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                           FORM 10-K

               SECURITIES AND EXCHANGE COMMISSION
                      WASHINGTON, DC  20549

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

          For the fiscal year ended September 30, 1998

                               OR

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

                   Commission File No. 0-12194

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

              CALIFORNIA                          94-2566313
    (State or other jurisdiction of             (IRS Employer
     incorporation or organization)          Identification No.)

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

                         (510) 440-9600
      (Registrant's telephone number, 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, no par value
                        (Title of Class)

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

The aggregate market value of the Registrant's Common Stock held by 
nonaffiliates on November 30, 1998 (based upon the closing sale price of 
stock on such date) was $76,981,765.  As of November 30, 1998, 21,907,553 
shares of the Registrant's Common Stock were outstanding.

              Documents Incorporated by Reference:

Portions of the Company's 1998 Notice of Annual Meeting of Shareholders and
Proxy Statement are incorporated by reference into Part III hereof.


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

                             PART I

Item 1:  BUSINESS

Zitel Corporation ("Zitel" or the "Company") is an information technology 
company specializing in systems optimization, correlation and search 
technology. Zitel employs these core competencies in two business units: a 
software products and services business unit marketing multi-platform 
performance analysis and correlation software used to optimize performance in 
mission critical systems, databases and applications, and a solution services 
business unit that markets Year 2000 services and consulting, which includes 
project management, planning, analysis, code conversion and testing using the 
MatriDigm Corporation technology tools.

The Company was organized in 1979 to develop, market and sell semiconductor 
memory systems.  It subsequently developed memory algorithms which it 
incorporated in high performance data storage systems developed, marketed and 
sold by its data storage business unit.  With the acquisition, in June 1997, 
of the business of Datametrics Systems Corporation, the Company commenced the 
transition to an information technology company.  This transition was 
completed in July 1998, when the Company sold its data storage business unit.

                             General

Zitel develops, markets and supports a wide range of data management 
solutions in the form of multi-platform performance analysis and correlation 
software used to optimize performance in mission critical systems, databases 
and applications and it provides Year 2000 conversion services through 
product and professional services offerings.  The Company does so through its 
two business units:

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The software products business unit is the combination of Datametrics Systems 
Corporation and Palmer & Webb Systems companies, which were acquired in 1997 
and combined with Zitel's Performance and Modeling, Inc. subsidiary.  The 
business unit operates under the Datametrics Systems name.  The business unit 
includes a business that markets a suite of ViewPoint software utilized for 
data management that automatically alerts, analyzes, correlates, investigates 
and reports on data center performance for mainframe computers, open systems 
and distributed network systems.  In addition, the business unit includes a 
professional services business to solve customers' IT professional needs and 
a training business to assist customers with their software training needs.  
Products are sold through a direct sales force in the United States and 
Europe, and through VARs, distributors and OEMs worldwide.  The business unit 
provides both direct and indirect customer maintenance and support for its 
software products.

The solution services business unit provides services to convert customers' 
legacy software code that could not properly recognize or utilize dates in 
and after the year 2000 into code that is able to recognize and utilize dates 
into the next century.  The business unit also provides a service to verify 
that code that has been converted is ready to be placed back into service.  
The business unit operates under the name Zitel Solution Services ("ZSS").  
Year 2000 conversion services include analysis and code conversion.  Zitel's 
primary code conversion methodology is based on the MatriDigm MAP2000 
("MatriDigm Advance Process") process for IBM COBOL and its primary audit 
tool is the MARC2000 ("MatriDigm Analysis of Remediated Code") audit process 
for IBM COBOL. MARC2000, introduced June 1998, provides an independent audit 
to confirm the accuracy and completeness of COBOL Year 2000 code conversions. 
It provides extensive reports identifying faulty and potentially faulty code 
and helps the customer to record the activities needed to demonstrate due 
diligence in auditing COBOL Year 2000 renovation projects.  The business unit 
acts as a "Technology Associate" to MatriDigm, representing their factory 
service for code remediation and their Independent Validation and 
Verification product for remediated IBM COBOL code. In addition, as a 
solution provider, Zitel utilizes other tools and processes to meet customer 
needs in different environments.  Zitel serves its Year 2000 customers both 
directly, with its own consulting staff, and through a teaming program where 
Zitel may be a subcontractor or partner to other solution providers worldwide.

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An investment in the Company involves a high degree of risk.  Please refer to 
information included under the caption "Risk Factors", below.

                      Products and Services

Software Products

The Company, on June 30, 1997, concluded the acquisition of three companies 
primarily engaged in development and marketing of software products: 
Datametrics Systems Corporation, headquartered in Fairfax, Virginia; Palmer & 
Webb Systems, Limited, headquartered in the United Kingdom; and Palmer & Webb 
Systems, B.V., headquartered in The Netherlands.  These entities, combined 
with the Company's subsidiary, Performance & Modeling, Inc., form the 
business unit operating as Datametrics Systems.  The Company's software 
products business unit is a provider of automated performance analysis and 
correlation software to solve computer performance problems of mainframe 
computers, open systems servers and distributed network systems.  Corporate 
customers with significant investments in management information systems 
utilize these products to maximize efficiency of existing systems and plan 
system enhancements.  The ViewPoint product suite automatically monitors, 
alerts, analyzes, and reports performance problems before they happen - to 
improve service levels, minimize risk, and plan for the future.

The flagship product of the business unit is ViewPoint, which is a real-time 
data collector of approximately 2,000 different system attributes.  It 
operates on select computer mainframes and all major open systems platforms.  
While the data is collected on the computer system, ViewPoint allows the user 
to replay the real-time data on any Windows-based PC.  Included in ViewPoint 
are extensive comparative and auto-analysis capabilities and an 
auto-correlation engine.

Year 2000 Services

The Company's solution services business unit was launched during fiscal 1997 
and provides Year 2000 conversion services, including analysis and code 
conversion.  The primary code conversion methodology of this business unit is 
based on MatriDigm's MAP2000 process and its primary audit tool is based on 
MatriDigm's MARC2000 audit process.  The Company has an exclusive right to 
create temporary, portable conversion centers utilizing the MAP2000 process 
at customer sites for customers with security or other requirements which 
prohibit delivery of code to offsite 

                              Page 4

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conversion facilities.  Commercial availability of MatriDigm's MAP2000 
windowing process was announced in May and June, 1997.  The demand for Year 
2000 conversion services has emerged more slowly than originally anticipated 
by industry sources and the Company has not as yet realized significant 
revenues from the provision of such services.

                            Marketing

The Company's software products are sold through a direct sales force in the 
United States, the United Kingdom and The Netherlands, and through VARs, 
distributors and OEMs worldwide.  The Company provides direct customer 
maintenance and support for its software products.

The Company markets its Year 2000 conversion services through a direct sales 
force and through teaming agreements with professional services and 
consulting firms in the United States and internationally.

                           Competition

The market for system management tools in which the Company's software 
products business unit competes is intensely competitive.  Many of the 
companies with which the Company competes such as TeamQuest Corporation, 
Computer Associates International, Inc., Hewlett-Packard Company, and BMC 
Software, Inc. have substantially larger installed bases and greater 
financial resources than the Company.  The Company believes that the 
important considerations for software customers are ease of use, product 
reliability, quality and price.  The Company believes that it competes 
favorably in each of these areas.

The market for Year 2000 conversion services is highly competitive, with 
services being provided by a number of international, national, regional and 
local firms, many of which have existing relationships and contractual 
arrangements with customers.  Many of these competitors have substantially 
greater financial, technical and marketing resources than the Company.  The 
Company competes by integrating tools and professional services into a 
complete solution for Year 2000 conversion needs.

                      Proprietary Technology

The Company currently relies on a combination of patent, copyright and 
trademark laws, trade secrets, confidentiality agreements and contractual 
provisions to protect its proprietary 

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rights.  The Company seeks to protect its software, documentation and other 
written materials under trade secret and copyright laws, which afford only 
limited protection.  The Company has registered its Zitel and Datametrics 
trademarks and will continue to evaluate the registration of additional 
trademarks as appropriate.  The Company generally enters into confidentiality 
agreements with its employees and with key vendors and suppliers.  The 
Company currently has one United States patent.  The Company believes that 
the rapidly changing technology in the computer industry makes the Company's 
success depend more on the technical competence and creative skills of its 
personnel than on patents.

The Company's solution services business unit relies primarily on proprietary 
technology developed by MatriDigm and licensed to the Company and the 
prospects for the business unit are dependent on the ability of MatriDigm to 
maintain and expand a toolset which provides a relative advantage over 
competing Year 2000 conversion service providers.

                            Employees

At the end of fiscal 1998, the Company employed 122 persons on a full-time 
basis: 18 in research and development, 20 in professional services, 7 in 
operations, 45 in sales and marketing, and 32 in general management and 
administration.

The Company believes that its further success will depend, in part, on its 
ability to attract and retain qualified employees, who are in great demand. 
None of the Company's employees are represented by a labor union and the 
Company believes that its employee relations are good.

               Investment in MatriDigm Corporation

Zitel has invested $7,414,000 through September 30, 1998, and owned 
approximately 31% of MatriDigm Corporation, a private company formed to 
provide COBOL software maintenance and re-engineering services for users of 
IBM mainframe computer systems.  In addition, the Company had notes totalling 
$2.0 million and a bank guarantee in the amount of $1.0 million.  The 
Company's percentage ownership has changed and will continue to change as 
MatriDigm raises additional capital and as options under MatriDigm's stock 
option plan vest and are exercised.  At September 30, 1998, the Company wrote 
off its investment in MatriDigm and fully reserved the notes and bank 
guarantee.  On October 5, 1998, the Company signed a definitive agreement to 
acquire the remaining 68.7% of MatriDigm Corporation 

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("MatriDigm") not currently owned in a tax-free exchange of stock, which 
would be accounted for as a purchase combination.  The MatriDigm shareholders 
would receive approximately 0.65 share, of a newly created company, for each 
MatriDigm share they currently own.  The merger is subject to the approval of 
the shareholders of the Company and MatriDigm and regulatory approval.  Under 
the definitive agreement, the Company committed to fund the working capital 
needs of MatriDigm from October 5, 1998 through the date of the closing of 
the merger, which was expected to be in early calendar year 1999.  On 
December 21, 1998, the Company and MatriDigm terminated the definitive 
agreement to acquire the remaining portion of MatriDigm not already owned.  
The Company and MatriDigm have restructured the transaction to provide for 
the exchange of the fully reserved MatriDigm notes held by the Company at 
September 30, 1998 of $2.0 million and $1.2 million notes receivable 
subsequent to year end plus accrued interest into equity in MatriDigm.  Upon 
completion of the exchange, the Company's ownership will increase to 
approximately 58% on a fully converted basis.  (See "Investment in 
Unconsolidated Company" for additional information about MatriDigm.)

MatriDigm has devoted substantially all of its engineering resources to the 
development of technology to automate the conversion of legacy software code. 
In May 1997, MatriDigm announced the commercial availability of its MAP2000 
COBOL renovation process for programs written in ANSI COBOL 85.  MatriDigm 
has subsequently extended the capability of MAP2000 to cover COBOL ANSI 68 
and 74, with support for CICS and IMS/DC transactions and VSAM, IMS/DB SQL 
and DB2 databases and file systems.  MatriDigm's MARC2000, introduced June 
1998, provides an independent audit to confirm the accuracy and completeness 
of COBOL Year 2000 code conversions.  It provides extensive reports 
identifying faulty and potentially faulty code and helps the customer to 
record the activities needed to demonstrate due diligence in auditing COBOL 
Year 2000 renovation projects.  MatriDigm intends to continue to refine its 
current toolset and to extend its toolset.

Substantially all software programs written assume that the first two digits 
of any date are "19" and cannot recognize or utilize dates commencing with 
the year 2000.  Estimates of the cost and available market for conversion of 
existing code to eliminate this problem are in the multi-billions of dollars; 
however, the demand for conversion services has emerged more slowly than 
anticipated.  A large number of companies, many of which have substantially 
greater resources than MatriDigm, are offering 

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conversion services or are developing systems to provide such services, and 
competition is expected to be intense among the providers of such services.

                          Risk Factors

Recent Levels of Net Sales Have Been Insufficient

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

Significant Losses

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

While the Company has taken a number of steps to attempt to return to 
profitability, there is no assurance that it will be successful.  A 
significant portion of the recent losses were caused by the operations of the 
Company's former storage systems business unit, in July 1998, the Company 
sold that business unit.  The Company is in the process of attempting to 
sublease its Fremont, California headquarters and move to substantially 
smaller and less costly premises.  There is no assurance that the Company 
will not incur significant costs in addition to $750,000 reserved for excess 
facility capacity in the third quarter of fiscal year 1998.

The Company is taking other actions to reduce its costs in an effort to bring 
costs into line with anticipated revenues.  There can be no assurance that 
the Company will be successful in this effort and remain a viable operating 
entity.

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Nasdaq Listing Criteria

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

Change of Nature of Business

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

Fluctuations in Quarterly Results

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

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

  .Market acceptance of new products and product enhancements;

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

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<PAGE>

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

  .Changes in pricing by Zitel or its competitors;

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

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

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

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

  .Levels of expenditures on research and development;

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

  .General economic trends and other factors.

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

Investment in MatriDigm Corporation

At September 30, 1998, the Company had invested approximately $7,400,000 to 
acquire approximately 31% interest in MatriDigm Corporation, a private 
company organized to provide COBOL software maintenance and re-engineering 
services for users of IBM mainframe computer systems.  In addition, the 
Company has demand notes in the amount of $2,000,000 and has guaranteed a 
bank guarantee of $1,000,000.  At September 30, 1998, the Company has written 
off its investment and fully reserved the demand notes and the bank 
guarantee.  The initial focus of MatriDigm has been development of technology 
to automate the conversion of legacy software code which could not recognize 
or utilize dates after the year 1999 (the "Year 2000 Problem") into code 
which is able to recognize and utilize dates into the next century.  
MatriDigm has devoted substantially all of its engineering resources to 
development of such technology.  In May 1997, MatriDigm announced the 
commercial availability of its MAP2000 windowing process for programs written 
in ANSI COBOL 85.  MatriDigm has subsequently extended the capability of 
MAP2000 to cover COBOL ANSI 68 and 74, 

                              Page 10
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with support for CICS and IMS/DC transactions and VSAM, IMS/DB SQL and DB2 
databases and file systems.  MatriDigm's MARC2000, introduced June 1998, 
provides an independent audit to confirm the accuracy and completeness of 
COBOL Year 2000 code conversions.  It provides extensive reports identifying 
faulty and potentially faulty code and helps the customer to record the 
activities needed to demonstrate due diligence in auditing COBOL Year 2000 
renovation projects.  MatriDigm intends to continue to refine its current 
toolset and to extend its toolset.

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

A large number of companies, many of which have substantially greater 
resources than MatriDigm, are offering conversion services or are developing 
systems to provide such services, and competition is intense among the 
providers of such services.  However, the demand for Year 2000 conversion 
services has emerged at a slower pace than originally anticipated and there 
is no assurance that it can successfully market its automated toolset, 
develop extensions for other computer languages or generate substantial 
revenue and profits.  During the course of development, the Company has made 
additional investments in MatriDigm and continues to make additional 
investments.  To the extent other investors are unable or unwilling to 
continue to make investments in MatriDigm, the Company may be required to 
make a disproportionate share of such investments.  These investments could 
have a material adverse effect on the Company's business results of 
operations and financial condition.

Zitel Stock Price Has Been Volatile

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

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Competition

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

The market for Year 2000 conversion services is highly competitive, with 
services being provided by a number of international, national, regional and 
local firms, many of which have existing relationships and contractual 
arrangements with customers.  Many of these competitors have substantially 
greater financial, technical and marketing resources than the Company.  The 
ability of the Company to compete in the IBM COBOL segment of this market 
will depend primarily on the ability of MatriDigm to achieve market 
acceptance of its automated solution and as yet there can be no assurance 
that MatriDigm will be successful in this effort.  In addition, the Company 
must achieve general credibility as a provider of Year 2000 conversion 
services by generating substantial net sales.

Dependence on New Products; Rapid Technological Change

The markets in which the Company operates are characterized by rapid 
technological change, changing customer needs, frequent new product 
introductions and evolving industry standards.  The introduction of products 
embodying new technologies and/or the emergence of new industry standards 
could render the Company's existing products and services obsolete and 
unmarketable. The Company's future success will depend upon its ability to 
develop and to introduce new products and services on a timely basis that 
keep pace with technological developments and emerging industry standards and 
address the increasingly sophisticated needs of its customers.  There can be 
no assurance that the Company will be successful in developing and marketing 
products or services that respond to technological changes or evolving 
industry standards, that the Company will not experience difficulties that 
could delay or prevent the successful development, introduction and marketing 
of new products or services, or that its new products 

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or services will adequately meet the requirements of the marketplace and 
achieve market acceptance.  If the Company is unable, for technological or 
other reasons, to develop and introduce new products or services in a timely 
manner in response to changing market conditions or customer requirements, 
the Company's business, operating results and financial condition will be 
materially and adversely affected.

Product Liability

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

The market for Year 2000 conversion services is in the early stages of 
development and service warranty standards have not as yet been defined.  The 
extent to which the solution services business unit must provide warranty 
protection to its customers in order to be competitive remains uncertain.  To 
the extent that future warranty obligations shift risks to the Company that 
are in excess of the warranty protection provided to the Company by MatriDigm 
and other toolset providers, a successful claim against the Company could 
have a material adverse effect on the Company's business, operating results 
and financial condition.

Dependence on Proprietary Technology

The Company's success depends significantly upon its proprietary technology. 
The Company currently relies on a combination of patent, copyright and 
trademark laws, trade secrets, confidentiality agreements and contractual 
provisions to protect its proprietary rights.  The Company seeks to protect 
its software, documentation and other written materials under trade secret 
and copyright laws, which afford only limited protection.  The Company has 
registered its Zitel and Datametrics trademarks and will continue to evaluate 
the registration of additional trademarks as appropriate.  The Company 
generally enters into confidentiality agreements with its employees and with 
key vendors and suppliers.  The Company currently holds a United 

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States patent on one of its software technologies.  There can be no assurance 
that this patent will provide the Company with any competitive advantages or 
will not be challenged by third parties, or that the patents of others will 
not have a material adverse effect on the Company's ability to do business.  
The Company believes that the rapidly changing technology in the computer 
industry makes the Company's success depend more on the technical competence 
and creative skills of its personnel than on patents.

