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

                                    FORM 10-K

[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

     For the transition period from ___________ to ___________ 

                         COMMISSION FILE NUMBER: 0-25862

                               AG ASSOCIATES, INC.
             (Exact name of Registrant as specified in its charter)

          CALIFORNIA                                           94-2776181
(State or other jurisdiction of                             (I.R.S. Employer
incorporation or organization)                              Identification No.)

               4425 FORTRAN DRIVE, SAN JOSE, CALIFORNIA 95134-2300
              (Address of principal executive offices and zip code)

       Registrant's telephone number, including area code: (408) 935-2000

        Securities registered pursuant to Section 12(b) of the Act: NONE
          Securities registered pursuant to Section 12(g) of the Act:

                                  COMMON STOCK

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

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

The aggregate market value of the voting stock held by non-affiliates of the
Registrant, based on the closing price of the Common Stock on November 30, 1998
as reported by the Nasdaq National Market ($4.88), was approximately
$17,018,450. Shares of Common Stock held by each officer and director and by
each person who owns 5% or more of the outstanding Common Stock have been
excluded from this computation in that such person may be deemed to be
affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.

The Registrant had 6,202,743 shares of Common Stock outstanding as of November
30, 1998.

DOCUMENTS INCORPORATED BY REFERENCE

None.

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INDEX


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                                           Description                                             Page Number
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PART I.

       Item 1.    Description of Business......................................................           3
       Item 2.    Properties...................................................................          11
       Item 3.    Legal Proceedings............................................................          11
       Item 4.    Submission of Matters to a Vote of Shareholders..............................          12

PART II.

       Item 5.    Market for the Registrant's Common Stock and Related Shareholder
                     Matters...................................................................          12
       Item 6.    Selected Financial Data......................................................          13
       Item 7.    Management's Discussion and Analysis of Financial Condition and
                      Results of Operations....................................................          14
       Item 7A.   Quantitative and Qualitative Disclosures About Market Risk...................          22
       Item 8.    Consolidated Financial Statements and Supplementary Data.....................          22
       Item 9.    Changes in and Disagreements with Accountants on Accounting
                     and Financial Disclosure..................................................          23

PART III.

       Item 10.   Directors and Executive Officers of the Registrant...........................          23
       Item 11.   Executive Compensation.......................................................          25
       Item 12.   Security Ownership of Certain Beneficial Owners and Management...............          30
       Item 13.   Certain Relationships and Related Transactions...............................          31

PART IV.

       Item 14.   Exhibits, Financial Statement Schedules and Reports on Form 8-K..............          33

Signatures.....................................................................................          34

Index to Financial Statements..................................................................          35
Index to Financial Statement Schedules.........................................................          35
Index to Exhibits..............................................................................          36
Schedule II: Valuation and Qualifying Accounts.................................................          S-2
</TABLE>


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PART I

ITEM 1.  DESCRIPTION OF BUSINESS

FORWARD-LOOKING STATEMENTS

    Except for the historical information contained herein, the matters
discussed in this Annual Report on Form 10-K, and specifically in the Sections
entitled "Description of Business" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations," are forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended, and Section 27A of the Securities Act of 1933, as amended. These
forward-looking statements are subject to significant risks and uncertainties,
including those identified within the "Factors That May Affect Future Results"
section of "Management's Discussion and Analysis of Financial Condition and
Results of Operations." The actual results that AG Associates, Inc. (the
"Company") achieves may differ materially from any forward-looking projections
due to such risks and uncertainties. The Company has identified with a preceding
asterisk ("*") various sentences within this Annual Report on Form 10-K which
contain such forward-looking statements, and words such as "believes,"
"anticipates," "expects," "future," "intends" and similar expressions are
intended to identify forward-looking statements. In addition, the section
labeled "Factors That May Affect Future Results," which has no asterisks for
improved readability, consists primarily of forward-looking statements. The
Company undertakes no obligation to publicly release the results of any
revisions to these forward-looking statements that may be made to reflect events
or circumstances after the date hereof. Readers are urged to carefully review
and consider the various disclosures made by the Company in this report and in
the Company's other reports filed with the Securities and Exchange Commission
that attempt to advise interested parties of the risks and factors that may
affect the Company's business.

