIBIT
NUMBER  EXHIBITS
--------------------------------------------------------------------------------
<S>     <C>
10.19*  Form of Change of Control Agreement between the Company and each of
        Timothy J. Boyle, Phillip M. Truckle, Conor P. O'Mahoney, Joseph A.
        Savarese, Daniel D. Welton, William J. Haydamack and John P. Livingston
        as of June 9, 1995, June 9, 1995, June 9, 1995, June 9, 1995, June 9,
        1995, December 12, 1997 and December 8, 1997.(15)

10.20   Construction Funding Agreement (First Amendment to Lease) Between BNP
        Leasing Corporation and Electroglas, Inc. dated July 1, 1998.(13)

10.21*  Electroglas, Inc. 1998 Employee Stock Purchase Plan.(14)

23.1    Consent of Ernst & Young LLP, Independent Auditors.

27      Financial Data Schedule.
</TABLE>


 (1)    Incorporated by reference to the identically numbered exhibit to the
        Company's Registration Statement on Form S-1 (Commission File No.
        33-61528), which became effective on June 23, 1993.

 (2)    Incorporated by reference to the identically numbered exhibit to the
        Company's Registration Statement on Form S-1 (Commission File No.
        33-74860), which became effective on February 23, 1994.

 (3)    Incorporated by reference to Exhibit 10.5 of the Company's Annual Report
        on Form 10-K, filed with the Securities and Exchange Commission on March
        31, 1995.

 (4)    Incorporated by reference to Exhibit 10.9 of the Company's Annual Report
        on Form 10-K, filed with the Securities and Exchange Commission on March
        31, 1994.

 (5)    Incorporated by reference to the identically numbered exhibit of the
        Company's Annual Report on Form 10-K, filed with the Securities and
        Exchange Commission on March 31, 1996.

 (6)    Incorporated by reference to the identically numbered exhibit of the
        Company's Quarterly Report on Form 10-Q, for the quarter ended June 30,
        1996.

 (7)    Incorporated by reference to Exhibit 10.11 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended September 31, 1996.

 (8)    Incorporated by reference to Exhibit 10.12 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended September 31, 1996.

 (9)    Incorporated by reference to the identically numbered exhibit of the
        Company's Annual Report on Form 10-K, filed with the Securities and
        Exchange Commission on March 26, 1997.

(10)    Incorporated by reference to Exhibit 10.1 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended March 31, 1997.

(11)    Incorporated by reference to Exhibit 10.2 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended March 31, 1997.

(12)    Incorporated by reference to Exhibit 1 of the Company's Registration
        Statement on Form 8-A12G (Commission File No. 0-21626), filed with the
        Securities and Exchange Commission on November 19, 1997.

(13)    Incorporated by reference to Exhibit 10.1 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended June 30, 1998.

(14)    Incorporated by reference to Exhibit 10.2 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended June 30, 1998.

(15)    Incorporated by reference to the identically numbered exhibit of the
        Company's Annual Report on Form 10-K, filed with the Securities and
        Exchange Commission on March 30, 1998.


*       Management contracts, or Company compensatory plans or arrangements.

(b)     Reports on Form 8-K: 

                No reports on Form 8-K were filed during the fourth quarter 
ended December 31, 1998.


                                       52
<PAGE>   53

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.



                                       ELECTROGLAS, INC.

Date:  March 12, 1999

                                       By /s/ CURTIS S. WOZNIAK
                                          --------------------------------------
                                          Curtis S. Wozniak
                                          Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.


<TABLE>
<CAPTION>
            SIGNATURE               TITLE                                    DATE
            ---------               -----                                    ----

<S>                                 <C>                                 <C> 
    /s/ CURTIS S. WOZNIAK           Chairman and Chief Executive        March 12, 1999
--------------------------------    Officer (Principal Executive
        Curtis S. Wozniak           Officer)


    /s/ ARMAND J. STEGALL           Vice President, Finance             March 12, 1999
--------------------------------    Chief Financial Officer,
        Armand J. Stegall           Treasurer and Secretary
                                    (Principal Financial and
                                    Accounting Officer)


      /s/ NEIL R. BONKE             Director                            March 12, 1999
--------------------------------
          Neil R. Bonke


     /s/  JOSEPH F. DOX             Director                            March 12, 1999
--------------------------------
          Joseph F. Dox


    /s/ ROGER D. EMERICK            Director                            March 12, 1999
--------------------------------
        Roger D. Emerick


  /s/ ROBERT J. FRANKENBERG         Director                            March 12, 1999
--------------------------------
      Robert J. Frankenberg
</TABLE>


                                       53

<PAGE>   54


                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER  EXHIBITS
--------------------------------------------------------------------------------
<S>     <C>
 3.1    Certificate of Incorporation of Electroglas, Inc., as amended.(1)

 3.2    By-laws of Electroglas, Inc., as amended.

 3.3    Certificate of Designation for Electroglas, Inc.(15)

 4.1    Reference is made to Exhibits 3.1 and 3.2.

 4.2    Specimen Common Stock Certificate of Electroglas, Inc., a Delaware
        corporation.(1)

10.1    Asset Transfer Agreement by and among General Signal Corporation,
        General Signal Technology Corporation and Electroglas, Inc., dated June
        23, 1993, with schedules and exhibits thereto.(2)