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

The Company expects that companies in its markets will increasingly be 
subject to infringement claims as the number of products and competitors in 
the Company's target markets grows.  Any such claims or litigation may be 
time-consuming and costly, cause product shipment delays, require the Company 
to redesign its products or require the Company to enter into royalty or 
licensing agreements, any of which could have a material adverse effect on 
the Company's business, operating results or financial condition.  Despite 
the Company's efforts to protect its proprietary rights, unauthorized parties 
may attempt to copy aspects of the Company's products or to obtain and use 
information that the Company regards as proprietary.  There can be no 
assurance that the Company's means of protecting its proprietary rights will 
be adequate or that the Company's competitors will not independently develop 
similar technology, duplicate the Company's products or design around patents 
issued to the Company or other intellectual property rights of the Company.

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

                              Page 14
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International Sales and Operations

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

Dependence on Key Personnel

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

The future success of the Company's solution services business unit in 
particular will depend to a significant extent on its ability to attract, 
train, motivate and retain highly skilled software development professionals, 
particularly project 

                              Page 15
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managers, software engineers and other senior technical personnel.  The 
Company believes that in the United States and elsewhere there is a shortage 
of, and significant competition for, software development professionals with 
the advanced technological skills necessary to perform the services offered 
by the solution services business unit.  The increasing recognition of the 
scope and significance of the Year 2000 problem has materially increased the 
competition for personnel with appropriate skills and salary requirements 
have increased as availability of such personnel has declined precipitously.  
The Company's ability to maintain and renew existing relationships and obtain 
new business depends, in large part, on its ability to hire and retain 
technical personnel. An inability to hire such additional qualified personnel 
could impair the ability of the solution services business unit to manage and 
complete its existing projects and to bid for or obtain new projects.

Anti-Takeover Provisions

Certain provisions of the Company's Certificate of Incorporation, as amended 
and restated, and Bylaws, as amended, California law and the Company's 
indemnification agreements with certain officers and directors of the Company 
may be deemed to have an anti-takeover effect.  Such provisions may delay, 
defer or prevent a tender offer or takeover attempt that a stockholder might 
consider to be in that stockholder's best interests, including attempts that 
might result in a premium over the market price for the shares held by 
stockholders.

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

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

                              Page 16
<PAGE>

per Right.  Each one one-hundredth of a share of Preferred Stock has 
designations and the powers, preferences and rights, and the qualifications, 
limitations and restrictions which make its value approximately equal to the 
value of a Common Share.

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

The Rights have certain anti-takeover effects, as they would cause 
substantial dilution to a person or group that attempted to acquire the 
Company on terms not approved by the Company's Board of Directors.  The 
Rights should not interfere with any merger or other business combination 
approved by the Board of Directors, since the Rights may be redeemed by the 
Company at $.01 per Right prior to the earliest of (i) the twentieth day 
following the time that a person or group has acquired beneficial ownership 
of 15% or more of the Common Shares (unless extended for one or more 10 day 
periods by the Board of Directors), (ii) a change of control, or (iii) the 
final expiration date of the rights.

Item 2:  PROPERTIES

Zitel leases its operating facilities in Fremont, CA, Fairfax, VA, 
Leatherhead, United Kingdom, and Rotterdam, The Netherlands, under 
non-cancelable operating leases which expire at various dates through the 
year 2005.  Average annual rent is approximately $1.7 million per year.

Item 3:  LEGAL PROCEEDINGS

         None.

Item 4:  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company did not submit any matters to a vote of security holders during 
the fourth quarter of the fiscal year ended September 30, 1998.

                              Page 17
<PAGE>

Executive Officers of the Registrant

Set forth below is information regarding executive officers of the Company who
are not directors.

<TABLE>
<CAPTION>
Name               Age  Position
----               ---  --------
<S>                <C>  <C>
Henry C. Harris     50  Senior Vice President, Strategic Planning
                          & Alliances
Anna M. McCann      40  Vice President, Chief Accounting Officer,
                          Assistant Secretary
Larry B. Schlenoff  52  Vice President, Finance & Administration,
                           Chief Financial Officer, Secretary
</TABLE>


Henry C. Harris, Senior Vice President of Strategic Planning & Alliances

Henry Harris, CPA, has served as vice president of finance and 
administration, chief financial officer and chief accounting officer from 
December 1986 through July 1997 and as secretary of the Company from November 
1987 through October 1997.  He currently holds the position of senior vice 
president of strategic planning and alliances.  Prior to joining Zitel, he 
was employed by Dynamic Disk, Inc. as vice president of finance and 
administration and chief financial officer from October 1983 until November 
1986.  Prior to Dynamic Disk, he spent over 10 years in financial management 
and public accounting positions.

Anna M. McCann, Vice President, Chief Accounting Officer, Assistant Secretary

Anna McCann joined Zitel in August 1982.  She was promoted to Corporate 
Controller in February 1987.  She was appointed Assistant Secretary of the 
Company in April 1993.  She was promoted to Vice President, Chief Accounting 
Officer in October 1997.

Larry B. Schlenoff, Vice President of Finance and Administration, Chief
Financial Officer, Corporate Secretary

Larry Schlenoff joined Zitel in July 1997 as vice president of finance and 
administration and chief financial officer.  In October 1997, he assumed the 
role of corporate secretary.  Prior to joining Zitel, he held several 
executive positions at IBM including director of finance for the IBM Systems 
Technology Division, director of financial planning at IBM corporate and 
director of business evaluation for the IBM Printing Systems Company.  Mr. 
Schlenoff's career at IBM spanned 27 years.

                              Page 18
<PAGE>

















Zitel is a registered trademark of Zitel Corporation.  Datametrics and 
ViewPoint are registered trademarks of Datametrics Systems Corporation.  
MatriDigm is a registered trademark and service mark of MatriDigm, Inc.  All 
other service marks, trademarks and registered trademarks are the property of 
their respective holders.

                              Page 19
<PAGE>

                             PART II

Item 5:  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
         STOCKHOLDER MATTERS

Zitel Corporation's common stock is traded in the over-the-counter market and 
is listed on the Nasdaq National Market System under the symbol ZITL.

The following table shows the quarterly high and low closing prices in the 
Nasdaq National Market System:

<TABLE>
<CAPTION>
          FISCAL              1998                  1997
                       -------------------   -------------------
                         High        Low       High        Low
                       --------   --------   --------   --------
<S>                    <C>        <C>        <C>        <C>
     First Quarter      23 5/8     9 3/8     61 1/4     10 7/8
     Second Quarter     16 3/4     9 1/2     50 1/8     27 7/8
     Third Quarter      14 3/8     4 1/32    33 1/8     11 1/2
     Fourth Quarter      8 1/8     2 7/32    25 9/16    19 1/16
</TABLE>


As of September 30, 1998, the Registrant had approximately 566 shareholders 
of record of its Common Stock.

The Company has paid no cash dividends on its common stock and does not plan 
to pay cash dividends to its shareholders in the foreseeable future.

Item 6:  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
Five-Year Financial Summary 
(In thousands except per share data)

                                          1998     1997     1996     1995    1994
<S>                                     <C>      <C>      <C>      <C>     <C>
Total revenue                           $21,700  $17,966  $23,066  $23,714 $17,452
Net income (loss)                       (43,205) (17,501)   4,049    8,526  (6,961)

Basic net income (loss) per share         (2.48)   (1.15)     .27      .60    (.55)
Diluted net income (loss) per share       (2.48)   (1.15)     .26      .56    (.55)
Shares used in basic 
 per share calculation                   17,433   15,222   14,726   14,157  12,654
Shares used in 
 diluted per share calculation           17,433   15,222   15,626   15,166  12,654

At year end:
Working capital                           3,874   18,763   20,445   19,969   7,202
Total assets                             18,070   49,294   30,699   26,206  13,678
Total long-term liabilities               4,585   24,161        -        -      13
Shareholders' equity                      6,234   15,946   27,089   22,957  10,004
</TABLE>


                              Page 20


<PAGE>

Item 7:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITION AND RESULTS OF OPERATIONS

In addition to historical information, this Annual Report contains 
forward-looking statements that involve risks and uncertainties.  Future 
trends in revenues and operating income will be dependent on both external 
factors and on the success of the various efforts described in this report.  
Risks and uncertainties include, but are not limited to, product and services 
demand, market acceptance, the effect of economic conditions, the impact of 
competitive products and pricing, product development, capacity and supply 
constraints or difficulties, and other risks detailed under the caption 
"Business - Risk Factors" and in other reports filed by the Company with the 
Securities and Exchange Commission.

General

Zitel Corporation ("Zitel" or the "Company") is an information technology 
company specializing in systems optimization, correlation and search 
technology. Zitel employs these core competencies in two business units: a 
software products and services business unit marketing multi-platform 
performance analysis and correlation software used to optimize performance in 
mission critical systems, databases and applications, and a solution services 
business unit that markets Year 2000 services and consulting, which includes 
analysis and code conversion using the MatriDigm Corporation technology tools.

The Company was organized in 1979 to develop, market and sell semiconductor 
memory systems.  It subsequently developed memory algorithms which it 
incorporated in high performance data storage systems developed, marketed and 
sold by its data storage business unit.  With the acquisition, in June 1997, 
of the business of Datametrics Systems Corporation the Company commenced the 
transition to an information technology company.  This transition was 
completed in July 1998, when the Company sold its data storage business unit.

Results of Operations

Fiscal 1998 Compared With Fiscal 1997

Total revenue for fiscal year 1998 was $21,700,000 compared with total 
revenue of $17,966,000 in fiscal year 1997, an increase of $3,734,000 or 21%. 
The increase in revenue is directly attributable to an increase in net 
sales, partially offset by a 

                              Page 21
<PAGE>

decrease in royalty revenue.  Net sales for the current year were $20,159,000 
versus $12,626,000 in the prior year, an increase of $7,533,000 or 60%.  The 
increase in net sales is directly attributable to the net sales generated by 
the Company's software business unit, which was only included in the last 
quarter of the prior fiscal year.  In July 1998, the Company sold it storage 
business unit which generated revenue in fiscal 1998 of $5,698,000 compared 
with $10,304,000 in fiscal 1997.  Royalty revenue for the current year was 
$1,541,000 versus $5,340,000 in the prior year.  During April 1998, the 
Company negotiated and received the final payment for all royalty obligations 
from International Business Machines Corporation ("IBM").  Net sales of 
approximately $660,000 were generated by the Company's Year 2000 business 
unit compared to none in the previous fiscal year.

Gross margin, as a percent of net sales, was 40% for the year ended September 
30, 1998 compared to 26% in the prior year.  The increase in gross margin 
percentage during the current year is primarily attributable to the increase 
in sales generated by the software business unit which generated a gross 
margin of 61% in the current year.

Research and development expenses for the year ended September 30, 1998 were 
32% of net sales compared with 59% in the prior year.  Actual dollars 
decreased $1,085,000.  With the sale of the Company's storage business unit 
and the shift in emphasis to software products and services, it is 
anticipated that research and development spending will continue to decrease 
as a percentage of net sales.

Selling, general and administrative ("SG&A") expenses were $24,012,000 or 
119% of net sales in the current year versus $14,468,000 or 115% of net sales 
in the prior year.  Actual spending increased $9,544,000.  The increase in 
spending is primarily attributable to the added SG&A expenses of the acquired 
software companies of approximately $7,250,000, an increase in SG&A spending 
of the solution services business unit of $861,000, an increase of $655,000 
in legal costs, $1,110,000 for severance for the storage business unit 
personnel, and $750,000 estimated loss on excess capacity at the Fremont, CA 
facility. Management continues to monitor and reduce operating expenses to 
bring them in line with the current business operations.

Because of the uncertainties in MatriDigm Corporation's future and their 
ability to generate sufficient operating cash flows, the Company has taken a 
loss of $10,616,000 which consisted of the write off of its investment of 
$7,414,000, and a reserve in 

                              Page 22
<PAGE>

the amount of $3,202,000 against demand notes of $2,022,000, a bank guarantee 
of $1,000,000, and a note and an option from an officer of MatriDigm in the 
amount of $180,000.

Interest expense was $3,466,000 for the year ended 1998, $1,111,000 of which 
relates to the discount on the 3% convertible subordinated debentures and 
$2,355,000 is related to the interest on both the 3% and 5% debentures. 
Interest income in the current year is $598,000.  Other expense in the 
current year included an accrual of $300,000 related to a potential liability 
from the sale of the storage business unit.

Due to the uncertainty surrounding the realization of the net operating 
losses and credit carryforwards in future tax years, the Company established 
a 100% valuation allowance against its deferred tax asset in the amount of 
$6,500,000 during fiscal year 1998.

Fiscal 1997 Compared With Fiscal 1996

Revenues for fiscal 1997 decreased by $5,100,000 or 22%, from fiscal year 
1996. Royalty revenue decreased $9,133,000 or 63% while net sales increased 
$4,033,000 or 47%.  The increase in product sales in fiscal 1997 was related 
to the sale of both storage products and software products acquired on June 
30, 1997.  Storage product sales competition remained high during the year 
with average sales prices declining 45% during fiscal 1997 versus 1996.  The 
Company anticipates that software sales will increase during fiscal 1998, as 
only one quarter of software revenue from the three acquired companies was 
included in fiscal 1997 revenue.  The Company's Year 2000 remediation 
business unit did not produce revenue during the year but the Company 
anticipates revenue generation from this business unit during fiscal 1998.

Cost of goods sold, as a percentage of net sales, was 74% in fiscal 1997 as 
compared to 77% in 1996.  The three-percentage point improvement in gross 
margins is attributable to higher margins from the sale of software products 
during the fourth quarter of the year.

Research and development expenses were 59% of net sales in the current year 
as compared to 76% in fiscal 1996.  Actual dollars increased $953,000.  
Spending continued to increase in support of efforts to enhance existing 
products and for the development of the next generation of products; however, 
the majority of the spending increase was to support software products for 
the newly-acquired business unit.

                              Page 23
<PAGE>

Selling, general and administrative costs were $14,468,000 or 115% of net 
sales in fiscal 1997 versus $8,002,000 or 93% in the prior fiscal year.  The 
transition in the storage business to the open systems marketplace required a 
major restructuring of sales and marketing and the hiring of additional 
personnel which increased spending by $2,959,000.  In addition, the Solution 
Services Business unit, which began during the year, added $779,000 in 
operating expenses.  The acquisition of the software companies on June 30, 
1997 added operating expenses of $2,428,000 during the fourth quarter.  The 
Company's intent is to more aggressively manage all operating expenses in 
order to realize an acceptable expense-to-revenue relationship.

The Company incurred a charge of $6,600,000 for in-process research and 
development expenses related to the acquisition of companies on June 30, 
1997. The amount of the purchase price allocated to purchased research and 
development, which had no alternative future use and relates to products for 
which technological feasibility had not been established, was expensed at the 
acquisition date.

Interest expense totaled $3,532,000 during fiscal year 1997, $2,778,000 of 
which was related to the discount on the convertible subordinated debentures 
issued during the year.  Interest income was $746,000 in fiscal 1997 compared 
to $482,000 in the prior year.  Included in other income in the current year 
is $777,000 of realized gains from the sale of marketable securities as 
compared to $4,177,000 in the prior fiscal year.

The tax benefit for fiscal 1997 was 20% of the loss before taxes and the 
Company established a valuation allowance of  $2,475,000 during the year.  In 
1996, the tax provision was 38% of income before income taxes.

Liquidity and Capital Resources

The Company's principal sources of working capital are product sales and 
convertible debt.  During the fiscal year ended September 30, 1998, working 
capital decreased $14,889,000 and cash flow utilized by operating activities 
was $12,960,000.  The utilization of cash in operating activities resulted 
primarily from the net loss of $43,205,000.  This was partially offset by the 
decrease in deferred and refundable taxes of $6,509,000, a decrease in 
accounts receivable of $3,021,000, a decrease in inventory of $1,795,000, a 
loss on impairment of assets in the amount of $2,061,000, amortization of 
capitalized financing costs of $1,322,000, depreciation and amortization in 
the amount of 

                              Page 24
<PAGE>

$3,036,000, and a loss from the unconsolidated company of $10,616,000.

During the current year, net cash provided by investing activities was 
$3,141,000.  $9,596,000 was generated from the maturity of a short-term 
investment.  This was partially offset by the Company's investment of 
$1,559,000 in an unconsolidated company, the purchase of other assets in the 
amount of $1,351,000, notes receivable from an unconsolidated company of 
$2,022,000, and a bank guarantee for the unconsolidated company of $1,000.000.

Net cash provided by financing activities was $12,184,000 which included 
$10,741,000 which was raised from the issuance of 3% convertible subordinated 
debentures and $1,443,000 from the exercise of employee stock options and for 
the sale of stock under the Company's employee stock purchase plan.

Management believes that the Company will meet its cash requirements for the 
next twelve months from cash on hand, other working capital, and cash flow 
from operations.  If the Company is unable to generate sufficient cash flow 
from operations or should management determine it to be prudent, it may 
attempt to raise additional debt or equity.  There can be no assurance that 
management will be able to raise additional debt or equity financing.

Recent Accounting Pronouncements

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income". 
SFAS No. 130 establishes standards for the reporting and display of 
comprehensive income and its components in a full set of general purpose 
financial statements. Comprehensive income is defined as the change in equity 
of a business enterprise during a period from transactions and other events 
and circumstances from non-owner sources.  The impact of adopting SFAS No. 
130, which is effective for the Company beginning in fiscal year 1999, has 
not been determined.

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

                              Page 25
<PAGE>

segment financial information to amounts reported in the financial statements 
would be provided.  SFAS No. 131 is effective for the Company beginning in 
fiscal year 1999 and the impact of adoption has not been determined.

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

Impact of the Year 2000 Issue

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

The Year 2000 issue is the result of computer programs being written using 
two digits rather than four to define the applicable year.  The issue arises 
if date-sensitive software recognizes a date using "00" as the year 1900 
rather than the 

                              Page 26
<PAGE>

year 2000.  This could result in a system failure or miscalculations causing 
disruptions of operations, including, among other things, a temporary 
inability to process transactions, send invoices, or engage in similar normal 
business activities.

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

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

The Company's most likely worst case Year 2000 scenario would be an 
interruption in work or cash flow resulting from unanticipated problems 
encountered with the information systems of the Company, or of any of the 
significant third parties with whom the company does business.  The Company 
believes that the risk of significant business interruption due to 
unanticipated problems with its own systems is low based on the progress of 
the Year 2000 project to 

                              Page 27
<PAGE>

date.  If unforeseen internal disruptions occur, the Company believes that 
its existing disaster recovery program, which includes the manual processing 
of certain key transactions, would significantly mitigate the impact.  The 
Company's highest risk relates to significant suppliers or customers failing 
to remediate their Year 2000 issues in a timely manner.  Relating to its 
suppliers, the Company has identified and will continue to identify 
alternative suppliers. The Company's suppliers are generally locally or 
regionally based, which tends to lessen the Company's exposure from the lack 
of readiness of any single supplier.  The risk relating to the Company's 
customers relates primarily to any delay in receipt of payment due to a 
customer's unresolved Year 2000 issue.  The Company's existing financial 
resources will help to mitigate such an impact and the Company will continue 
to assess this risk as it receives communications about the Year 2000 status 
of its customers.