RECENT EVENTS

    On November 25, 1998, the Company announced that it is in discussions with
Steag Electronic Systems GmbH, a subsidiary of Steag AG (Essen, Germany),
concerning a possible cash acquisition of the Company. *The terms and conditions
of an acquisition have not been finalized, but it is expected that an
acquisition, if it occurs, will value the equity of AG Associates in excess of
$30 million. *Completion of a transaction will be subject to the negotiation of
definitive documentation, board approval and obtaining required third-party and
government approvals. *Consequently, there can be no assurance that an agreement
between the two companies with respect to an acquisition will be reached or that
a transaction will be completed. *In addition, the Company has not yet made a
determination as to whether any business combination would be in the best
interests of its stockholders. *It is the general policy of the Company not to
comment upon or disclose preliminary negotiations regarding significant
corporate transactions, and the Company intends to continue this policy in the
future; therefore, no further announcement with regards to the proposed
transaction will be made until and unless its terms have been finalized.

THE COMPANY AND ITS PRODUCTS

    AG Associates, Inc. designs, manufactures, markets and supports advanced
single-wafer rapid thermal processing ("RTP") equipment used in manufacturing
integrated circuits. The Company's products, marketed under the Heatpulse(R) and
Starfire(TM) names, utilize high-intensity light to precisely heat a single
silicon wafer, causing a chemical process needed to produce an integrated
circuit. During the second quarter of fiscal 1998, the Company commenced Beta
shipments of its new Starfire RTP system, which is intended to provide
previously unavailable RTP capabilities for the .18 and .25 micron linewidths on
200 and 300mm wafers. In October 1997, the Company announced that it had
received the 1997 Editors' Choice Best Product Award from Semiconductor
International magazine for its Heatpulse 8800 RTP system. In 1998, the Company
also received the VLSI Customer Satisfaction Award. The Company was incorporated
under the laws of California in 1981.

    Historically, thermal processing has been performed in conventional batch
furnaces where 100 to 200 wafers are processed at one time. However, as
integrated circuit feature size has become smaller, semiconductor manufacturers
have encountered significant technical and practical constraints, which have
made thermal processing in batch furnaces impractical, and in some cases
impossible with regard to certain steps in the integrated circuit manufacturing
process. These constraints include severe limitations on how long a wafer can be
held at high temperature, the need for an impurities-free thermal-processing
environment, inefficiencies of batch processing in a predominantly single wafer
processing environment and the potential significant financial loss from
processing errors.


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    The Company was the first to introduce products utilizing a new thermal
processing method, known as rapid thermal processing, to address many of the
limitations of traditional batch furnaces. The Company's RTP products have been
widely adopted for use by many of the manufacturers of technologically advanced
integrated circuits. *The Company believes that, as integrated circuit feature
size decreases and processing power and performance increase, more process steps
in manufacturing integrated circuits will continue to be converted to RTP from
batch furnace processing, and new process steps will be made possible by RTP.

TRADITIONAL THERMAL PROCESSING

    Integrated circuits are fabricated by repeating a complex series of chemical
and physical process steps on a silicon wafer. The principal steps in
manufacturing integrated circuits are heating the wafer to cause a chemical
reaction or structural change that modifies the electrical and physical
properties on the wafer surface (thermal processing), the deposition of
insulating or conducting materials on a wafer (deposition), the projection of a
pattern through a mask onto light sensitive materials known as photoresist
(photolithography) and the etching or removal of the deposited materials not
covered by the pattern (etching). Each of these steps is typically repeated many
times during the fabrication process.