10.2    Foreign Units Management Service Agreement by and among General Signal
        Corporation, General Signal Technology Corporation and Electroglas,
        Inc., dated June 23, 1993.(2)

10.3    Registration Rights Agreement by and between General Signal Corporation
        and Electroglas, Inc., dated June 23, 1993.(2)

10.4*   Electroglas, Inc. 1993 Long-Term Incentive Plan.(2)

10.5*   Electroglas, Inc. Amended and Restated 1993 Employee Stock Purchase
        Plan.(3)

10.6    Lease between RREEF USA FUND-III, a California Group Trust, and
        Electroglas, Inc. dated as of December 20, 1993.(4)

10.7*   Change of Control Agreement between Electroglas, Inc. and Neil R. Bonke
        dated as of June 9, 1995.(5)

10.8*   Change of Control Agreement between Electroglas, Inc. and William J.
        Cornwell dated as of June 9, 1995.(5)

10.9*   Change of Control Agreement between Electroglas, Inc. and Armand J.
        Stegall dated as of June 9, 1995.(5)

10.10*  Electroglas, Inc. Restricted Stock Bonus Agreement Between Electroglas,
        Inc. and Curtis S. Wozniak.(6)

10.11*  Change of Control Agreement between Electroglas, Inc. and Curtis S.
        Wozniak dated as of April 4, 1996.(6)

10.12*  Employment and Consulting Agreement Between Electroglas, Inc. and Neil
        R. Bonke.(7)

10.13*  Electroglas Officers' Retirement Medical and Dental Coverage Policy.(8)

10.14*  Severance Agreement between Electroglas, Inc. and William J. Cornwell
        dated as of April 1, 1996.(9)

10.15   Lease Agreement between BNP Leasing Corporation and Electroglas, Inc.
        dated March 31, 1997.(10)

10.16   Agreement and Plan of Reorganization among Knights Technology, Inc.,
        certain shareholders of Knights Technology, Inc., and Electroglas, Inc.
        dated March 12, 1997.(11)

10.17   Rights Agreement between Electroglas, Inc., and BankBoston, N.A., as
        rights agent dated as of November 18, 1997.(12)

10.18*  Electroglas, Inc. 1997 Stock Incentive Plan.(15)
</TABLE>



                                       
<PAGE>   55


<TABLE>
<CAPTION>
EXHIBIT
NUMBER  EXHIBITS
--------------------------------------------------------------------------------
<S>     <C>
10.19*  Form of Change of Control Agreement between the Company and each of
        Timothy J. Boyle, Phillip M. Truckle, Conor P. O'Mahoney, Joseph A.
        Savarese, Daniel D. Welton, William J. Haydamack and John P. Livingston
        as of June 9, 1995, June 9, 1995, June 9, 1995, June 9, 1995, June 9,
        1995, December 12, 1997 and December 8, 1997.(15)

10.20   Construction Funding Agreement (First Amendment to Lease) Between BNP
        Leasing Corporation and Electroglas, Inc. dated July 1, 1998.(13)

10.21*  Electroglas, Inc. 1998 Employee Stock Purchase Plan.(14)

23.1    Consent of Ernst & Young LLP, Independent Auditors.

27      Financial Data Schedule.
</TABLE>


 (1)    Incorporated by reference to the identically numbered exhibit to the
        Company's Registration Statement on Form S-1 (Commission File No.
        33-61528), which became effective on June 23, 1993.

 (2)    Incorporated by reference to the identically numbered exhibit to the
        Company's Registration Statement on Form S-1 (Commission File No.
        33-74860), which became effective on February 23, 1994.

 (3)    Incorporated by reference to Exhibit 10.5 of the Company's Annual Report
        on Form 10-K, filed with the Securities and Exchange Commission on March
        31, 1995.

 (4)    Incorporated by reference to Exhibit 10.9 of the Company's Annual Report
        on Form 10-K, filed with the Securities and Exchange Commission on March
        31, 1994.

 (5)    Incorporated by reference to the identically numbered exhibit of the
        Company's Annual Report on Form 10-K, filed with the Securities and
        Exchange Commission on March 31, 1996.

 (6)    Incorporated by reference to the identically numbered exhibit of the
        Company's Quarterly Report on Form 10-Q, for the quarter ended June 30,
        1996.

 (7)    Incorporated by reference to Exhibit 10.11 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended September 31, 1996.

 (8)    Incorporated by reference to Exhibit 10.12 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended September 31, 1996.

 (9)    Incorporated by reference to the identically numbered exhibit of the
        Company's Annual Report on Form 10-K, filed with the Securities and
        Exchange Commission on March 26, 1997.

(10)    Incorporated by reference to Exhibit 10.1 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended March 31, 1997.

(11)    Incorporated by reference to Exhibit 10.2 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended March 31, 1997.

(12)    Incorporated by reference to Exhibit 1 of the Company's Registration
        Statement on Form 8-A12G (Commission File No. 0-21626), filed with the
        Securities and Exchange Commission on November 19, 1997.

(13)    Incorporated by reference to Exhibit 10.1 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended June 30, 1998.

(14)    Incorporated by reference to Exhibit 10.2 of the Company's Quarterly
        Report on Form 10-Q, for the quarter ended June 30, 1998.

(15)    Incorporated by reference to the identically numbered exhibit of the
        Company's Annual Report on Form 10-K, filed with the Securities and
        Exchange Commission on March 30, 1998.


*       Management contracts, or Company compensatory plans or arrangements.