The Company estimates that costs to address the Year 2000 issue will total 
approximately $275,000, including costs already incurred.  These estimated 
costs include consulting fees and costs to remediate or replace hardware and 
software as well as non-incremental costs resulting from redeployment of 
internal resources.  To date, an insignificant amount has been incurred and 
expensed related to the Year 2000 issue.  The Company's Year 2000 costs will 
be funded from its operating cash flows.

Item 7A: Quantitative and Qualitative Disclosures about Market Risk

The Company considered the provision of Financial Reporting Release No. 48, 
"Disclosure of Accounting Policies for Derivative Financial Instruments and 
Derivative Commodity Instruments, and Disclosure of Quantitative and 
Qualitative Information about Market Risk Inherent in Derivative Financial 
Instruments, Other Financial Instruments and Derivative Commodity 
Instruments".  The Company had no holdings of derivative financial or 
commodity instruments at September 30, 1998.  A review of the Company's other 
financial instruments and risk exposures at that date revealed that the 
Company had exposure to interest rate risk.  At September 30, 1998, the 
Company performed sensitivity analyses to assess the potential effect of this 
risk and concluded that near-term changes in interest rates should not 
materially adversely affect the Company's financial position, results of 
operations or cash flow.

                              Page 28
<PAGE>

Item 8:  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Consolidated Balance Sheets
(In thousands)

<TABLE>
<CAPTION>
                                                                September 30,
                                                              1998        1997
                                                            --------    --------
<S>                                                         <C>         <C>
Assets
Current assets:
  Cash and cash equivalents                                 $  6,589     $ 4,224
  Short-term investments                                           -       9,596
  Accounts receivable, less allowance for doubtful
    accounts of $122 in 1998 and $175 in 1997                  3,579       6,547
  Inventories                                                      -       3,050
  Deferred and refundable taxes                                  208       3,540
  Other current assets                                           749         993
                                                            --------    --------
    Total current assets                                      11,125      27,950

Fixed assets-net                                               1,311       3,700
Intangible assets-net                                          4,070       5,846
Investment in unconsolidated company                               -       5,879
Other assets-net                                               1,564       5,919
                                                            --------    --------
  Total assets                                              $ 18,070     $49,294
                                                            ========    ========

Liabilities And Shareholders' Equity
Current liabilities:
  Accounts payable                                          $  3,585     $ 4,768
  Accrued liabilities                                          1,527       3,319
  Deferred revenue                                             2,139       1,100
                                                            --------    --------
    Total current liabilities                                  7,251       9,187
Convertible subordinated debenture                             4,585      24,161
                                                            --------    --------
    Total liabilities                                         11,836      33,348
                                                            --------    --------

Commitments (See note)

Shareholders' equity:
  Preferred stock, no par value; 1,000 shares
    authorized, none issued
  Common stock, no par value; 40,000 shares authorized:
    Issued and outstanding; 20,601 shares and 15,603 shares
    at September 30, 1998 and 1997, respectively              60,574      27,081
  Accumulated deficit                                        (54,340)    (11,135)
                                                            --------    --------
    Total shareholders' equity                                 6,234      15,946
                                                            --------    --------
  Total liabilities and shareholders' equity                $ 18,070     $49,294
                                                            ========    ========
</TABLE>


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



                              Page 29
<PAGE>

Consolidated Statements of Operations
(In thousands except per share data)

<TABLE>
<CAPTION>
                                                      Year Ended September 30,
                                                     1998       1997       1996
                                                  --------    --------   -------
<S>                                               <C>         <C>        <C>
Net sales                                         $ 20,159    $ 12,626   $ 8,593
Royalty revenue                                      1,541       5,340    14,473
                                                  --------    --------   -------
  Total revenue                                     21,700      17,966    23,066

Costs and expenses:
  Cost of goods sold                                12,155       9,301     6,630
  Research and development                           6,419       7,504     6,551
  Selling, general and administrative               24,012      14,468     8,002
  Loss on impairment of assets                       2,061           -         -
  Loss from unconsolidated company                  10,616           -         -
  Acquisition of in-process research 
    & development                                        -       6,600         -
                                                  --------    --------   -------
    Operating income (loss)                        (33,563)    (19,907)    1,883

Interest income                                       (598)       (746)     (482)
Interest expense                                     3,466       3,532        25
Other income and expense                               274        (689)   (4,188)
                                                  --------    --------   -------
    Income (loss) before income taxes              (36,705)    (22,004)    6,528

Provision (benefit) for income taxes                 6,500      (4,503)    2,479
                                                  --------    --------   -------
    Net income (loss)                             $(43,205)   $(17,501)   $4,049
                                                  ========    ========   =======

Basic net income (loss) per share                 $  (2.48)   $  (1.15)   $  .27
                                                  ========    ========   =======
Diluted net income (loss) per share               $  (2.48)   $  (1.15)   $  .26
                                                  ========    ========   =======

Shares used in basic per share calculation          17,433      15,222    14,726
                                                  ========    ========   =======
Shares used in diluted per share calculation        17,433      15,222    15,626
                                                  ========    ========   =======
</TABLE>



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


                              Page 30
<PAGE>

Consolidated Statements of Shareholders' Equity
(In thousands except per share data)

<TABLE>
<CAPTION>
                                                                        Retained
                                                    Common   Common     Earnings          Total
                                                     Stock    Stock (Accumulated  Shareholders'
                                                    Shares   Amount    (Deficit)         Equity
                                                    ------  ------- ------------  -------------
<S>                                                  <C>    <C>     <C>           <C>
Balances at September 30, 1995                      14,552  $19,916    $  3,041     $ 22,957

Issuance of common stock:
  Stock options exercised ($0.82-$7.94
    per share)                                         310      686           -          686
  Employee stock purchase plan ($4.15 and $5.10
    per share)                                          66      303           -          303
  Stock repurchase                                    (130)    (182)       (724)        (906)
  Stock warrants                                        22        -           -            -
Net income                                               -        -       4,049        4,049
                                                    ------  -------    --------     --------
Balances at September 30, 1996                      14,820   20,723       6,366       27,089

Issuance of common stock:
  Stock options exercised ($0.81 - $9.50
    per share)                                         498    1,104           -        1,104
  Employee stock purchase plan ($7.87 and $16.58
    per share)                                          35      390           -          390
  Stock warrants                                        15        -           -            -
  Common stock issued for acquisition                   61    1,200           -        1,200
  Conversion of subordinated debenture                 174    3,664           -        3,664
Net loss                                                 -        -     (17,501)     (17,501)
                                                    ------  -------    --------     --------
Balances at September 30, 1997                      15,603   27,081     (11,135)      15,946

Issuance of common stock:
  Stock options exercised ($0.34-$9.88
    per share)                                         367      915           -          915
  Employee stock purchase plan ($6.28 and $10.73
    per share)                                          65      528           -          528
  Conversion of subordinated debenture               4,566   30,325           -       30,325
  Discount on $10 million convertible
    subordinated debenture                               -    1,111           -        1,111
  Valuation of stock warrants issued in
    connection with $10 million convertible
    subordinated debenture                               -      614           -          614
Net loss                                                 -        -     (43,205)     (43,205)
                                                    ------  -------    --------     --------
Balances at September 30, 1998                      20,601  $60,574    $(54,340)    $  6,234
                                                    ======  =======    ========     ========
</TABLE>


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

                             Page 31
<PAGE>
Consolidated Statements of Cash Flows 
(In thousands)                        

<TABLE>
<CAPTION>
                                                                Year Ended September 30,
                                                                1998       1997     1996
                                                             --------   --------   -------
<S>                                                          <C>        <C>        <C>
Cash flows provided by (used in) operating activities:
Net income (loss)                                            $(43,205)  $(17,501)  $ 4,049
  Adjustments to reconcile net income (loss) to
    net cash provided by (used in) operating activities:
  Acquisition of in-process research & development expenses         -      6,600         -
  Sale of storage business unit                                  (200)         -         -
  Loss on impairment of assets                                  2,061          -         -
  Loss from unconsolidated company                             10,616          -         -
  Writedown of inventory                                        1,095          -         -
  Writeoff of patents                                             387          -         -
  Writeoff of capitalized software                                103          -         -
  Adjustment of goodwill and purchased technology                 909          -         -
  Amortization of capitalized financing costs                   1,322          -         -
  Discount amortization on subordinated debenture               1,111      2,778         -
  Depreciation and amortization                                 3,036      1,404       935
  Loss on disposal of fixed assets                                  -          -        15
  Provision for doubtful accounts                                 (53)       284       185
  Provision for inventory allowances                              160        480       480
  Unrealized gains on marketable securities                         -          -    (2,041)
  Realized gains on marketable securities                           -       (777)   (2,136)
  Deferred and refundable income taxes                          6,509     (4,743)    2,124
  Change in operating assets and liabilities:
  Decrease (increase) in accounts receivable                    3,021     (1,289)   (1,527)
  Decrease (increase) in inventories                            1,795        681    (1,770)
  Increase in other current assets                                244       (513)      (62)
  Increase (decrease) in accounts payable                      (1,183)     2,702       341
  Increase (decrease) in accrued liabilities                     (688)     2,875        33
                                                             --------   --------   -------
    Net cash provided by (used in) operating activities       (12,960)    (7,019)      626
                                                             --------   --------   -------
Cash flows provided by (used in) investing activities:
  Acquisition of fixed assets                                    (723)    (2,650)   (1,676)
  Investment in unconsolidated company                         (1,559)    (2,024)   (3,497)
  Purchase of short-term investments                                -     (9,596)        -
  Proceeds from sale of short-term investments                  9,596      3,159     2,795
  Notes receivable from unconsolidated company                 (2,022)         -         -
  Bank guarantee for unconsolidated company                    (1,000)         -         -
  Proceeds from sale of storage business unit                     200          -         -
  Purchase of other assets                                     (1,351)    (1,089)     (367)
  Purchase of companies net of cash acquired                        -    (11,062)        -
                                                             --------   --------   -------
    Net cash provided by (used in) investing activities         3,141    (23,262)   (2,745)
                                                             --------   --------   -------
Cash flows provided by (used in) financing activities:
  Issuance of common stock                                      1,443      1,494       989
  Repurchase of common stock                                        -          -      (906)
  Repayments of borrowings                                          -          -       (13)
  Issuance of subordinated debenture                           10,741     23,795         -
                                                             --------   --------   -------
    Net cash provided by financing activities                  12,184     25,289        70
                                                             --------   --------   -------
Net increase (decrease) in cash                                 2,365     (4,992)   (2,049)
Cash and cash equivalents, beginning of year                    4,224      9,216    11,265
                                                             --------   --------   -------
Cash and cash equivalents, end of year                       $  6,589   $  4,224   $ 9,216
                                                             ========   ========   =======
Supplemental cash flow information:
  Income taxes paid                                          $     27   $    265   $    82
  Interest paid                                                    35          -         -
Supplemental non-cash investing and financing activities:
  Issuance of common stock in business combination                  -   $  1,200         -
  Capitalized financing costs                                $    558   $  1,038         -
  Conversion of subordinated debenture and accrued interest  $ 30,325   $  3,664         -
  Conversion of note receivable to investment in
    unconsolidated company                                   $      -   $    300         -
  Common stock purchase warrants                             $    614          -         -
</TABLE>


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

                              Page 32
<PAGE>

Notes to Consolidated Financial Statements
(In thousands except per share data)

Summary of Significant Accounting Policies:

Zitel Corporation ("Zitel" or the "Company") is an information technology 
company specializing in systems optimization, correlation and search 
technology. Zitel employs these core competencies in two business units: a 
software products and services business unit marketing multi-platform 
performance analysis and correlation software used to optimize performance in 
mission critical systems, databases and applications, and a solution services 
business unit that markets Year 2000 services and consulting, which includes 
project management, planning, analysis, code conversion and testing using the 
MatriDigm Corporation technology tools.  Zitel conducts its business within 
one industry segment.

The following is a summary of Zitel's significant accounting policies:

Basis of Presentation:

These consolidated financial statements contemplate the realization of assets 
and the satisfaction of liabilities in the normal course of business.  The 
Company has incurred net losses in fiscal 1997 and 1998 and there can be no 
assurance that the Company will attain profitability.  At September 30, 1998, 
the company had aggregate consolidated net losses of $54,340 thousand. 
Management believes that its existing cash balances and other potential 
financing alternatives will be sufficient to meet the Company's capital and 
operating requirements for the next 12 months.  If expenditures required to 
achieve the Company's plans are greater than projected, or if the Company is 
unable to generate adequate cash flow from sales of its products, the Company 
may need to seek additional sources of capital.  The Company has no 
commitments or arrangements to obtain any additional funding and there can be 
no assurance that the Company will be able to obtain such funding, if 
necessary, on acceptable terms or at all.  The failure to raise needed funds 
on sufficiently favorable terms could have a material adverse effect on the 
Company's business, operating results and financial condition.

Principles of Consolidation:

The consolidated financial statements include the accounts of 

                              Page 33
<PAGE>

Zitel Corporation and its wholly-owned subsidiaries.  Zitel's preferred stock
interest in an unconsolidated company is accounted for under the equity method. 
All significant intercompany accounts and 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 reported amount of assets and liabilities and disclosure of 
contingent assets and liabilities at the date of the financial statements and 
the reported amounts of revenues and expenses during the reporting period. 
Actual results could differ from these estimates.

Cash Equivalents:

For purposes of the statements of cash flows, the Company considers all 
highly liquid debt instruments purchased with a maturity of three months or 
less to be cash equivalents.

Fixed Assets:

Fixed assets are stated at cost less accumulated depreciation, other than 
leasehold improvements, and are depreciated on a straight-line basis over 
their estimated useful lives (three years).  Leasehold improvements are 
amortized over the lesser of their useful life or remaining term of the 
related lease.  When assets are disposed of, the cost and related accumulated 
depreciation are removed from the accounts and the resulting gains and losses 
are included in the results of operations.

Deferred Software Implementation Costs:

The Company capitalizes substantially all costs related to the purchase of 
software and its implementation, which includes the cost of purchased 
software, consulting fees and the use of certain specified Company resources 
and amortizes such costs on a straight-line basis over the estimated life of 
the computer software, which is five years.  The Company evaluates the fair 
value of the deferred software implementation costs at each balance sheet 
date and records writedowns to the recoverable costs.  In June 1998, the 
Company wrote down the net book value of amounts capitalized, which related 
to all the manufacturing modules of the recently sold storage business unit, 
of $550 thousand, net of related accumulated amortization of $192 thousand.  
This amount is included in the loss on impairment of 

                              Page 34
<PAGE>

assets.  As of September 30, 1998 and 1997, $351 thousand and $1,092 
thousand, respectively, in costs have been capitalized and are included in 
other long-term assets.  Amortization in the amount of $193 thousand and $111 
thousand had been charged to expense during fiscal years 1998 and 1997, 
respectively.  American Institute of Certified Public Accountants Statement 
of Position ("SOP") 98-1, "Accounting for Costs of Computer Software 
Developed or Obtained for Internal Use", issued on March 4,1998, will be 
effective for the Company in fiscal year 1999.  The Company believes there 
will not be a significant impact upon adoption.

Revenue Recognition:

Software revenue is recognized in accordance with SOP 91-1, "Software Revenue 
Recognition".  The effect of the new SOP 97-2, "Software Revenue 
Recognition", issued on October 27, 1997, has yet to be determined and will 
become effective for the Company in fiscal year 1999.

Warranty:

All of the Company's products are covered by a one-year limited warranty. 
Estimated future costs of repair, replacement or customer accommodation are 
accrued and charged to cost of sales based upon estimates of future product 
returns and repair costs derived from historical product sales information 
and analyses of historical data.  In estimating the level of accrual, the 
Company's management makes assumptions relating to the level of product 
returns and costs of repair.  Management reviews the adequacy of these 
assumptions based on historical experience.

Research and Development Expenditures:

Research and development expenditures are charged to operations as incurred.

Software Development Costs:

Statement of Financial Accounting Standards ("SFAS") No. 86 provides for the 
capitalization of certain software development costs after technological 
feasibility of the software is attained.  Capitalized costs will be amortized 
over the estimated product life cycle (approximately three years).  The 
Company evaluates the estimated net realizable value of each software product 
at each balance sheet date and records write-downs to net realizable value 
for any products with a net book value in excess 

                              Page 35
<PAGE>

of net realizable value.  Software development costs capitalized in fiscal 
years 1998 and 1997 were $562 thousand and $189 thousand, respectively.  
Amortization in the amount of $62 thousand was charged to expense during the 
year.

Foreign Currency Translation:

The U.S. dollar is considered to be the functional currency for the Company's 
foreign operations.  Accordingly, non-monetary assets and liabilities have 
been translated into U.S. dollars at a historical rate; monetary assets and 
liabilities have been translated into U.S. dollars using the exchange rate at 
the balance sheet date; and revenues and expenses have been generally 
translated into U.S. dollars at the weighted average exchange rate during the 
period. Foreign currency transaction gains and losses, as well as the effects 
of remeasurement (which have not been material in the aggregate), are 
included in the accompanying statements of operations.

Intangible Assets:

Intangible assets include goodwill and purchased technology, recorded in 
connection with the acquisition of the three software companies, which are 
being amortized on a straight-line basis over seven and five years, 
respectively.  The Company periodically assesses the recoverability of 
intangible assets by determining whether the amortization of the asset 
balance over its remaining life can be recovered through undiscounted future 
operating cash flows of the acquired operation.  The amount of impairment, if 
any, is measured based on projected discounted future operating cash flows 
and is recognized as a write down of the asset to a net realizable value.  In 
fiscal year 1998, the Company reassessed the amortization period for goodwill 
and reduced the life from seven to five years based on future projections.

Income Taxes:

Income taxes are accounted for in accordance with SFAS No. 109, "Accounting for
Income Taxes".  Under this method, deferred income taxes are recognized for
temporary differences by applying enacted statutory rates applicable to future
years to differences between the financial statement carrying amounts and the
tax basis of existing assets and liabilities.  The effect on deferred taxes of a
change in tax rates is recognized in income in the period that includes the
enactment date.  Valuation allowances are established when necessary to reduce
deferred tax assets to the amounts expected to be realized.