    Historically, thermal processing has been performed in conventional batch
furnaces where loads of 100 to 200 wafers are processed at one time. However, as
feature size of integrated circuits has become smaller, semiconductor
manufacturers have encountered significant technical and practical constraints,
which have made thermal processing in batch furnaces impractical, and in some
cases, impossible. These constraints include:

    -   Limited thermal budget. Thermal budget is the total number of minutes
        that a wafer can be held at high temperature during the fabrication
        process. As integrated circuits have become more complex, their thermal
        budget has decreased dramatically. Certain furnace heating steps require
        exposure of between 30 to 90 minutes at high temperature, while the
        total thermal budget for certain more complex integrated circuits is on
        the order of five minutes.

    -   Inability to achieve pure wafer environment. Large batch furnace
        chambers reduce the ability to eliminate contaminants, such as oxygen,
        that may be present in the chamber during the heating process. These
        contaminants produce defects in the processed wafer, reducing yield.

    -   Inefficiencies of batch processing in a single wafer environment. Most
        integrated circuit fabrication equipment processes individual wafers in
        a cassette of 25 wafers at a time. Diffusion furnaces process wafers in
        batches of up to 200 (eight cassettes) at a time, resulting in
        bottlenecks and inefficiencies in the integrated circuit manufacturing
        process.

    -   Cost of processing failure. As the cost of a wafer has increased to
        several thousand dollars, manufacturers have focused increasingly on
        minimizing wafer loss in the fabrication cycle. Batch furnace processing
        creates a significant risk of loss in the case of misprocessing or
        equipment malfunction, since up to 200 wafers may need to be scrapped as
        a result of one error.

    These limitations, which became critical in the early 1990's, have driven
semiconductor manufacturers to search for alternative thermal processing
methods.

RAPID THERMAL PROCESSING -- THE AG ASSOCIATES SOLUTION

    The Company was the first to introduce a product utilizing a new thermal
processing method, known as rapid thermal processing, which addresses many of
the limitations of traditional batch furnaces. Since its introduction, RTP has
become integrated into the production of many advanced integrated circuits. The
Company's RTP products have been widely adopted for use by many of the
manufacturers of technologically advanced integrated circuits such as four
megabit and larger dynamic memory chips, one megabit and larger static memory
chips and 486 class and higher-performance microprocessors.

    RTP involves radiating a single wafer with high intensity light in a precise
manner. During RTP processing, individual wafers are rapidly heated from room
temperature to steady state temperatures between 400 degrees centigrade and 1200
degrees centigrade, held there for a short time and then rapidly cooled.
Typically, the entire heating and cooling process takes between 30 to 100
seconds per wafer. The Company's RTP systems have enabled its customers to
overcome the limitations of traditional thermal processing and to process
today's complex devices by:

    -   Meeting thermal budget limitations. RTP permits the thermal processing
        of advanced integrated circuits to be completed within their limited
        thermal budgets. By heating and cooling a wafer more rapidly than a
        furnace, RTP 


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        permits processing at higher temperatures for a shorter duration than a
        furnace. This reduces thermal budget demands and improves performance
        characteristics at approximately the same cost of ownership.

    -   Providing superior contamination control. The small size and ambient
        purge capabilities of RTP processing chambers permit the removal of
        unwanted gases from the wafer-processing environment, thereby reducing
        the possibility of contamination. For the past several years, RTP has
        been used extensively to heat wafers with metal layers that are
        sensitive to residual oxygen. Such precise contamination control is
        impractical in a batch furnace.

    -   Improving wafer process flow. RTP's single wafer technology is well
        matched to the single wafer cassette processes used in modern wafer
        fabrication facilities. Since most other integrated circuit process
        steps are single wafer processes, RTP streamlines the process flow of
        wafers, avoiding bottlenecks in production, and enables users to reduce
        work-in-process.