                              Page 36
<PAGE>

Recent Accounting Pronouncements:

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income". 
SFAS No. 130 establishes standards for the reporting and display of 
comprehensive income and its components in a full set of general purpose 
financial statements. Comprehensive income is defined as the change in equity 
of a business enterprise during a period from transactions and other events 
and circumstances from non-owner sources.  The impact of adopting SFAS No. 
130, which is effective for the Company beginning in fiscal year 1999, has 
not been determined.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an 
Enterprise and Related Information".  SFAS No. 131 requires publicly-held 
companies to report financial and other information about key 
revenue-producing segments of the entity for which such information is 
available and is utilized by the chief operations decision maker.  Specific 
information to be reported for individual segments includes profit or loss, 
certain revenue and expense items and total assets.  A reconciliation of 
segment financial information to amounts reported in the financial statements 
would be provided.  SFAS No. 131 is effective for the Company beginning in 
fiscal year 1999 and the impact of adoption has not been determined.

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

                              Page 37
<PAGE>

Net Income (Loss) Per Share:

The Company has adopted the provisions of SFAS No. 128, "Earnings Per Share", 
effective December 31, 1997.  SFAS No. 128 requires the presentation of basic 
and diluted income per common share.  Basic income per common share is 
computed by dividing net income available to common stockholders by the 
weighted average number of common shares outstanding for the period.  Diluted 
income per common share is computed giving effect to all potentially dilutive 
common shares that were outstanding during the period.  Dilutive common 
shares consist of the incremental common shares issuable upon the conversion 
of convertible subordinated debt (using the "if converted" method) and 
exercise of stock options and warrants for all periods.  All prior period 
income per common share amounts have been restated to comply with SFAS No. 
128.

Concentrations of Credit Risk:

Financial instruments which potentially subject the Company to concentrations 
of credit risk consist principally of cash, short-term investments and trade 
receivables.  The Company places its cash investments and short-term 
investments with high credit quality financial institutions and limits the 
amount of exposure to any one financial institution.  Concentrations of 
credit risk with respect to trade receivables are limited due to the 
diversity of the Company's customers, both geographically and within 
different industry segments.

Fair Value of Financial Instruments:

Carrying value amounts of certain of the Company's financial instruments, 
including cash and cash equivalents, short-term investments, accounts 
receivable, accounts payable, subordinated debentures, and other accrued 
liabilities approximate fair value due to their short maturities.

Sale of Storage Business Unit:

Due to the lack of performance of the storage business unit, on July 24, 
1998, the Company completed the sale of the net assets of the business unit, 
which totalled $2.1 million, for cash and a note totalling $1.0 million and 
royalties of up to $4.0 million, payable over four years based on the sales 
performance of the new company.

Fixed assets in the amount of $1.3 million and deferred software 
implementation costs of $800 thousand, which related to 

                              Page 38
<PAGE>

manufacturing modules that would no longer be used, were taken as a loss on 
impairment of assets during the current fiscal year.  Inventory in the amount 
of $1.7 million and patents in the amount of $400 thousand were charged 
against cost of sales.

Due to the excess facility capacity resulting from the sale of the storage 
business unit, a reserve in the amount of $750 thousand was recorded in 
selling, general and administrative expense during fiscal year 1998.  In 
addition, a reserve of $1.1 million was recorded in selling, general and 
administrative expense for the severance costs of the storage business unit 
personnel.

<TABLE>
<CAPTION>
                                               September 30,
                                             1998         1997
                                           -------      -------
<S>                                        <C>          <C>
Inventories:
  Raw materials                            $     -      $   953
  Work in progress                               -          576
  Finished goods                                 -        1,521
                                           -------      -------
                                           $     -      $ 3,050
                                           =======      =======
Fixed Assets:
  Manufacturing equipment                  $     -      $ 3,965
  Office furniture and equipment             3,105        4,162
  Engineering equipment                         10        4,576
  Leasehold improvements                       661          683
                                           -------      -------
                                             3,776       13,386
  Less accumulated depreciation
    and amortization                        (2,465)      (9,686)
                                           -------      -------
                                           $ 1,311      $ 3,700
                                           =======      =======
</TABLE>


Depreciation expense was $1,600 thousand, $1,316 thousand and $827 thousand for
the fiscal years ended September 30, 1998, 1997 and 1996, respectively.

Intangible Assets:

Intangible assets include goodwill and purchased technology, recorded in
connection with the acquisition of the three software companies, which were
being amortized on a straight-line basis over seven and five years,
respectively.  The Company periodically assesses the recoverability of the
intangible assets 

                              Page 39
<PAGE>

by determining whether the amortization of the asset balance over its 
remaining life can be recovered through undiscounted future operating cash 
flows of the acquired operation.  The amount of impairment, if any, is 
measured based on projected discounted future operating cash flows and is 
recognized as a write down of the asset to net realizable value.  At June 30, 
1998, a write-down of a combined total of $658 thousand was made to goodwill 
and purchased technology. In addition, the amortization period of goodwill 
was adjusted to five years from seven years.  As of September 30, 1998, 
intangible assets consist of the following:

<TABLE>
<CAPTION>
                                               September 30,
                                             1998        1997
                                            ------      ------
<S>                                         <C>         <C>
    Goodwill                                $2,768      $3,242
    Purchased technology                     2,588       2,862
    Less accumulated amortization           (1,286)       (258)
                                            ------      ------
                                            $4,070      $5,846
                                            ======      ======

Other Assets:
  Deferred software implementation costs   $   351     $ 1,092
  Deferred taxes, net                            -       3,177
  Capitalized financing costs on
    subordinated debt                          273       1,038
  Purchased technology                         550           -
  Other                                        716         947
                                           -------     -------
                                             1,890       6,254
  Less accumulated amortization               (326)       (335)
                                           -------     -------
                                           $ 1,564     $ 5,919
                                           =======     =======
</TABLE>


Investment in Unconsolidated Company:

In November 1995, Zitel purchased 9.6 million shares of preferred stock of 
MatriDigm Corporation ("MatriDigm") in the development stage, in exchange for 
$3.35 million in cash, $66 thousand in equipment and $150 thousand in future 
rent and administrative services.  The technology rights include an exclusive 
license to manufacture and market certain products using proprietary 
technology of the company, subject to a royalty to the company.  In July 
1996, Zitel entered into an agreement to resell services of the company on a 
commission basis.  The agreement also 

                              Page 40
<PAGE>

provides Zitel the exclusive right to create portable, on-site centers for 
the performance of services offered by the company for certain accounts in 
certain circumstances.  During fiscal year 1997, the Company purchased an 
additional one million shares of preferred stock of the company in exchange 
for $2.0 million in cash.  The Company also exercised an option to purchase 
500 thousand shares of the company's common stock from an officer of the 
company for $300 thousand.

During the quarter ended December 31, 1997, Zitel invested an additional $1.5 
million in MatriDigm in exchange for a convertible promissory note.  The note 
was converted into 1,050 thousand shares of common stock in May 1998.  As of 
September 30, 1998, the Company's investment in MatriDigm amounted to $7.4 
million, or 31%, consisting of 10.6 million shares of preferred stock and 
approximately 1.6 million shares of common stock.  The Company recorded $624 
thousand equity in losses of the unconsolidated company during the year ended 
September 30, 1998.  The Company guaranteed a bank guarantee in the amount of 
$1 million.  In addition, the Company has short-term demand notes in the 
amount of $2 million.  Because of the uncertainties in MatriDigm's future and 
their ability to generate sufficient operating cash flows, at September 30, 
1998, the Company has written off its investment in MatriDigm and fully 
reserved the bank guarantee and the short-term demand notes for a total of 
approximately $11 million.  (Refer to "Subsequent Events" footnote.)

The following is a summary of financial information with respect to 
MatriDigm, as of and for the year ended September 30, 1997 and 1996:

<TABLE>
<CAPTION>
                                1997          1996
                             --------      --------
<S>                          <C>           <C>
     Net sales               $    123      $      -
     Gross profit                  38             -
     Net loss                 (14,549)       (1,873)
     Current assets             3,816         2,612
     Non-current assets         4,009         1,009
     Current liabilities        1,504           324
</TABLE>


The complete financial statements of MatriDigm Corporation for fiscal year 
1998 are included in this Form 10-K.  Refer to Page F-1.

                              Page 41
<PAGE>

Option and Note Receivable from Related Party:

The Company holds an option to purchase 500 thousand shares of common stock 
of MatriDigm Corporation from an officer of MatriDigm in the amount of $75 
thousand.  At September 30, 1997 and 1998, the option was classified in other 
long-term assets.  In February 1998, the Company secured a promissory note 
from the same officer in the amount of $100 thousand.  At September 30, 1998, 
the note was included in other long-term assets.  At September 30, 1998, both 
the option and note have been fully reserved due to the uncertainty in the 
future of MatriDigm.

Accrued Liabilities:

<TABLE>
<CAPTION>
                                             September 30,
                                           1998        1997
                                          ------      ------
<S>                                       <C>         <C>
  Accrued payroll and related             $  788      $1,062
  Accrued vacation                           523         886
  Accrued commissions                         52         170
  Deferred warranty costs                      -       1,023
  Other accrued liabilities                  164         178
                                          ------      ------
                                          $1,527      $3,319
                                          ======      ======
</TABLE>


Commitments:

The Company leases its operating facilities in Fremont, CA, Fairfax, VA, 
Leatherhead, United Kingdom, and Rotterdam, The Netherlands, under 
non-cancelable operating leases that expire at various dates through the year 
2005.  Rent expense incurred under all operating leases and charged to 
operations was $1,763 thousand in 1998, $789 thousand in 1997 and $574 
thousand in 1996.

Future minimum obligations under all facility leases at September 30, 1998 
aggregate approximately $7.6 million, payable as follows:

<TABLE>
<CAPTION>
                    Fiscal Year       Amount
                    -----------       ------
               <S>                  <C>
                        1999          $1,372
                        2000           1,508
                        2001           1,546
                        2002           1,580
                        2003           1,034
                  Thereafter             518
</TABLE>




                              Page 42
<PAGE>

5% Convertible Subordinated Debentures:

On May 22, 1997, the Company issued $25 million principal amount of 5% 
Convertible Subordinated Debentures (the "Debentures") which are due November 
22, 1999.  The Debentures accrue interest at the rate of 5% per annum and 
principal and accrued interest are convertible into Common Stock of the 
Company at a price equal to 90% of the average of the closing bid prices for 
the Common Stock on the five consecutive trading days preceding the date of 
conversion, but in no event greater than $26.975 per share.  The Debentures 
are not convertible until the earlier of (a) 90 days following the date of 
issue or (b) the effective date of a corporate reorganization to which the 
Company is a party, and any Debentures outstanding on November 22, 1999 
automatically will be converted into Common Stock.  The Debentures restrict 
distributions and repurchases of capital stock.

The Consolidated Statement of Operations for fiscal year 1997 included a 
charge to interest expense in the amount of $2,778 thousand related to the 
amortization of the total discount on the 5% Convertible Subordinated 
Debentures.  During fiscal year 1997, approximately $3.3 million was 
converted to 174 thousand shares of common stock at prices ranging from 
$20.28 to $22.74 per share. During fiscal year 1998, approximately $21.7 
million was converted to 3.3 million shares of common stock at prices ranging 
from $4.20 to $13.95 per share. All outstanding debentures were converted to 
common stock during fiscal year 1998.

3% Convertible Subordinated Debentures:

On June 16, 1998, the Company issued $10 million principal amount of 3% 
Convertible Subordinated Debentures (the "Debentures") which are due June 15, 
1999, and five-year common stock purchase warrants totalling 150,000 shares 
of the Company's common stock.  The Debentures accrue interest at the rate of 
3% per annum and principal and accrued interest are convertible into Common 
Stock of the Company at a price of $3.92625.  The warrants are exerciseable 
at $5.1041.  These warrants were valued, using the Black-Scholes model, at 
$614,000, which will be amortized over the conversions of the Debentures.  
Any Debentures outstanding on June 15, 1999 automatically will be converted 
into Common Stock.  The Debentures restrict distributions and repurchases of 
capital stock.

The current year Consolidated Statement of Operations includes a charge to 
interest expense in the amount of $1,111 thousand related to the amortization 
of the total discount on the 3% 

                              Page 43
<PAGE>

Convertible Subordinated Debentures.  During fiscal 1998, approximately $5.1 
million was converted to 1,308 thousand shares of common stock.  The 
Debentures outstanding as of September 30, 1998 will convert to approximately 
1.2 million shares of common stock.  Subsequent to September 30, 1998, the 
Debentures have been fully converted.

CAPITAL STOCK:

Preferred Stock:

In October 1983, the Company authorized one million shares of preferred 
stock. The Board of Directors has the authority to establish all rights and 
terms with respect to the preferred stock without future vote or action by 
the shareholders.

Stock Option Plans:

At September 30, 1998, the Company had reserved 6.2 million common shares for 
issuance under its 1990 Stock Option, 1982 Incentive Option and 1984 
Supplemental Stock Option Plans.  Under the Company's stock option plans, 
options become exercisable at dates and in amounts as specified by the 
Compensation Committee of the Board of Directors and expire two to ten years 
from the date of grant.  Options may be granted to employees at prices not 
less than fair market value at the date of grant.  At September 30, 1998 and 
1997, there were 338 thousand and 34 thousand shares reserved for future 
grants, respectively.

Activity in the Company's option plans during fiscal years 1996, 1997 and 
1998 is summarized as follows:

                              Page 44

<PAGE>
<TABLE>
<CAPTION>
                                         Weighted
                               Number    Average       Options
                                 of       Price         Price        Total
                               Shares   Per Share     Per Share     Amount
                               ------   ---------   -------------   -------
<S>                            <C>      <C>         <C>             <C>
Balances, September 30, 1995   1,860      $ 2.89    $  .34-$ 9.50   $ 5,377
  Granted                        260      $ 7.10    $ 4.82-$ 9.88     1,851
  Cancelled                      (40)     $ 4.69    $ 1.19-$ 7.94      (190)
  Exercised                     (310)     $ 2.13    $  .82-$ 7.94      (660)
                               -----                -------------   -------
Balances, September 30, 1996   1,770      $ 3.60    $  .34-$ 9.88     6,378
  Granted                      1,008      $23.47    $13.63-$44.38    23,662
  Cancelled                     (291)     $28.75    $ 1.06-$44.38    (8,372)
  Exercised                     (477)     $ 2.05    $  .81-$ 9.50      (978)
                               -----                -------------   -------
Balances, September 30, 1997   2,010      $10.29    $  .34-$44.38    20,690
  Granted                      1,471      $11.51    $ 2.53-$16.63    16,928
  Cancelled                   (1,024)     $17.30    $ 1.50-$33.00   (17,712)
  Exercised                     (367)     $ 2.49    $  .34-$ 9.88      (915)
                               -----                -------------   -------
Balances, September 30, 1998   2,090      $ 9.09    $ 1.38-$23.25   $18,991
                               =====      ======    =============   =======
</TABLE>

At September 30, 1998, 1997 and 1996, respectively, options for 1,301 thousand,
867 thousand and 1,044 thousand shares were exercisable at prices ranging from
$0.34 to $23.25.  The estimated weighted average fair value of options granted
during fiscal years 1998, 1997 and 1996 were $6.80, $13.02 and $4.42,
respectively.

1995 Non-Employee Directors' Stock Option Plan:

In April 1995, the Board of Directors approved the adoption of a Directors' plan
which provides for automatic, non-discretionary grants of options to purchase an
aggregate of 200 thousand shares of common stock.  Options in the amount of 30
thousand, 24 thousand, 24 thousand, and 24 thousand were granted in fiscal years
1995, 1996, 1997, and 1998, respectively, at prices ranging from $5.88 to $33.00
per share.  No options were exercised during fiscal 1998.  98 thousand shares
are available for future grant.  At September 30, 1998, 69 thousand shares were
exercisable at prices ranging from $5.88 to $33.00.  At September 30, 1997, 38
thousand shares were exercisable at prices ranging from $5.88 to $33.00.

Preferred Share Purchase Rights Plan:

In June 1996, the Company adopted a Preferred Share Purchase Rights Plan whereby
shareholders will receive one right to purchase one one-hundredth of a share of
a new series of preferred stock ("Rights") for each outstanding share of the 

                              Page 45
<PAGE>
Company's common stock held at the date of record, July 1, 1996.  The Rights do
not become exercisable or transferable apart from the common stock until a
person or group (a) acquires beneficial ownership of 15% or more of the
Company's common stock or (b) announces a tender or exchange offer, the
consummation of which would result in ownership by a person or group of 15% or
more of the Company's common stock.  The Rights will be distributed as a
non-taxable dividend and will expire in ten years from the date of declaration
of the dividend.  The exercise price is $69.50 per 1/100 of a share of preferred
stock.

Stock Purchase Plan:

In April 1984, the Board of Directors approved the adoption of an Employee Stock
Purchase Plan under which 400 thousand shares of common stock were reserved for
issuance to eligible employees.

In January 1988, January 1990, January 1992, and January 1995, the shareholders
approved amendments to increase the shares reserved for the Plan by 300 thousand
shares, 400 thousand shares, 400 thousand shares, and 500 thousand shares,
respectively.  Employees who do not own 5% or more of the outstanding shares are
eligible to participate through payroll deductions, which may not exceed 10% of
an employee's compensation.  At the end of each offering period, shares are
purchased by the participants at 85% of the lower of the fair market value at
the beginning or the end of the offering period.  The 15% discount is treated as
equivalent to the cost of issuing stock for financial reporting purposes.  65
thousand, 35 thousand and 66 thousand shares were issued under the Plan during
fiscal years 1998, 1997 and 1996, respectively.  Since inception of the Plan,
approximately 1.7 million shares have been issued.

Pro Forma Stock-Based Compensation:

As of September 30, 1998, options outstanding under both the stock option plans
and 1995 Non-Employees Directors' Stock Option Plan were as follows:


                              Page 46
<PAGE>
<TABLE>
<CAPTION>
                 OPTIONS OUTSTANDING                     OPTIONS EXERCISABLE
-----------------------------------------------------   ---------------------
                                  Weighted
          Range                    Average   Weighted                Weighted
             of                  Remaining    Average                 Average
       Exercise       Number   Contractual   Exercise        Number  Exercise
         Prices  Outstanding          Life      Price   Exercisable     Price
---------------  -----------   -----------   --------   -----------  --------
<S>              <C>           <C>           <C>        <C>          <C>
$ 1.38 - $ 2.06          257          1.66     $ 1.96           257    $ 1.96
$ 2.31 - $ 5.63          344          7.21     $ 4.51           236    $ 4.80
$ 5.69 - $ 6.81          286          6.91     $ 6.22           154    $ 6.23
$ 7.00   $ 9.88          184          7.93     $ 8.29           137    $ 8.35
$10.69 - $10.69          251          9.34     $10.69            58    $10.69
$10.81 - $13.63           61          8.45     $12.24            25    $12.28
$13.88                   699          8.54     $13.88           446    $13.88
$14.19 - $20.56           63          9.41     $14.36            31    $14.34
$23.25                     2          8.66     $23.25             2    $23.25
$33.00                    24          8.41     $33.00            24    $33.00
                   ---------          ----     ------       -------    ------
$ 1.38 - $33.00        2,171          7.37     $ 9.33         1,370    $ 8.87
</TABLE>

The Company has elected to continue to follow the provisions of Accounting
Principles Board ("APB") No. 25, "Accounting for Stock Issued to Employees", for
financial reporting purposes and has adopted the disclosure-only provisions of
SFAS No. 123, "Accounting for Stock-Based Compensation".  Accordingly, no
compensation cost has been recognized for the Company's stock option plans or
employee stock purchase plan.  Had compensation cost for the Company's stock
option plans and employee stock purchase plan been determined based on the fair
value at the grant date for awards in fiscal years 1998, 1997 and 1996
consistent with the provisions of SFAS No. 123, the Company's net income (loss)
and net income (loss) per share for fiscal years 1998, 1997 and 1996 would have
been modified to the pro forma amounts indicated below (in thousands, except per
share amounts):

<TABLE>
<CAPTION>
                                                      Year ended September 30,
                                                     1998       1997      1996
                                                   --------   --------  --------
<S>                                                <C>        <C>       <C>
Net income (loss) applicable to
  common stockholders - as reported                $(43,205)  $(17,501)  $ 4,049
Net income (loss) applicable to                    ========   ========  ========
  common stockholders - pro forma                  $(51,574)  $(22,138)  $ 3,637
                                                   ========   ========  ========
Basic net income (loss) per share - as reported    $  (2.48)  $  (1.15)  $  0.27
                                                   ========   ========  ========
Basic net income (loss) per share - pro forma      $  (2.96)  $  (1.45)  $  0.25
                                                   ========   ========  ========
Diluted net income (loss) per share - as reported  $  (2.48)  $  (1.15)  $  0.26
                                                   ========   ========  ========
Diluted net income (loss) per share - pro forma    $  (2.96)  $  (1.45)  $  0.23
                                                   ========   ========  ========
</TABLE>

The above pro forma disclosures are not necessarily representative of the
effects on reported net income or loss for future years.

                              Page 47
<PAGE>
The aggregate fair value and weighted average fair value of each option granted
in fiscal years 1998, 1997 and 1996 were $5.3 million, $13.4 million and $1.2
million and $6.75, $12.99 and $4.23, respectively.  The fair value of each
option grant is estimated on the date of grant using the Black-Scholes Option
Pricing Model with the following weighted average assumptions for fiscal years
1998, 1997 and 1996:

<TABLE>
     <S>                            <C>
     Expected volatility              76% - 103%
     Risk-free interest rate        5.07% - 6.22%
     Expected life                    .88 - 5.17 years
     Expected dividend yield             0.0%
</TABLE>

The Company has also estimated the fair value for the purchase rights under the
employee stock purchase plan using the Black-Scholes Model, with the following
assumptions for fiscal years 1998 and 1997:

<TABLE>
     <S>                            <C>
     Expected volatility              65% - 136%
     Risk-free interest rate        5.39% - 5.63%
     Expected life                    .50 years
     Expected dividend yield             0.0%
</TABLE>

Savings and Investment Plan:

The Company has a Savings and Investment Plan, qualified under sections 
401(k) and 401(a) of the Internal Revenue Code, that enables participating 
U.S. employees to prepare for retirement.  The Plan allows eligible employees 
to defer up to 15%, but no greater than $10 thousand per year, of their 
earnings on a pre-tax basis through contributions to the Plan.  The Plan 
provides for employer contributions at the discretion of the Board of 
Directors; however, no such contributions were made in fiscal 1998, 1997 or 
1996.

Earnings Per Shares ("EPS") Disclosures:

In accordance with the disclosure requirements of SFAS 128, a reconciliation 
of the numerator and denominator of basic and diluted EPS is provided as 
follows (in thousands except per share amounts):

                              Page 48
<PAGE>
<TABLE>
<CAPTION>
                                                    Year Ended September 30,
                                                  1998       1997       1996
                                                --------   --------   -------
<S>                                             <C>        <C>        <C>
Numerator - basic and diluted EPS
  Net income (loss)                             $(43,205)  $(17,501)  $ 4,049
                                                --------   --------   -------
Denominator - basic EPS
  Common stock outstanding                        17,433     15,222    14,726
                                                --------   --------   -------
Total shares used in calculation of basic EPS     17,433     15,222    14,726
                                                --------   --------   -------
Basic net income (loss) per share               $  (2.48)  $  (1.15)  $  0.27
                                                --------   --------   -------

Denominator - diluted EPS
  Denominator - basic EPS                         17,433     15,222    14,726
  Effect of dilutive securities:
    Common stock options                               -          -       900
                                                --------   --------   -------
Total shares used in calculation of diluted EPS   17,433     15,222    15,626
                                                --------   --------   -------
Diluted net income (loss)per share              $  (2.48)  $  (1.15)  $  0.26
                                                ========   ========   =======
</TABLE>

Stock options to purchase 2.1 million, 2.0 million and 870 thousand shares of
common stock in 1998, 1997 and 1996, respectively, at prices ranging from $0.34
to $44.38 were outstanding but not included in the computation of diluted net
income (loss) per share as they were antidilutive.  The Company had 150 thousand
warrants outstanding at September 30, 1998 to purchase common stock, which were
not included, as their effect was antidilutive.

In addition, the Company had $4.9 million and $21.7 million of convertible
Debentures outstanding in 1998 and 1997, respectively, which were convertible
into approximately 1.2 million and 990 thousand shares of common stock but were
not included in the computation of diluted net income (loss) per share as they
were antidilutive.

Income Taxes:

The provision (benefit) for income taxes for the years ended September 30, 1998,
1997 and 1996 is as follows:


                              Page 49
<PAGE>
<TABLE>
<CAPTION>
                                       1998      1997      1996
                                     -------   -------   -------
<S>                                  <C>       <C>       <C>
   Current expense:
     Federal                         $     -   $     -   $    77
     State                                 -         -        23
     Foreign                             189         -         -
                                     -------   -------   -------
                                         189         -       100
   Deferred tax expense (benefit):
     Federal                           5,397    (3,989)    2,091
     State                               914      (514)      288
                                     -------   -------   -------
                                     $ 6,500   $(4,503)  $ 2,479
                                     =======   =======   =======
</TABLE>

The Company's effective tax rate for the years ended September 30, 1998 and 
1997 differs from the U.S. federal statutory income tax rate as follows:

<TABLE>
<CAPTION>
                                                    1998      1997      1966
                                                   -----     -----     -----
  <S>                                              <C>       <C>        <C>
  Federal income tax (benefit) at statutory rate   (34.0)%   (34.0)%    34.0%
  State taxes, net of federal benefit               (3.4)     (4.1)      6.1
  Tax credits                                       (1.5)     (2.3)     (2.7)
  Non-deductible interest expense                      -       5.1         -
  Other, net                                         2.4       3.6       0.6
  Change in valuation allowance                     61.0      11.2         -
                                                   -----     -----     -----
                                                    24.5%    (20.5)%    38.0%
                                                   =====     =====     =====
</TABLE>

The following table shows the major components of the deferred tax asset as of
September 30, 1998 and 1997:

<TABLE>
<S>                                           <C>        <C>
Deferred tax assets and liabilities:
  Current:
    Accounts receivable, inventory and 
      other reserves                          $ 1,634    $ 1,109
    Accrued liabilities                            45        330
    Net operating losses                       13,597      3,975
    Tax credit carryforwards                    3,399      2,391
    Other                                           -        981
                                              -------    -------
    Total before valuation allowance           18,675      8,786
    Valuation allowance                       (18,675)    (2,475)
                                              -------    -------
    Net deferred tax asset                    $     -    $ 6,311
                                              =======    =======
</TABLE>

                              Page 50
<PAGE>
At September 30, 1998, the Company has federal and state net operating loss
("NOL") carryforwards of $37.7 million and $13.2 million, respectively, to
reduce future taxable income.  The Company has federal and state general
business credit carryforwards of $2.3 million and $0.9 million, respectively, to
reduce future taxable income.  These carryforwards expire in 1999 through 2013
if not utilized.

In addition, the Company has $6.3 million of NOLs related to stock option
exercises, the benefit of which will be credited to equity when utilized.

Due to the net loss incurred in fiscal year 1998, accumulated deficit and lack
of alternative tax planning strategies, there is uncertainty surrounding the
realization of the favorable tax attributes in future tax returns.  Accordingly,
the Company has placed a valuation allowance against its otherwise recognizable
net deferred tax assets.

Research and Development Contract:

During fiscal year 1992, the Company entered into a joint development contract
to develop a product with a third party.  The Company received funding from the
third party based on completion milestones.  In addition, upon completion of the
project, the Company has received a royalty based on sales by the third party of
the product developed.  Royalties totalling approximately $1.5 million, $5.3
million and $14.5 million were received from the third party in fiscal years
1998 1997 and 1996, respectively.  During fiscal year 1998, the Company
negotiated and received the final payment for all royalty obligations from the
third party.

Foreign Operations:

The Company's foreign operations are those of its European branches and
subsidiaries.  All of their sales are made to unaffiliated European customers. 
The following table summarizes the Company's European operations:

<TABLE>
<CAPTION>
                                     1998       1997      1996
                                   -------    -------    ------
<S>                                <C>        <C>        <C>
     Net sales                     $ 8,123    $ 4,530    $2,924
     Operating income (loss)        (2,972)    (1,080)      585
     Total assets                    3,195      6,693     1,368
</TABLE>


                              Page 51
<PAGE>
Export Sales:

Export sales from domestic operations were $3.4 million, $2.2 million and $1.4
million in 1998, 1997 and 1996, respectively.

Major Customers:

There were no sales to one customer that exceeded 10% of net sales in 1998. 
Sales to one customer amounted to 14.6% of net sales in 1997.  Sales to two
customers amounted to 13% and 11.8% of net sales in 1996.

Subsequent Events:

Definitive Merger Agreement

On October 5, 1998, the Company signed a definitive agreement to acquire the
remaining 68.7% of MatriDigm Corporation ("MatriDigm") not currently owned in a
tax-free exchange of stock, which would be accounted for as a purchase
combination.  The MatriDigm shareholders would receive approximately 0.65 share,
of a newly created company, for each MatriDigm share they currently own.  The
merger is subject to the approval of the shareholders of the Company and
MatriDigm and regulatory approval.  Under the definitive agreement, the Company
committed to fund the working capital needs of MatriDigm from October 5, 1998
through the date of the closing of the merger, which was expected to be in early
calendar year 1999.  On December 21, 1998, the Company and MatriDigm terminated
the definitive agreement to acquire the remaining portion of MatriDigm not
already owned.  The Company and MatriDigm have restructured the transaction to
provide for the exchange of the fully reserved MatriDigm notes held by the
Company at September 30, 1998 of $2.0 million and $1.2 million notes receivable
subsequent to year end plus accrued interest into equity in MatriDigm.  Upon
completion of the exchange, the Company's ownership will increase to
approximately 58% on a fully converted basis.  (See "Investment in
Unconsolidated Company" for additional information about MatriDigm.)


                              Page 52
<PAGE>
                Report of Independent Accountants



December 16, 1998


To the Board of Directors and Shareholders
Zitel Corporation

In our opinion, the accompanying consolidated balance sheets and the related 
consolidated statements of operations, of shareholders' equity and of cash 
flows present fairly, in all material respects, the financial position of 
Zitel Corporation and subsidiaries at September 30, 1998 and 1997, and the 
results of their operations and their cash flows for each of the three years 
in the period ended September 30, 1998, in conformity with generally accepted 
accounting principles.  These financial statements are the responsibility of 
the Company's management; our responsibility is to express an opinion on 
these financial statements based on our audits.  We conducted our audits of 
these statements in accordance with generally accepted auditing standards 
which 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, assessing 
the accounting principles used and significant estimates made by management, 
and evaluating the overall financial statement presentation. We believe that 
our audits provide a reasonable basis for the opinion expressed above.

                    /s/ PricewaterhouseCoopers LLP
                    ------------------------------
                    PricewaterhouseCoopers LLP

                              Page 53
<PAGE>
Item 9:  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
         ACCOUNTING AND FINANCIAL DISCLOSURE

     None.

                            PART III

Item 10:  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information regarding directors under the caption "Election of Directors" of
the Proxy Statement for the Annual Meeting of Shareholders to be held March 4,
1999, is incorporated herein by reference.  The information regarding executive
officers under the caption "Executive Officers of the Registrant" is included
herein on page 18.

Item 11:  EXECUTIVE COMPENSATION

The information under the caption "Executive Compensation" of the Proxy
Statement for the Annual Meeting of Shareholders to be held on March 4, 1999, is
incorporated herein by reference.

Item 12:  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
          MANAGEMENT

The information under the caption "Security Ownership of Certain Beneficial
Owners and Management" of the Proxy Statement for the Annual Meeting of
Shareholders to be held on March 4, 1999, is incorporated herein by reference.

Item 13:  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     None.

                             PART IV

Item 14:  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
          FORM 8-K

     (a)  Financial Statements and Schedules

          The consolidated financial statements, together with the report
thereon from PricewaterhouseCoopers LLP, appear in Item 8 in this Form 10-K. 
Financial statement schedules not included in this Form 10-K have been omitted
because they are not applicable or the required information is shown in the
financial statements or the notes thereto.

                              Page 54
<PAGE>
          (1)  Financial Statements:

ZITEL CORPORATION:

  Consolidated Balance Sheets of Zitel Corporation (p. 29)
  Consolidated Statements of Operations of Zitel Corporation 
    (p. 30)
  Consolidated Statements of Shareholders' Equity of Zitel
    Corporation (p. 31)
  Consolidated Statements of Cash Flows of Zitel Corporation
    (p. 32)
  Notes to Consolidated Financial Statements of Zitel Corporation
    (pgs. 33-52)
  Report of Independent Accountants of Zitel Corporation (p. 53)

MATRIDIGM CORPORATION (a significant unconsolidated company):
    See pages F-1 thru F-23

          (2)  Financial Statement Schedules:

  Report of Independent Accountants (p. 65)
  SCHEDULE VIII-Valuation and Qualifying Accounts (p. 66)

          (3)  Exhibits

               Exhibits filed as part of this report are listed
               below.  Certain exhibits have been previously
               filed with the Commission and are incorporated by
               reference.
<TABLE>
<CAPTION>
Exhibit
Number                       Description
-------                      -----------
<S>           <C>
 3.1          Restated Articles of Incorporation. (7)

 3.2          Bylaws. (2)

10.1          1982 Incentive Stock Option Plan, as amended, and form of Stock
              Option Grant. (3)

10.2          1984 Supplemental Stock Option Plan and form of Stock Option
              Grant. (3)

10.3          1984 Stock Purchase Plan, as amended through November 1987. (7)

10.4          Agreement dated February 27, 1979 among Robert H. Welch, Jack
              Melchor, Bernard Wagner, Tony Tadin, John C. Blackie, John J.
              DePalma, James F. Riley and the Company, amended as of 
              November 15, 1979. (1)


                              Page 55
<PAGE>
10.5          Agreement for the Sale and Purchase of Intel Memory Product 
              Lines dated as of February 2, 1983 between the Company and 
              Intel Corporation, and amendments dated March 16, 1983, April 
              22, 1983,  June 23, 1983 and October 25, 1983 (portions 
              deleted pursuant to a Confidentiality Order). (1)

10.6          Stock Purchase Agreement dated September 29, 1980 between the 
              Company and Oxford Venture Fund, Oxford Venture (California) 
              Fund II, and Oxford Venture Offshore Fund. (1)

10.7          Stock Purchase Agreement dated June 2, 1983 between the 
              Company and Oxford Venture Fund, Oxford Venture (California) 
              Fund II, and Oxford Venture Offshore Fund. (1)

10.8          Agreement dated as of October 1, 1983 between the Company and 
              Motorola, Inc. (portions deleted pursuant to a Confidentiality 
              Order). (1)

10.9          Agreement and Plan of Reorganization among the Company, Zitel 
              Merger Corporation and Gifford Computers Systems, Inc. (4)

10.10         Agreement for Purchase and Sale of Assets dated as of November 
              1, 1985 between the Company and React Corporation with 
              Exhibits (portions deleted pursuant to a Confidentiality 
              Order). (5)

10.11         Agreement for Purchase and Sale of Marketing Rights dated as 
              of June 8, 1986 between the Company and React Corporation 
              (portions deleted pursuant to a Confidentiality Order). (6)

10.12         Lease agreement dated February 7, 1986 between the Company, 
              John Arrillaga, Trustee, and Richard T. Peery, Trustee. (7)

10.13         Senior Management Incentive Plan (SMIP) dated November 18, 
              1987. (8)

10.14         Unisys Cooperative Marketing Agreement dated April 13, 1990 
              between the Company and Unisys Corporation and Amendment One 
              effective October 25, 1990. (The Company has applied for 
              confidential treatment of a portion of this Exhibit.) (9)

10.15         Amendment Two to the Unisys Cooperative Marketing Agreement 
              effective February 5, 1991. (10)

10.16         Amendment Three to the Unisys Cooperative Marketing Agreement 
              effective March 31, 1991. (10)

                              Page 56
<PAGE>


10.17         Amendment Four to the Unisys Cooperative Marketing Agreement 
              effective June 30, 1991. (10)

10.18         Sublease agreement dated August 11, 1992 between the Company 
              and Credence Systems Corporation. (11)

10.19         Loan and Security Agreement dated August 2, 1993 between the 
              Company and IBM Credit Corporation. (12)

10.20         Development Agreement between the Company and IBM Corporation 
              dated October 14, 1992.  (Confidential treatment has been 
              requested for a portion of the exhibit.) (13)

10.21         Amendment No. 1 dated June 23, 1993 to the Development 
              Agreement between the Company and IBM Corporation dated 
              October 14, 1992.  (Confidential treatment has been requested 
              for a portion of the exhibit.) (13)

10.22         Amendment No. 2 dated July 26, 1993 to the Development 
              Agreement between the Company and IBM Corporation dated 
              October 14, 1992.  (Confidential treatment has been requested 
              for a portion of the exhibit.) (13)

10.23         Amendment No. 3 dated November 29, 1993 to the Development 
              Agreement between the Company and IBM Corporation dated 
              October 14, 1992.  (Confidential treatment has been requested 
              for a portion of the exhibit.) (13)

10.24         Amendment No. 4 dated April 15, 1994 to the Development 
              Agreement between the Company and IBM Corporation dated 
              October 14, 1992.  (Confidential treatment has been requested 
              for a portion of the exhibit.) (13)

10.25         Loan and Security Agreement, dated as of September 30, 1994, 
              between the Company and CoastFed Business Credit Corporation. 
              (14)

10.26         Accounts Collateral Security Agreement, dated as of September 
              30, 1994, between the Company and CoastFed Business Credit 
              Corporation. (14)