    -   Reducing cost of processing errors. RTP's single wafer processing
        technology has dramatically reduced the cost of processing errors. In
        the event of a malfunction, self-tests and interlock mechanisms shut
        down the processing equipment, generally limiting loss to one or two
        wafers. The reduced wafer loss also enables cost-efficient testing of
        new technologies.

    RTP has been widely adopted for use by most manufacturers of integrated
circuits and is a necessary process in the production of certain integrated
circuits. The Company believes that the production of 486 microprocessors, most
static memory chips larger than one megabit and most dynamic memory chips
greater than four megabits utilizes at least one RTP step. More powerful
integrated circuits such as advanced microprocessors and very large memories
often require multiple RTP steps in the manufacturing process.

PRODUCTS

    AG Associates' products, marketed under the Heatpulse and Starfire names,
use a processing chamber which includes arrays of lamps that supply the heating
energy to the wafer, advanced temperature measurement and control subsystems and
an ultra clean gas delivery system. The heating cycle typically includes a short
purge step to drive contaminants out of the chamber, a ramp-up to the processing
temperature, a steady state step at the processing temperature of between 10 to
60 seconds and a cool-down period prior to removing the wafer from the
processing chamber.

    The Company's products also incorporate an automated wafer-handling robotic
subsystem and software for advanced system and process control and host
communication that, except for the operating system and certain module
components, are designed, developed and tested by the Company. The Company
believes, based upon comments by its customers, that its Heatpulse products are
reliable and compare favorably with other products in the market.

    Starfire. The Company's Starfire (200mm or 8 inch wafer size) Rapid Thermal
Processing system was first introduced to the market at Semicon West in July
1997. Beta shipments of this product commenced in March 1998. This system is a
totally new design to be used for .25 and .18 micron linewidths for R&D and
production of 200mm wafers. Starfire utilizes a dynamic emissivity independent
temperature measurement and multi-point control system for improved uniformity
and repeatability. Starfire is the Company's first multi-chamber platform-based
RTP system that can process approximately 90 wafers per hour. In November 1998,
the Company shipped a steam version of Starfire for use in production.

    Starfire 300. The Company's Starfire 300 (300mm or 12 inch wafer size) Rapid
Thermal Processing system was first introduced to the market at Semicon West in
July 1998. Beta shipments of this product (in a cluster platform configuration)
commenced in March 1998. This system is a new design and scale-up of the
Starfire (200mm) product to be used for .18 and below micron linewidths for R&D
and production of 300mm wafers. In addition, the Starfire 300 incorporates many
of the same advanced features of the Starfire (200mm). *The Company is currently
preparing to ship a Beta Starfire 300 front opening universal pod ("FOUP")
configuration in December 1998. *This configuration is anticipated to replace
the cluster platform configuration shipped in March of 1998.

    STEAMpulse (TM). The Company's STEAMpulse Rapid Thermal Processing system
was first introduced to the market at Semicon West in July 1998. An early
prototype was shipped in December 1997. This system is based on the Heatpulse
8800 and has the ability to run catalytic or pyrogenic steam for thin and thick
oxide films as well as low temperature metal annealing processes. *Beta
shipments of the STEAMpulse are anticipated to begin in calendar 1999.


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     Heatpulse 8800. The Company's Heatpulse 8800 Rapid Thermal Processing
system was introduced to the market at Semicon West in July 1996. This system is
based on the Company's Heatpulse 8108 model, with significant cost and
performance improvements. This model incorporates an individual lamp power
supply, which is controlled by sophisticated closed-loop AG lamp power modules
that provide fine control of wafer temperature uniformity. An additional feature
is a high throughput purge system that allows a 30% savings of the heating
cycle, thereby increasing throughput and reducing cost per wafer. The Heatpulse
8800 system is targeted for R&D and production of devices utilizing .25 micron
technology.

    Heatpulse 8108. The Company's Heatpulse 8108 rapid thermal processing system
was first shipped in October 1992. *This machine has been the Company's flagship
product targeted for volume production processes that utilize wafer sizes from
125 to 200 millimeters (5 to 8 inches) for feature sizes as small as .35 micron,
but the Company expects that sales of the Heatpulse 8108 will continue to
decline in favor of the Heatpulse 8800 and Starfire products as customer
technology requirements increase. This system is designed to accommodate
periodic upgrades to meet evolving customer needs. Heatpulse 8108 incorporates a
number of unique features that offer semiconductor manufacturers improved
thermal processing capability, reliability and performance. These features
include patented adjustable lamp heating zones to provide process and
temperature uniformity, a patented temperature measurement method to ensure
process accuracy and repeatability, as well as a proprietary automation package
for equipment-to-host communication. These and other product features of the
Heatpulse 8108 typically enable the device manufacturer to improve throughput,
uniformity and repeatability and to reduce wafer particle contamination.

    Heatpulse 4100 Series. The Heatpulse 4100S, first shipped in February 1988,
is the successor to the Heatpulse 4100 and was the first through-the-wall,
environmentally isolated automatic RTP system for the manufacture of 100 to 150
millimeter (4 to 6 inches) wafers. The Heatpulse 4100S is used in the processing
of wafers with feature sizes as small as .6 micron. This product currently
accounts for a small percentage of net sales. In March of 1997 the Company
announced that it was discontinuing the Heatpulse 4100 RTP system. In fiscal
1998, product shipments were phased out, even though many of the units shipped
are still in use throughout the world.

    Heatpulse 610. The Heatpulse 610, the successor to the Company's first
tabletop manual system, is the Company's current RTP tool targeted for research
and development and small-scale production applications. The Heatpulse 610 is
suitable for processing wafers of up to 150 millimeters (6 inches). Although
this product currently accounts for a small percentage of the Company's net
sales, many of the units shipped are still in use throughout the world.

     Upgrades. The Company currently offers a variety of upgrades that improve
throughput and yield for its products, including, the Ceramic Shield and
Enhanced Z-axis Direct Thermocouple Control ("ez-DTC") upgrade to the Heatpulse
8000 series of RTP systems. These upgrades allow semiconductor manufacturers to
lower their cost of ownership and achieve better yield with higher throughput
and improved temperature measurement and control with their existing systems.

RTP TECHNOLOGY

    During the fabrication process, wafers undergo between 100 to 200 principal
steps, nine to fifteen of which are thermal process steps. The following two
examples are only a subset of a number of processes in which RTP provides
significant technical and economic advantages to its users. The processes
described below were among the first processes in which RTP gained widespread
acceptance as an industry standard.

    A significant portion of all current RTP applications involve titanium
silicide, an important step in manufacturing integrated circuits with reduced
feature size and the step that first led to widespread acceptance of RTP in the
wafer fabrication process. In integrated circuit manufacturing, a thin titanium
layer is used to assure adequate conductivity between the silicon material and
the overlaying metal conductor. To create a good contact between the titanium
and the silicon it must be heated to approximately 650(Degree)C in an inert gas
(creating a thin conductive alloy called titanium silicide). Since titanium is
very sensitive to even minute traces of oxygen, it is impossible to perform this
operation in a conventional large batch furnace. RTP allows quick heating of
individual wafers in a small quartz chamber that ensures an extremely low level
of residual oxygen. *The Company believes that titanium silicide processes will
become increasingly important since titanium silicide permits extremely small
contact areas while maintaining low contact resistance.

    Another critical thermal process which is limited by conventional furnaces
is the activation of foreign dopants introduced into the wafer to build the
transistor (the switching element in the circuit). The high temperatures, 950 to
1,050(Degree)C, necessary to activate the dopants and complete the creation of
the transistor, when achieved in a furnace, cause the dopants to propagate
(diffuse) into the material, adversely affecting transistor speed. The use of a
very short and precise high temperature RTP 


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step, 1,100(Degree)C for 10 seconds, allows the needed activation but prevents
diffusion of the dopants, resulting in a significantly faster transistor.