10.27         Lease Agreement dated February 16, 1995 between the Company 
              and Renco Investment Company. (15)

10.28         Series A Preferred Stock Purchase Agreement between the 
              Company and MatriDigm Corporation dated November 17, 1995.  
              (Confidential treatment has been requested for a portion of 
              the 

                              Page 57
<PAGE>
              exhibit.  The confidential portion has been omitted and filed 
              separately with the Commission.) (16)

10.29         Rights Agreement, dated as of June 12, 1996, between Zitel 
              Corporation and American Stock Transfer & Trust Company, with 
              exhibits. (17)

10.30         Preferred Stock Purchase and Put Option among MatriDigm 
              Corporation, BRC Holdings, Inc., and the Company dated 
              December 2, 1996. (18)

10.31         Sales Representative Agreement between MatriDigm Corporation 
              and the Company dated August 22, 1996. (19)

10.32         Form of Convertible Subordinated Debenture. (20)

10.33         Registration Rights Agreement. (20)

10.34         Securities Purchase Agreement. (20)

10.35         Placement Agency Agreement. (20)

10.36         Asset Purchase Agreement dated as of June 25, 1997, by and 
              among Zitel World Trade, Datametrics Systems Corporation and 
              John C. Kelly. (21)

10.37         Asset Purchase Agreement dated as of June 30,1997, by and 
              among Zitel Corporation, Zitel Limited, Palmer & Webb Systems 
              Limited, Reginald Webb and Julian Palmer and Moebius Business 
              Training Limited. (21)

10.38         Stock Purchase Agreement dated as of June 30, 1997, by and 
              among Zitel Corporation, Zitel World Trade, Hell Sails B.V. 
              and Palmer and Webb Systems B.V. (21)

10.39         Lease Office Building for One Monument Place between Upland 
              Industrities Corporation and Collins Equities, Inc. and 
              Datametrics Systems Corporation dated July 31,1992. (21)

10.40         First Amendment to Lease between CMD Realty Investment Fund, 
              L.P. and Datametrics Systems Corporation dated October 16, 
              1996. (21)

10.41         Form of Palmer & Webb Lease. (21)

10.42         Form of Convertible Subordinated Debenture. (22)

                              Page 58
<PAGE>
10.43         Form of Common Stock Purchase Warrant. (22)

10.44         Registration Rights Agreement. (22)

10.45         Securities Purchase Agreement. (22)

10.46         Placement Agency Agreement. (22)

10.47         Agreement and Plan of Reorganization and Merger, dated as of 
              October 5, 1998, by and among Zitel Corporation, Millennium 
              Holding Corp., Zenith Acquisition Corp., Millennium 
              Acquisition I Corp., and MatriDigm Corporation. (23)

10.48         Form of Shareholder Agreement, dated as of October 5, 1998, by 
              and between, in each case, Zitel Corporation and a certain 
              specified shareholder of MatriDigm Corporation. (23)

10.49         Form of Lock-Up Letter, dated as of October 5, 1998, 
              addressed, in each case, to Millennium Holding Corp. from a 
              certain specified shareholder of MatriDigm Corporation. (23)

10.50         Selected Summary Financial Data for the period ended June 30,1998. (23)

10.51         Joint Press Release of Zitel Corporation and MatriDigm 
              Corporation, dated October 5, 1998. (23)

22.1          Subsidiaries of the Company.

23.1          Consent of Independent Accountants.

23.2          Consent of Independent Accountants.

27            Financial Data Schedule.
</TABLE>
----------
 (1)  Incorporated by reference to the indicated exhibits to the Company's 
Registration Statement on Form S-1 (File No. 2-87445) filed on October 27, 
1983.

 (2)  Incorporated by reference to the indicated exhibits to the Company's 
Registration Statement on Form S-8 (File No. 2-90366) filed on April 6, 1984.

 (3)  Incorporated by reference to the indicated exhibits to the Company's 
Registration Statement on Form S-8 (File No. 2-96804) filed on March 29, 1985.

                              Page 59
<PAGE>
 (4)  Incorporated by reference to the indicated exhibits to the Company's 
Current Report on Form 8-K filed on September 20, 1984.

 (5)  Incorporated by reference to the indicated exhibits to the Company's
Annual Report on Form 10-K filed December 18, 1985.

 (6)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed August 14, 1986.

 (7)  Incorporated by reference to the indicated exhibits to the Company's 
Annual Report on Form 10-K filed December 17, 1987.

 (8)  Incorporated by reference to the indicated exhibits to the Company's 
Annual Report on Form 10-K filed December 21, 1988.

 (9)  Incorporated by reference to the indicated exhibits to the Company's 
Annual Report on Form 10-K filed December 20, 1990.

(10)  Incorporated by reference to the indicated exhibits to the Company's 
Annual Report on Form 10-K filed December 20, 1991.

(11)  Incorporated by reference to the indicated exhibits to the Company's 
Annual Report on Form 10-K filed December 18, 1992.

(12)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed August 13, 1993.

(13)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed May 13, 1994.

(14)  Incorporated by reference to the indicated exhibits to the Company's 
Annual Report on Form 10-K filed December 22, 1994.

(15)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed May 11, 1995.

(16)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed February 13, 1996 and Form 10-QA filed on 
December 16, 1996.

(17)  Incorporated by reference to the indicated exhibits to the Company's 
Current Report on Form 8-K filed on June 25, 1996.

(18)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed February 12, 1997.

                              Page 60
<PAGE>
(19)  Incorporated by reference to the indicated exhibits to the Company's 
Quarterly Report on Form 10-Q filed May 14, 1997.

(20)  Incorporated by reference to the indicated exhibits to the Company's 
Current Report on Form 8-K filed May 29, 1997.

(21)  Incorporated by reference to the indicated exhibits to the Company's 
Current Report on Form 8-K filed July 14, 1997.

(22)  Incorporated by reference to the indicated exhibits to the Company's 
Current Report on Form 8-K filed June 25, 1998.

(23)  Incorporated by reference to the indicated exhibits to the Company's 
Current Report on Form 8-K filed October 6, 1998.

      (b) Reports on Form 8-K

         Date of Report - Item(s) Reported:

         July 10, 1998 - Other events - Adoption of 
         Statement of Financial Accounting Standards ("SFAS") 
         No. 128 - presentation of basic and diluted net income
         per share.

         October 6, 1998 - Entered into an Agreement and Plan
         of Reorganization and Merger, dated as of October 5,
         1998, by and among the Company, Millennium Holding
         Corp., a Delaware corporation and a wholly owned
         subsidiary of the Company ("Holdco"), Zenith 
         Acquisition Corp., a Delaware corporation and a wholly
         owned subsidiary of Holdco ("Zenith Acquisition"),
         Millennium Acquisition I Corp., a Delaware corporation
         and a wholly owned subsidiary of Holdco ("Millennium
         Acquisition"), and MatriDigm Corporation, a California
         corporation("MatriDigm").

For the purposes of complying with the amendments to the rules governing Form 
S-8 under the Securities Act of 1933, the undersigned Registrant hereby 
undertakes as follows, which undertaking shall be incorporated by reference 
into Registrant's Registration Statements on Form S-8 No.'s 33-40361 and 
33-47697 (filed May 3, 1991 and May 6, 1992).

Insofar as indemnification for liabilities arising under the Securities Act 
of 1933 may be permitted to directors, officers and controlling persons of 
the Registrant pursuant to the 

                              Page 61
<PAGE>
foregoing provisions, or otherwise, the Registrant has been advised that in 
the opinion of the Securities and Exchange Commission such indemnification is 
against public policy as expressed in the Securities Act of 1933 and is, 
therefore, unenforceable.  In the event that a claim for indemnification 
against such liabilities (other than the payment by the Registrant of 
expenses incurred or paid by a director, officer or controlling person of the 
Registrant in the successful defense of any action, suit or proceeding) is 
asserted by such director, officer or controlling person in connection with 
the securities being registered, the Registrant will, unless in the opinion 
of its counsel the matter has been settled by controlling precedent, submit 
to a court of appropriate jurisdiction the question whether such 
indemnification by it is against public policy as expressed in the Act and 
will be governed by the final adjudication of such issue.

                              Page 62
<PAGE>
                           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.

                              ZITEL CORPORATION




                                   /s/ Jack H. King
                              By:  Jack H. King
                                   President and Director
                                   Chief Executive Officer
                                   December 23, 1998



KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Jack H. King and Larry B. Schlenoff, jointly and
severally, his or her attorneys-in-fact, each with the power of substitution,
for him or her in any and all capacities, to sign any amendments to this Report
on Form 10-K, and to file the same, with exhibits thereto and other documents in
connection herewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said attorneys-in-fact, or his
substitute or substitutes, may do or cause to be done by virtue hereof.



                              Page 63

<PAGE>

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/ Jack H. King          President and Director      December 23, 1998
----------------------    (Chief Executive Officer)
Jack H. King        


/s/ Larry B. Schlenoff    Vice President of           December 23, 1998
----------------------    Finance, Chief Financial
Larry B. Schlenoff        Officer and Secretary


/s/ Anna M. McCann        Vice President and          December 23, 1998
----------------------    Chief Accounting Officer
Anna M. McCann           


/s/ Catherine P. Lego     Director                    December 23, 1998
----------------------
Catherine P. Lego


/s/ William R. Lonergan   Director                    December 23, 1998
-----------------------
William R. Lonergan



/s/ William M. Regitz     Director                    December 23, 1998
-----------------------
William M. Regitz


/s/ Robert H. Welch       Director                    December 23, 1998
-----------------------
Robert H. Welch
</TABLE>


                              Page 64

<PAGE>

                REPORT OF INDEPENDENT ACCOUNTANTS



To the Shareholders and Board of Directors
Zitel Corporation
Fremont, California

Our audit of the consolidated financial statements of Zitel Corporation and
Subsidiaries referred to in our report dated December 16, 1998 appearing in Item
8 in this Annual Report on Form 10-K also included an audit of the financial
statement schedule listed in Item 14a of this Form 10-K.

In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information required to be
included therein.



/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
San Jose, California
December 16, 1998



                              Page 65

<PAGE>

                                                                 SCHEDULE VIII

                           ZITEL CORPORATION

                   VALUATION AND QUALIFYING ACCOUNTS
                    FISCAL YEARS 1996, 1997 AND 1998

<TABLE>
<CAPTION>
   Column A                    Column B     Column C    Column D     Column E
   --------                   ----------  -----------  ----------   ----------
                                           Additions
                                          Charged to
                                Balance     Revenues   Write-offs   Balance at
                               Beginning   and Costs      and         End of
  Description                  of Period  and Expense  Deductions     Period
  -----------                 ----------  -----------  ----------  -----------

<S>                           <C>         <C>          <C>         <C>
1996
--------------
Allowance for Doubtful
  Accounts                    $   88,000  $         -  $       -   $    88,000

Provision for Obsolete
  Inventory                   $  309,000  $   480,000  $ 289,000   $   500,000

Valuation Allowance on 
  Deferred Tax Assets         $        -  $         -  $       -   $         -

Reserve for excess capacity   $        -  $         -  $       -   $         -

1997
--------------
Allowance for Doubtful
  Accounts                    $   88,000  $    87,000  $       -   $   175,000

Provision for Obsolete
  Inventory                   $  500,000  $   480,000  $ 341,000   $   639,000

Valuation Allowance on
  Deferred Tax Assets         $        -  $ 2,475,000  $       -   $ 2,475,000

Reserve for excess capacity   $        -  $         -  $       -   $         -

1998
--------------
Allowance for Doubtful
  Accounts                    $  175,000  $   122,000  $ 175,000   $   122,000

Provision for Obsolete
  Inventory                   $  639,000  $   160,000  $ 798,000   $         -

Valuation Allowance on
  Deferred Tax Assets         $2,475,000  $16,200,000  $       -   $18,675,000

Reserve for excess capacity   $        -  $   750,000  $ 225,000   $   525,000
</TABLE>


                              Page 66


<PAGE>


                        MatriDigm Corporation

                    Index to Financial Statements



<TABLE>
<CAPTION>
                                                           PAGE
<S>                                                        <C>
Report of Independent Accountants ......................... F-2

Balance Sheet as of September 30, 1997 and 1998 ........... F-3

Statement of Operations for the period 
  August 9, 1995 (date of inception) to 
  September 30, 1996, and for the years ended
  September 30, 1997 and 1998 ............................. F-4

Statement of Changes in Shareholders' Equity (Deficit)
  for the periods ended September 30, 1996, 1997 and 1998.. F-5

Statement of Cash Flows for the period August 9, 1995
  (date of inception) to September 30, 1996, and for
  the years ended September 30, 1997 and 1998 ............. F-6

Notes to Financial Statements ............................. F-7
</TABLE>



                             Page F-1

<PAGE>

                Report of Independent Accountants


To the Board of Directors and
the Shareholders of MatriDigm Corporation

In our opinion, the accompanying balance sheet and the related statements of
operations, of changes in shareholders' (deficit) equity and of cash flows
present fairly, in all material respects, the financial position of MatriDigm
Corporation at September 30, 1998 and 1997, and the results of its operations
and its cash flows for the years ended September 30, 1998 and 1997 and for the
period from August 9, 1995 (date of inception) to September 30, 1996, in
conformity with generally accepted accounting principles.  These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits.  We conducted our audits of these statements in accordance with
generally accepted auditing standards which 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,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation.  We
believe that our audits provide a reasonable basis for the opinion expressed
above.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern.  As discussed in Note 12 to the
financial statements, the Company has suffered recurring losses from operations
and has a net capital deficiency that raise substantial doubt about its ability
to continue as a going concern.  Management's plans in regard to these matters
are also described in Note 12.  The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.



PricewaterhouseCoopers LLP

Dallas, Texas
December 21, 1998




                             Page F-2

<PAGE>

MatriDigm Corporation
Balance Sheet

<TABLE>
<CAPTION>
                                                                    September 30,
                                                            -------------------------
                                                                 1998         1997   
                                                            ------------  -----------
<S>                                                         <C>           <C>
ASSETS
Current assets:
  Cash and cash equivalents                                 $    704,885  $ 3,106,938
  Restricted cash                                                 68,606      608,606
  Accounts receivable, net of allowance for doubtful
   accounts of $96,738 at September 30, 1998                   1,134,223       79,050
  Inventory                                                      125,529            -
  Prepaid expenses and other current assets                      126,913       21,898
                                                            ------------  -----------
  Total current assets                                         2,160,156    3,816,492

Property and equipment, net                                    2,890,007    3,589,658
Technology rights, net                                           213,632      301,353
Deferred financing costs, net                                    200,000            -
Other assets                                                      59,646      117,144
                                                            ------------  -----------
    Total assets                                            $  5,523,441  $ 7,824,647
                                                            ============  ===========

LIABILITIES AND SHAREHOLDERS' (DEFICIT) EQUITY
Current liabilities:
  Accounts payable                                          $    578,107  $   231,729
  Accrued compensation and benefits                              942,001      588,887
  Accrued other liabilities                                      450,329      261,265
  Deferred revenue to shareholder                                434,392            -
  Notes payable                                                3,005,666            -
  Notes payable to shareholder                                 2,000,000            -
  Current portion of long-term debt                              579,865      452,094
                                                            ------------  -----------
    Total current liabilities                                  7,990,360    1,533,975
Long-term debt                                                   172,111      478,575
Subordinated convertible note payable to shareholder           5,000,000    5,000,000
                                                            ------------  -----------
    Total liabilities                                         13,162,471    7,012,550
                                                            ------------  -----------

Commitments                                                            -            -
Shareholders' (deficit) equity:
 Convertible preferred stock, no par value
  Authorized:  30,000,000 shares;
   Series A; issued and outstanding:  9,600,000 shares;
   liquidation value:  $3,500,000                              3,566,471    3,566,471
   Series B; issued and outstanding:  2,000,000 shares;
   liquidation value:  $1,500,000                              1,500,000    1,500,000
   Series D; issued and outstanding:  2,000,000 shares;
   liquidation value:  $4,000,000                              4,000,000    4,000,000
 Common stock, no par value, stated value $.01 per share;
  authorized:  100,000,000 shares; issued and outstanding:
  21,335,602 and 20,372,010 shares for 1998 and 1997, 
  respectively                                                   213,356      203,720
 Additional paid-in capital                                   13,186,006    8,036,323
 Note receivable from shareholder                                (31,800)     (42,400)
 Accumulated deficit                                         (30,073,063) (16,452,017)
                                                            ------------  -----------
    Total shareholders' (deficit) equity                      (7,639,030)     812,097
                                                            ------------  -----------
    Total liabilities and shareholders' (deficit) equity    $  5,523,441  $ 7,824,647
                                                            ============  ===========
</TABLE>

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



                             Page F-3

<PAGE>

MatriDigm Corporation
Statement of Operations

<TABLE>
<CAPTION>
                                                      
                                                             For the Period
                                   For the Year Ended        August 9, 1995
                                       September 30,      (date of inception)
                               --------------------------   to September 30,
                                    1998          1997             1996      
                               ------------  ------------ -------------------
<S>                            <C>           <C>          <C>
Sales                          $  5,478,549  $    123,162      $         -
                               ------------  ------------      -----------
Operating expenses:
  Cost of sales                   3,284,226        85,486                -
  General and administrative      6,640,134     5,883,235          561,976
  Research and development        6,649,907     7,003,032        1,237,515
  Sales and marketing             2,160,217     1,790,442          205,585
                               ------------  ------------      -----------
    Total operating expenses     18,734,484    14,762,195        2,005,076
                               ------------  ------------      -----------
    Loss from operations        (13,255,935)  (14,639,033)      (2,005,076)

Interest income and other            94,038       179,889          132,197
Interest expense                   (459,149)     (119,994)               -
                               ------------  ------------      -----------
    Net loss                   $(13,621,046) $(14,579,138)     $(1,872,879)
                               ============  ============      ===========

Weighted average common
 shares outstanding              20,649,554    19,115,068       14,038,462
                               ------------  ------------      -----------

Basic and diluted net loss
  per common share             $      (0.66) $      (0.76)     $     (0.13)
                               ============  ============      ===========
</TABLE>


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


                             Page F-4

<PAGE>

MatriDigm Corporation
Statement of Changes in Shareholders' (Deficit) Equity

<TABLE>
<CAPTION>
                                                                                              Note
                             Convertible Preferred Stock     Common Stock     Additional   Receivable
                             --------------------------- -------------------    Paid-in       from      Accumulated
                                     Shares     Amount     Shares    Amount     Capital    Shareholder    Deficit       Total   
                                   ---------- ---------- ---------- -------- ------------   ---------   ------------  -----------
<S>                                <C>        <C>        <C>        <C>      <C>           <C>          <C>           <C>
Common stock issuances                      - $        - 16,000,000 $160,000 $          -   $ (53,000)  $          -  $   107,000

Series A preferred stock
 issuances, net                     9,600,000  3,562,995          -        -            -           -              -    3,562,995

Series B preferred stock
 issuances, net                     2,000,000  1,500,000          -        -            -           -              -    1,500,000

Net loss                                    -          -          -        -            -           -     (1,872,879)  (1,872,879)
                                   ---------- ---------- ---------- --------  -----------   ---------   ------------  -----------
Balance, September 30, 1996        11,600,000  5,062,995 16,000,000  160,000            -     (53,000)    (1,872,879)   3,297,116

Common stock issuances, net                 -          -  3,912,019   39,120    7,589,965           -              -    7,629,085

Stock option exercises, net                 -          -    459,991    4,600      166,358           -              -      170,958

Series D preferred stock
 issuances, net                     2,000,000  4,000,000          -        -            -           -              -    4,000,000

Other                                       -      3,476          -        -      280,000      10,600              -      294,076

Net loss                                    -          -          -        -            -           -    (14,579,138) (14,579,138)
                                   ---------- ---------- ---------- --------  -----------   ---------   ------------  -----------
Balance, September 30, 1997        13,600,000  9,066,471 20,372,010  203,720    8,036,323     (42,400)   (16,452,017)     812,097


Common stock issuances, net                 -          -    400,272    4,003      561,572           -              -      565,575

Stock option exercises, net                 -          -    162,267    1,622       99,096           -              -      100,718

Conversion of notes payable                 -          -    401,053    4,011    4,006,515           -              -    4,010,526

Warrant issuances                           -          -          -        -      482,500           -              -      482,500

Other                                       -          -          -        -            -      10,600              -       10,600

Net loss                                    -          -          -        -            -           -    (13,621,046) (13,621,046)
                                   ---------- ---------- ---------- --------  -----------   ---------   ------------  -----------
Balance, September 30, 1998        13,600,000 $9,066,471 21,335,602 $213,356  $13,186,006    $(31,800)  $(30,073,063) $(7,639,030)
                                   ========== ========== ========== ========  ===========   =========   ============  ===========
</TABLE>

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



                             Page F-5


<PAGE>

MatriDigm Corporation
Statement of Cash Flows

<TABLE>
<CAPTION>
                                                                             For the Period
                                                                             August 9, 1995
                                                     For the Year Ended    (date of inception)
                                                        September 30,        to September 30,
                                                     1998          1997            1996     
                                                ------------  ------------ -------------------
<S>                                             <C>           <C>            <C>
Cash flows from operating activities:
 Net loss                                       $(13,621,046) $(14,579,138)   $(1,872,879)
 Adjustments to reconcile net loss to
  net cash used in operating activities:
   Depreciation and amortization                   1,826,917       987,604        134,780
   Noncash expenses incurred                          10,600        14,076          7,000
   Loss (gain) on disposal of 
    property and equipment                            11,232        (2,102)             -
   Changes in current assets and liabilities:
    Accounts receivable                           (1,055,173)      (79,050)             -
    Inventory                                       (125,529)            -              -
    Prepaid expenses and other 
     current assets                                  (71,821)       (1,034)       (20,864)
    Accounts payable                                 346,378        47,518        184,211
    Accrued liabilities and 
     deferred revenue                                976,570       710,364        139,788
                                                ------------  ------------    -----------
    Net cash used in operating 
     activities                                  (11,701,872)  (12,901,762)    (1,427,964)
                                                ------------  ------------    -----------

Cash flows from investing activities:
 Acquisition of property and equipment              (416,800)   (3,066,852)      (552,357)
 Purchase of technology rights                             -             -       (362,174)
 Proceeds from the sale of property
  and equipment                                        2,900       253,752              -
 Decrease (increase) in other assets                   8,600       (80,341)       (63,203)
                                                ------------  ------------    -----------
    Net cash used in investing 
     activities                                     (405,300)   (2,893,441)      (977,734)
                                                ------------  ------------    -----------

Cash flows from financing activities:
 Payments on capital leases                         (566,600)     (160,122)             -
 Proceeds from subordinated 
  convertible note payable                                 -     5,000,000              -
 Proceeds from issuance of 
  convertible preferred stock                              -     4,000,000      4,996,524
 Proceeds from issuance of common stock              666,293     7,800,043              -
 Proceeds from note payable                        9,010,526             -              -
 Payments on notes payable                           (27,600)            -              -
 Other proceeds                                            -       280,000              -
 Proceeds from issuance of stock warrants             82,500             -              -
 Cash deposits for leases                            540,000      (608,606)             -
                                                ------------  ------------    -----------

    Net cash provided by 
     financing activities                          9,705,119    16,311,315      4,996,524
                                                ------------  ------------    -----------
     Net (decrease) increase
      in cash and cash equivalents                (2,402,053)      516,112      2,590,826
Cash and cash equivalents
 Beginning of the period                           3,106,938     2,590,826              -
                                                ------------  ------------    -----------
 End of the period                              $    704,885  $  3,106,938    $ 2,590,826
                                                ============  ============    ===========
</TABLE>

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


                               Page F-6

<PAGE>

Notes to Financial Statements of MatriDigm Corporation

1.   FORMATION AND BUSINESS OF THE COMPANY

MatriDigm Corporation ("the Company" or "MatriDigm") was incorporated in the
state of California in August 1995 to specialize in COBOL maintenance and
reengineering.  For the periods ended September 30, 1996 and 1997, the Company
was in the development stage and devoted substantially all of its efforts to
develop its process, raise capital and recruit personnel.  During the year ended
September 30, 1997, the Company completed development of a process to renovate
COBOL language software code to operate in the Year 2000 and beyond.  Revenue
for the period from August 9, 1995 (date of inception) to September 30, 1997 was
insignificant.  The Company emerged from the development stage during the year
ended September 30, 1998 and has not generated sufficient funds to finance
operations as discussed in Note 12.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation:

The accompanying financial statements have been prepared in conformity with
generally accepted accounting principles.

Cash and cash equivalents:

Cash and cash equivalents consist primarily of demand deposits.  Cash
equivalents are defined as highly liquid instruments with original maturities of
three months or less.  The restricted cash balance represents time deposits
which are restricted under letters of credit.  The letters of credit are
maintained  to satisfy requirements under leases.

Fair value of financial instruments:

Carrying amounts of certain of the Company's financial instruments, including
cash and cash equivalents, accounts payable and other accrued liabilities,
approximate fair value due to their short maturities.  The fair value of the
subordinated convertible note payable to shareholder of $4,800,000 at September
30, 1998 is estimated based on discounted cash flows using the Company's
incremental borrowing rate.

Property and equipment:

Property and equipment is stated at cost, net of accumulated 


                             Page F-7

<PAGE>

depreciation and amortization.  Depreciation is recorded on a straight-line
basis over the estimated useful lives.  Leasehold improvements are capitalized
and amortized over the lesser of the life of the lease or the estimated useful
life of the asset.  The carrying value and estimated useful lives of property
and equipment are evaluated annually to determine whether current events and
circumstances indicate an adjustment is warranted.

The estimated useful lives for such assets are as follows:

<TABLE>
<S>                                               <C>
     Furniture and fixtures                       3 years
     Purchased computer software and equipment    7 years
     Leasehold improvements                       7 years
</TABLE>

Technology rights:

The cost of acquiring the technology which is the basis for the COBOL language
software code renovation process has been capitalized and are being amortized on
a straight-line basis over an estimated useful life of five years.  The carrying
value and amortization period of the technology rights are evaluated annually to
determine whether current events and circumstances indicate an adjustment is
warranted.  Accumulated amortization was $248,542 and $160,821 at September 30,
1998 and 1997, respectively.

Deferred financing costs:

Financing costs are capitalized and amortized over the life of the financing
agreement.  Accumulated amortization was $200,000 as of September 30, 1998.

Deferred revenue:

Deferred revenue represents the balance of prepayments made by a shareholder for
code renovation for which revenue has not yet been recognized.

Revenue recognition:

The Company's current principal business is providing Year 2000 computer code
renovating (conversion) services, consisting of upgrading or supplementing
software code to enable computer programs to function in the year 2000 and
beyond.  The Company contracts with representatives ("Technology Associates") to
market and distribute code conversion services to its clients.  These Technology
Associates act as independent contractors. 

                             Page F-8

<PAGE>

Revenue is recognized upon shipment of renovated code to a Technology Associate.
Revenue from sales to Technology Associates of the hardware and/or software used
in the code preparation process is recognized upon shipment of the hardware
and/or software.

Research and development:

Research and development expenses are charged to operations as incurred.

Income taxes:

The Company accounts for income taxes under Statement of Financial Accounting
Standards ("SFAS") No. 109, "Accounting for Income Taxes," which prescribes the
use of the liability method.  Under the liability method, deferred tax assets
and liabilities are calculated at the balance sheet date using current tax laws
and rates in effect.  Valuation allowances are recorded when it is more likely
than not that a tax benefit will not be realized prior to the expiration of the
related carryforward periods.

Net loss per share:

Net loss per common share for each period is computed using the weighted average
number of common and common equivalent shares outstanding during the respective
periods. Potentially dilutive common shares which were not considered in the
calculation of diluted net loss per share because to do so would have been
antidilutive include:

<TABLE>
<CAPTION>
                                                 September 30,            
                                     -------------------------------------
                                         1998         1997         1996   
                                     -----------  -----------  -----------
<S>                                  <C>          <C>          <C>
Subordinated convertible note
       payable to shareholder          1,666,667      416,667            -
Convertible preferred stock           13,600,000   13,600,000   11,600,000
Stock options and warrants             6,045,805    3,757,763    3,177,200
                                      ----------   ----------   ----------
                                      21,312,472   17,774,430   14,777,200
                                      ==========   ==========   ==========
</TABLE>

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 reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. 
Actual results could differ from those estimates.

                             Page F-9

<PAGE>

Concentration of credit risk:

Financial instruments that potentially subject MatriDigm to concentration of
credit risk consist primarily of trade accounts receivable.  The Company does
not believe that it is subject to any unusual credit risk beyond the normal
credit risk attendant in its business.

New accounting pronouncements:

In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No.
130, "Reporting Comprehensive Income."  SFAS No. 130 established standards for
the reporting and the display of comprehensive income and its components
(revenues, expenses, gains and losses) in a full set of general-purpose
financial statements.  The Statement requires that all items that are required
to be recognized under accounting standards as components of comprehensive
income be reported in a financial statement that is displayed with the same
prominence as other financial statements.  SFAS No. 130 requires that an
enterprise (a) classify items of other comprehensive income by their nature in a
financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital in the equity section of a statement of financial position.  The
Statement is effective for fiscal years beginning after December 15, 1997. 
Reclassification of financial statements for earlier periods provided for
comparative purposes is required.  The Company adopted SFAS No. 130 for the year
ended September 30, 1998, and it had no impact on the Company's financial
position or results of operations.

In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information."  SFAS No. 131 established standards for
reporting information about operating segments in annual financial statements
and in interim financial reports issued to stockholders.  It also establishes
standards for related disclosures about products and services, geographic areas,
and major customers.  In general, such information must be reported externally
in the same manner used for internal management purposes.  SFAS No. 131 is
effective for financial statements issued for periods beginning after December
15, 1997.  In the initial year of adoption, comparative information for earlier
years must be restated.  Since SFAS No. 131 only requires disclosure of certain
information, its adoption will not affect the Company's financial position or
results of operations.



                             Page F-10

<PAGE>

In October 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2, "Software Revenue
Recognition."  This SOP provided guidance on when revenue should be recognized
and in what amounts for licensing, selling, leasing and otherwise marketing
computer software.  This SOP is effective for transactions entered into in
fiscal years beginning after December 15, 1997.  The Company will adopt SOP 97-2
for the year ending September 30, 1999.  Since the Company's primary activities
do not involve licensing selling, leasing or marketing software, the adoption of
SOP 97-2 is not expected to have a significant impact on the Company's financial
position or results of operations.

In March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use."  This SOP provides guidance on
accounting for the costs of computer software developed or obtained for internal
use.  The SOP is effective for fiscal years beginning after December 15, 1998. 
The provisions of the SOP should be applied to internal-use software costs
incurred, including those projects in progress upon initial application.  Costs
incurred prior to initial application, whether capitalized or not, should not be
adjusted to the amounts that would have been capitalized had the SOP been in
effect when the costs were incurred.  The Company will adopt SOP 98-1 for the
year ending September 30, 1999, and, because there are no projects in progress
or scheduled to be in progress, it is expected to have no impact on the
Company's financial position or results of operations.

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities."  SFAS No. 133 established a new model for
accounting for derivatives and hedging activities and supercedes and amends a
number of existing standards.  SFAS No. 133 is effective for fiscal years
beginning after June 15, 1999, but earlier adoption is permitted.  Upon initial
application, all derivatives are required to be recognized in the statement of
financial position as either assets or liabilities and measured at fair value. 
Recognition of changes in fair value depends on whether the derivative is
designated and qualifies as a hedge, and the type of hedging relationship that
exists.  The Company does not currently, nor does it expect to, hold any
derivative instruments or participate in any hedging activities.

3.   PROPERTY AND EQUIPMENT

Property and equipment is comprised of:

                             Page F-11

<PAGE>

<TABLE>
<CAPTION>
                                                           September 30,    
                                                     -----------------------
                                                         1998       1997    
                                                     ----------- -----------
     <S>                                             <C>         <C>
     Furniture and fixtures                          $   995,369 $   903,551
     Purchased computer software and equipment         3,183,650   2,787,767
     Leasehold improvements                            1,089,322     757,346
                                                     ----------- -----------
                                                       5,268,341   4,448,664
     Less: accumulated depreciation and amortization  (2,378,334)   (859,006)
                                                     ----------- -----------
                                                     $ 2,890,007 $ 3,589,658
                                                     =========== ===========
</TABLE>

Purchased computer equipment includes assets which are subject to capital leases
with an aggregate cost of $1,478,714 and $1,090,791 and accumulated amortization
of $523,317 and $81.940 at September 30, 1998 and 1997, respectively. 
Amortization expense was $441,377 and $81,940 for the year ended September 30,
1998 and 1997, respectively.

4.   NOTES PAYABLE AND LONG-TERM DEBT

Notes payable:

Notes payable is comprised of:

<TABLE>
<CAPTION>
                                                             September 30,   
                                                        ---------------------
                                                           1998       1997   
                                                        ---------- ----------
<S>                                                     <C>        <C>
Note payable to bank due on April 1, 1999; interest
payable quarterly beginning June 30, 1998 at LIBOR
plus 1.125% (7% at September 30, 1998); guaranteed
by three shareholders who were issued 825,000 warrants
in consideration for guaranteeing the note              $3,000,000 $        -

Note payable related to insurance due
in monthly principal installments; final payment due in
November 1998                                                5,666          -
                                                        ---------- ----------
                                                        $3,005,666 $        -
                                                        ========== ==========
</TABLE>

Notes payable to shareholder:

Notes payable to shareholder is comprised of:

<TABLE>
<S>                                                     <C>        <C>
Notes payable to shareholder; due upon demand;
Interest at 7% per annum                                $2,000,000 $        -
                                                        ========== ==========
</TABLE>

Long-term debt and subordinated convertible note payable to shareholder:

Long-term debt and subordinated convertible note payable to shareholder are
comprised of:




                             Page F-12

<PAGE>

<TABLE>
<CAPTION>
                                                                     September 30,    
                                                                ----------------------
                                                                   1998        1997   
                                                                ----------  ----------
<S>                                                             <C>         <C>
Subordinated convertible note payable to shareholder;
interest at 6% per annum through December 31, 1997,
2% per annum effective January 1, 1998; interest payable
on September 30, 1997, then monthly from December 31, 1997; 
principal scheduled for payment in six equal monthly 
installments from September 15, 1998; principal 
payments subordinated to the note payable to bank and 
capital leases; principal convertible into common 
stock at $5.83 per share ($12 at September 30, 1997); 
the capital lessor has not consented to the payment of 
principal during the term of the leases                         $5,000,000  $5,000,000

Capitalized lease obligations at 
 various interest rates                                            751,976     930,669
                                                                ----------  ----------
                                                                 5,751,976   5,930,669
Less: current portion                                             (579,865)   (452,094)
                                                                ----------  ----------
                                                                $5,172,111  $5,478,575
                                                                ==========  ==========
</TABLE>

Interest payments of $367,141 and $119,994 were made during the years ended
September 30, 1998 and 1997, respectively.

Restricted cash of $68,606 and $108,606 at September 30, 1998 and 1997,
respectively, is related to the capital leases. Maturities of capital lease
obligations at September 30, 1998 are:

<TABLE>
    <S>                                      <C>
     1999                                    $579,865
     2000                                     172,111
                                             --------
                                             $751,976
                                             ========
</TABLE>

In December 1997, the Company obtained $4 million of financing from related 
parties as described in Note 10.  This debt was converted into common stock 
at a rate of approximately $1.43 per share during April 1998.  The conversion 
resulted in the issuance of 401,053 shares of common stock and the 
contribution and reissuance of 2,406,315 of founders' shares.

In October 1998, the subordinated convertible note payable to shareholder was
amended as described in Note 13.

In December 1998, the Company agreed to exchange the notes payable to
shareholder for stock as described in Note 13.

5.   INCOME TAXES

     The components of deferred tax assets are:




                              Page F-13

<PAGE>

<TABLE>
<CAPTION>
                                                         September 30,     
                                                  -------------------------
                                                      1998          1997   
                                                  ------------  -----------
<S>                                               <C>           <C>
Net operating loss                                $  5,920,494  $ 2,742,500
Capitalized research and development costs (net)     4,182,422    2,900,500
Credits for research activities                      1,188,740      499,200
Other, net                                             407,637      110,600
                                                  ------------  -----------

Net deferred tax assets                             11,699,293    6,252,800
Less: valuation allowance                          (11,699,293)  (6,252,800)
                                                  ------------  -----------
                                                  $          -  $         -
                                                  ============  ===========
</TABLE>

The Company has established a valuation allowance to the extent of its deferred
tax assets since it is presently more likely than not that a tax benefit will
not be realized prior to the expiration of the related carryforward periods.

A reconciliation of the income tax provision to the amount computed by applying
the federal statutory benefit rate to the net loss follows:

<TABLE>
<CAPTION>
                                       For the Year Ended   For the Period
                                         September 30,          Ended     
                                       ------------------    September 30,
                                          1998    1997           1996     
                                          ----    ----      --------------
<S>                                     <C>       <C>          <C>
Federal statutory benefit rate           (35%)    (35%)         (35%)
State income tax provision, net of
   federal tax benefit                     -        -            (4%)
Research and development credit           (5%)     (3%)           -
Other, net                                 -        -            (1%)
Net operating loss not benefited          40%      38%           40%
                                         ---      ---           ---
                                           -        -             -
                                         ===      ===           ===
</TABLE>

The Company had federal and state net operating loss carryforwards of
approximately $16.9 million and $7.8 million at September 30, 1998 and 1997,
respectively.  The Company's federal and state net operating loss carryforwards
will begin expiring in the year 2011, if not utilized.  The Company also has
credits for research activities of approximately $1.2 million to carryforward at
September 30, 1998 which will begin to expire in 2011.  For the year ended
September 30, 1997, the Company has deducted $628,000 of compensation for tax
purposes only which is related to the exercise of stock options.

The Tax Reform Act of 1986 limits the use of net operating loss and tax credit
carryforwards in certain situations where changes occur in the stock ownership
of a company.  In the event the Company has a change in ownership, as defined,
utilization of the carryforwards could be restricted.


                             Page F-14

<PAGE>

6.   NOTE RECEIVABLE FROM SHAREHOLDER

On October 1, 1995, the Company entered into a note receivable agreement with a
shareholder for the purchase of 5,300,000 shares of common stock at $.01 per
share.  The shares are pledged as collateral in the case of default by the
shareholder.  The note is payable in five annual installments beginning October
1, 1996, of $10,600 of principal plus interest, which accrues at 7% per annum.

7.   COMMITMENTS

The Company leases its office facilities under a noncancelable operating lease
which expires in 2003.  The Company is responsible for certain taxes,
maintenance costs and insurance under the lease.  Restricted cash of $500,000 at
September 30, 1997 related to the building lease and one capital lease was
released during the year ended September 30, 1998.

During the years ended September 30, 1998 and 1997, the Company leased equipment
under noncancelable operating leases which expire at various dates through March
2002.

Future minimum rental payments at September 30, 1998 are as follows:

<TABLE>
     <S>                                <C>
     1999                               $  552,388
     2000                                  549,629
     2001                                  557,104
     2002                                  560,872
     2003                                  567,277
     Thereafter                             47,345
                                        ----------
                                        $2,834,615
                                        ==========
</TABLE>

Rent expense was $638,900 and $654,809 for the years ended September 30, 1998
and 1997, respectively.

8.   SHAREHOLDERS' EQUITY

Convertible preferred stock:

Under the Company's Articles of Incorporation, the Company's preferred stock is
issuable in series and the Company's board of directors is authorized to
determine the rights, preferences and terms of each series.



                             Page F-15

<PAGE>

During the period ended September 30, 1996, the Company amended its Article of
Incorporation to authorize the issuance of 30,000,000 shares of preferred stock
of which 9,600,000, 2,000,000 and 1,500,000 were designated as Series A, Series
B and Series C preferred stock, respectively.

During the period ended September 30, 1997, the Company designated 5,000,000,
666,666 and 500,000 shares as Series D, Series E and Series F preferred stock,
respectively.

The Company's Series A, B, C, D, E and F preferred stock have voting rights
equal to the number of common shares into which each preferred share converts. 
Each share of preferred stock is convertible into common stock on a one-for-one
basis, subject to certain adjustments as described in the Preferred Stock
Purchase Agreements.  Conversion is automatic upon the effective date of a
public offering of common stock for which the aggregate proceeds are not less
than $15,000,000 and the offering price is not less than $1.00 per share of
common stock.  At September 30, 1998, 1997 and 1996, the Company had 15,100,000,
15,100,000 and 13,100,000 shares, respectively, of common stock reserved for
conversion.

The Company is not required to declare a dividend in any year.  However, in
preference to any common stock dividends, holders of preferred stock are
entitled to a dividend in the amount of 5% of the initial sales price of shares
of each respective series of preferred stock; that is, $.017 per share of Series
A, $.038 per share of Series B, $.05 per share of Series C, $.10 per share of
Series D, $.15 per share of Series E and $.20 per share of Series F.  Preferred
dividends are noncumulative.  No dividends have been declared. The holders of
the Series A preferred stock are also entitled to registration rights as
described in the preferred stock purchase agreement.

In the event of any liquidation, dissolution, or winding up of the Company,
either voluntary or involuntary, the holders of the then outstanding Series A,
B, C, D, E and F preferred stock are entitled to receive, prior and in
preference to any distribution of any of the assets or surplus funds of the
corporation to the holders of the common stock, the amounts of $0.36, $0.75,
$1.00, $2.00, $3.00 and $4.00 per share for Series A, B, C, D, E and F preferred
stock, respectively, plus all declared but unpaid dividends for each share of
preferred stock.  If, upon occurrence of such event, the asset and funds thus
distributed among the holders of the preferred stock, shall be insufficient to
permit the payment to such holders of the full preferential amount, then 

                             Page F-16

<PAGE>

the entire assets and funds of the Company legally available for distribution
will be distributed ratably among the holders of the preferred stock in
proportion to their liquidation preference (as defined).

All preferred shares are subject to repurchase by the Company.

Common stock:

Each share of common stock is entitled to one vote.  The holders of common stock
are also entitled to receive dividends whenever funds are legally available and
when declared by the board of directors, subject to the prior rights of holders
of all classes of stock outstanding.

Beginning in May 1998, the Company offered 666,667 shares of common stock for 
sale.  The initial offering price of $6.00 was subsequently revised to $1.50. 
As of September 30, 1998, 400,272 shares had been issued.  In April 1998 the 
conversion of notes payable resulted in the issuance of 401,053 shares of 
common stock and the contribution and reissuance of 2,406,315 of founders' 
shares.

During the period ended September 30, 1996, the Company issued 16,000,000 shares
of its common stock to the founders under stock purchase agreements.

At September 30, 1998 and 1997, 13,700,000 of the shares issued to the founders
were subject to repurchase by the Company at book value upon termination of
employment.

9.   STOCK OPTIONS AND WARRANTS

Stock options:

In 1996, the Company adopted the 1996 Stock Option Plan (the "Plan").  At
September 30, 1998 and 1997, respectively, there were 5,777,742 and 5,940,009
shares of common stock reserved for issuance to employees of the Company
pursuant to the Plan.  Under the Plan, incentive options may be granted at
prices not lower than fair market value at the date of grant or 110% of the fair
market value if the optionee, immediately prior to the grant, owns stock
representing 10% or more of the voting power or value of all securities. 
Nonstatutory options may be granted at prices not lower than 85% of fair market
value at the date of grant or 100% of the fair market value if the optionee,
immediately prior to the grant, owns stock representing 10% or more of the
voting power or value of all securities.  Stock options granted under 

                             Page F-17

<PAGE>

the Plan are exercisable and vest at such times and under such conditions as
determined by the board of directors.

In September 1998, the Company adopted the 1998 Senior Employee Stock Option
Plan (the "1998 Plan") and reserved 1,500,000 shares for issuance pursuant to
the 1998 Plan.  The terms of the 1998 Plan are similar to those of the 1996
Stock Option Plan described above.

During the periods ended September 30, 1998, 1997 and 1996, the Company issued
10,000, 100,374 and 25,000 options, respectively, for the purchase of shares of
common stock at prices not lower than fair market value at the date of grant of
the options to nonemployees in return for services provided.  These stock
options are exercisable and vest at such times and under such conditions as
determined by the board of directors.

As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation", the
Company retained its prior method of accounting for stock compensation.  As
required by SFAS No. 123, the following information represents pro forma net
loss as if the Company had accounted for its employee stock options under the
fair value method prescribed by the standard.

The fair value of each option grant to an employee is estimated on the date of
grant using the Black-Scholes option valuation model with the following weighted
average assumptions:

<TABLE>
<CAPTION>
                         For the Year Ended   For the Period
                            September 30,          Ended
                        --------------------   September 30,
                          1998       1997           1996     
                        --------   ---------  --------------
<S>                     <C>        <C>        <C>
Interest rate             5.2%       6.5%           6.5%
Expected life           10 Years   9.8 Years      9.7 Years
Expected volatility       0.1%       0.1%           0.1%
Dividend yield             -          -              -
</TABLE>

For purposes of pro forma disclosures, the estimated fair value of the options
issued to employees is amortized to expense over the options' vesting periods. 
The pro forma information for the Company follows:


                             Page F-18

<PAGE>

<TABLE>
<CAPTION>
                               For the Year Ended September 30,
                    --------------------------------------------------   For the Period Ended
                              1998                      1997              September 30, 1996 
                    ------------------------  ------------------------  ----------------------
                         As          Pro           As          Pro          As          Pro
                      reported      forma       reported      forma      reported      forma  
                    -----------  -----------  -----------  -----------  ----------  ----------
<S>                 <C>          <C>          <C>          <C>          <C>         <C>
Net loss            $13,621,046  $13,830,503  $14,579,138  $14,746,109  $1,872,879  $1,874,631
Basic and diluted
 net loss per
  common share      $      0.66  $      0.67  $      0.76  $      0.77  $     0.13   $    0.13
</TABLE>

The effects of applying SFAS No. 123 in this pro forma disclosure are not 
indicative of future amounts as additional awards are anticipated in future 
years.

A summary of stock option transactions is as follows:

<TABLE>
<CAPTION>
                              For the Year Ended September 30, 
                          ---------------------------------------- For the Period Ended
                                  1998                1997          September 30, 1996 
                          ------------------- -------------------- -------------------
                                     Weighted             Weighted           Weighted
                                      Average              Average            Average
                                     Exercise             Exercise           Exercise
                            Shares     Price     Shares     Price    Shares    Price  
                          ---------  -------- ----------  -------- --------- ---------
<S>                       <C>        <C>      <C>         <C>      <C>       <C>
Outstanding at beginning
 of period                2,257,763    $1.50   1,677,200    $0.25          -       -
  Granted                 2,312,785     1.91   2,810,100     1.91  1,677,200   $0.25
  Exercised                (162,267)    0.79    (459,991)    0.54          -       -
  Cancelled                (687,476)    1.90  (1,769,546)    1.28          -       -
                          ---------           ----------           ---------
Outstanding at end of
 period                   3,720,805    $1.25   2,257,763    $1.50  1,677,200   $0.25
                          =========    =====  ==========    =====  =========   =====

Exercisable at end of
 period                     637,078    $1.43     292,650    $0.58     33,750   $0.05

Weighted average fair
 value of options granted
 during the period                     $0.78                $0.85              $0.12
</TABLE>

The following table summarizes information about the fixed-price stock options
outstanding at September 30, 1998:



                             Page F-19

<PAGE>

<TABLE>
<CAPTION>
                                Options Outstanding       Options Exercisable   
                               ----------------------   ----------------------  
                                  Weighted-Average      
       Range                   ----------------------                 Weighted
        of          Shares      Remaining                             Average
     Exercise    Outstanding   Contractual   Exercise                 Exercise
      Prices     at 9/30/98       Life         Price      Shares       Price
    ---------    -----------   -----------   --------   -----------   --------
<S>              <C>           <C>           <C>        <C>           <C>
     $.05-.08      511,750       6.64         $0.05      212,750      $0.05
      .60-.80      479,814       7.97          0.04      240,526       0.69
         1.50    1,984,710       9.85          1.50            -          -
    3.00-4.50      744,531       8.65          4.04      183,802       4.00
                 ---------                               -------
                 3,720,805       8.92         $1.62      637,078      $1.43
                 =========                               =======
</TABLE>

Warrants:

In May 1996, the Company issued a warrant, in connection with the Series B
preferred stock financing, to purchase up to 1,500,000 shares of the Company's
Series C preferred stock at $0.75 per share if exercised prior to the second
anniversary of the date of issuance; $0.83 per share if exercised prior to the
third anniversary of the date of issuance; $0.91 per share if exercised after
the later but on or prior to the fourth anniversary of the date of issuance; and
$1.00 per share if exercised after the later date.  The warrants are exercisable
at any time and expire May 16, 2001 or upon the effective date of an initial
public offering by the Company, whichever is sooner.

Pursuant to the April 1998 guarantee of the note payable to bank, warrants to
purchase 825,000 shares of common stock were issued to three shareholders. 
These warrant shares shall be purchasable at $1.00 per share if exercised prior
to the first anniversary of the guarantors' agreement, $1.10 per share after the
first anniversary and prior to the second anniversary, $1.20 per share after the
second anniversary and prior to the third anniversary, $1.35 per share after the
third anniversary and prior to the fourth anniversary, and $1.50 per share after
the fourth anniversary and prior to the fifth anniversary.  The warrants are
exercisable at any time and have a term of five years or upon the effective date
of an initial public offering by the Company, whichever is sooner.  The value of
these warrants, net of proceeds, of $400,000 was recorded as deferred financing
costs and is being amortized over the life of the debt, which is twelve months.

10.  RELATED PARTY TRANSACTIONS

As of September 30, 1998, Zitel Corporation ("Zitel") owned 78% 


                             Page F-20

<PAGE>

of the total issued preferred stock, or 35% of all stock outstanding.  The
Company has a sales representative agreement with Zitel, with terms and
conditions similar to other such agreements with third parties, in which the
shareholder will introduce interested parties to the Company.  The Company also
has an agreement to provide 1,000 hours of training and support to Zitel at no
charge.  Two of five board members of the Company are officers of Zitel.  In
addition, as of September 30, 1998, the Company has received $2,000,000 pursuant
to notes payable to Zitel.  Interest accrues at 7% per annum with principal and
interest payable on demand.  In December 1998, the balance of the notes payable
were converted to stock as described in Note 13.

On December 4, 1997, the Company obtained financing of $4 million from related
parties pursuant to three Convertible Promissory Notes and Agreements.  The
terms of these agreements provide for conversion of the outstanding principal of
the notes into shares of common stock at a conversion rate calculated in
accordance with the agreement, or payment of the principal after expiration of
the conversion period in six equal monthly installments.  The conversion rate
per share defined in the agreements was based upon the Company's profit as
defined for the period January 1 through March 31, 1998.  Interest was payable
quarterly beginning on December 31, 1997, and upon any conversion.  The notes
were converted into common shares at a rate of approximately 1.43 shares per $1
of principal during April 1998.  The conversion resulted in the issuance of
401,053 shares of common stock and the reallocation of ownership of founders'
shares.

On October 1, 1996, the Company entered into a consulting agreement with BRC
Holdings, Inc. ("BRC") which expires December 31, 1999, under which its Chairman
and Chief Executive Officer will serve as Chairman of the Board for MatriDigm. 
In return for such services, during the term of the consulting agreement, BRC
will receive 5% of the Company's cumulative pretax earnings up to $100,000,000
of MatriDigm's cumulative earnings.  When pretax earnings reach $100,000,000,
the percentage will incrementally decline until the Company's cumulative
earnings reach $1 billion, at which point the percentage will remain at 1% until
the end of the contract. On October 23, 1996, BRC purchased 2,000,000 shares of
common stock at $.75 per share. The shares have certain repurchase rights in the
event of the cancellation of the consulting agreement.  The Company has also
entered into a sales representative agreement with BRC under which the
shareholder will offer the Company's services to its clients.  In January 1998,
BRC made a prepayment of $1 million, which is being applied, to charges for code
being renovated for BRC customers in 


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<PAGE>

accordance with the related agreement.  In October 1998, in exchange for a
$400,000 note payable to BRC, the BRC consulting agreement was amended to
rescind the sections of that agreement related to services provided by BRC's
Chairman and Chief Executive Officer and to the compensation due to BRC related
to such services.  The repurchase rights related to the 2,000,000 shares of
common stock purchased by BRC in October 1996 were also waived with regard to
certain specified transfers.

In May 1996, an entity affiliated with the Chairman of the Board purchased the
2,000,000 shares of MatriDigm's Series B preferred stock for $1,500,000 and was
issued a warrant to purchase up to 1,500,000 shares of MatriDigm's Series C
preferred stock as described in Note 9.  Effective September 8, 1997, MatriDigm
granted a nonstatutory stock option to purchase 75,000 shares of common stock at
$4.50 per share to another entity affiliated with the Chairman of the Board in
connection with raising capital for the Company and setting up certain
relationships.

11.  EMPLOYEE BENEFIT PLANS

During the year ended September 30, 1996, the Company adopted a contributory
retirement and savings plan, which meets the requirements of Section 401(k) of
the Internal Revenue Code.  The plan allows for a discretionary matching
contribution by the Company as determined by the Company's board of directors. 
No contributions have been made by the Company.

The Company offered 200,000 shares of common stock to employees and directors at
$4.50 per share pursuant to the August 1997 Employee Stock Purchase Plan (the
"1997 Stock Plan").  Initially, employees were each eligible to purchase shares
with a value of up to 15% of their annual salary; officers and directors were
eligible to purchase up to 10,000 shares.  As provided for in the 1997 Stock
Plan, these maximums were increased.  As of September 10, 1997, the final date
for acquisitions according to the offering, 162,019 common shares were purchased
under the 1997 Stock Plan.

12.  FINANCIAL CONDITION

Subsequent to September 30, 1997, the Company emerged from the development
stage.  Revenues since September 30, 1997 have not generated sufficient funds to
finance operations.  The Company will require additional financing until
operations generate adequate cash flow to meet its financial obligations. 
Management is pursuing various funding alternatives and obtained financing 


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<PAGE>

from Zitel as discussed in Notes 10 and 13.  Other existing obligations could
make it difficult to obtain alternative financing.  There can be no assurance
that additional financing will be available.

13.  SUBSEQUENT EVENTS

In October 1998, the subordinated convertible note payable to shareholder was
amended.  The conversion price was reset to $3.00 per share.  Principal was
scheduled for payment in six equal monthly installments commencing June 30,
1999.

During October, November and December 1998, Zitel loaned the Company $1,200,000,
bringing the total of the notes payable to shareholder to $3,200,000 at December
21, 1998.  Interest accrues at 7% per annum, and principal and interest are
payable on demand.

On October 5, 1998, the Company signed a definitive agreement pursuant to which
Zitel would acquire the remaining 68.7% of MatriDigm not currently owned by
Zitel in a tax-free exchange of stock, which was to be accounted for as a
purchase combination.  The MatriDigm shareholders were to receive approximately
0.65 share, of a newly created company, for each MatriDigm share they currently
owned.  The merger was subject to the approval of the shareholders of the
Company and of Zitel and regulatory approval.  Under the definitive agreement,
Zitel committed to fund the working capital needs of MatriDigm from October 5,
1998 through the date of the closing of the merger, which was expected to be in
early calendar year 1999.  On December 21, 1998, the Company and Zitel
terminated the definitive agreement to acquire the remaining portion of
MatriDigm not already owned. 

The Company and Zitel have restructured the transaction to provide for the
exchange of the notes payable to a shareholder, with a balance of $3,200,000
plus accrued interest, into stock.  Upon completion of the exchange, the Zitel's
ownership of MatriDigm will increase to approximately 58% on a fully converted
basis. 

In December 1998, the Company reduced its workforce by almost one-half. 
Benefits paid and expenses recorded as a result of this action were $100,000 and
zero.


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