RESEARCH AND DEVELOPMENT

    Rapid Thermal Processing. The market served by the Company is characterized
by rapid technological change. The Company believes that continued and timely
development of new products and enhancements to existing products are necessary
for it to maintain its competitive position. Accordingly, the Company devotes a
significant portion of its resources to sustaining and upgrading the Company's
existing products to improve serviceability or add new capabilities and
features, to decreasing the cost of owning and operating such products, to
developing new products with improved capabilities and to maintaining close
relationships with its customers in order to identify their product needs. From
time to time, the Company enters into joint development efforts with other
organizations.

    Product Development. In August 1995, the Company undertook a major
development program to design and manufacture a .18 micron capable RTP system.
To properly execute this plan, the Company increased its R&D and engineering
personnel dedicated and focused on this program. In fiscal 1998, the Company
began beta shipments of the Starfire (200mm) and Starfire 300 RTP systems. *In
fiscal 1999, the Company anticipates spending approximately $10 million to
finalize the Starfire systems.

    Integrated Processing. In 1992, the Company became involved in the
development of integrated chemical vapor deposition ("CVD") processing systems
through its acquisition of Rapro Technology, Inc. ("Rapro"), a research and
development stage company. Integrated processing involves the use of more than
one process chamber that permits wafers to undergo two or more sequential
process steps without removing the wafer from a clean vacuum environment. In May
1995, the Company's CVD cluster tool development activities were transferred to
AG Associates (Israel) Ltd. ("AG Israel"). The Company currently owns a 28%
voting interest in AG in Israel.

    During the fiscal years ended September 30, 1998, 1997 and 1996, the Company
expended $15.9 million, $14.3 million and $16.7 million, respectively, on
research and development, representing approximately 35%, 29% and 23% of net
sales for such periods. See Part II, Item 7 "Management's Discussion and
Analysis of Financial Condition and Results of Operations".

    The Company's research and development efforts may not be successful and new
products may not achieve significant market acceptance.

SALES, SERVICE AND MARKETING

    The Company believes that close working relationships with leading
integrated circuit manufacturers help to ensure that the Company's products are
technically advanced and designed in conjunction with the development of the
semiconductor manufacturers' advanced process requirements. These relationships
typically involve exchange of material and information to develop processes and
equipment needed to manufacture state of the art integrated circuits or to lower
the semiconductor manufacturer's cost of ownership. The Company's close working
relationships with customers involve working with the customer in a continuous
improvement process on selected technical aspects of the Company's products.
Such improvements, after testing with selected customers, often become standard
on all the Company's products sold worldwide. Financial support for these
development programs is generally not provided by the customer.

    The Company's sales cycle is between three and nine months. The shorter
cycles relate to existing customers who desire to gradually increase the
capacity of their existing fabrication lines. The longer cycles are related to
customers who have long-term plans for constructing new production facilities,
which are typically planned at least a year in advance. Since RTP has gained
increased acceptance, this period of time has decreased. Nonetheless, customers
generally purchase evaluation units prior to making substantive commitments to
purchase the Company's products. Acceptance periods vary widely from customer to
customer.

    Warranty periods vary from customer to customer, but generally average 15
months. A limited number of training classes is included in the purchase price
of the Company's products. Subsequent training is provided for a nominal fee.

    The Company markets its products both directly, through in-house sales
personnel in conjunction with independent sales representatives, or indirectly
through independent distributors. To promote its products, the Company uses
demonstration laboratories in its San Jose, California facility. The Company and
its sales representatives and distributors have sales and 


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support centers located in the United States, Japan, Korea, Taiwan, Singapore,
Europe and Israel. When a higher level of technical expertise is needed, the
sales effort is supported by product marketing managers and process engineers
who work closely with customers and potential customers to find solutions to
their current and future processing challenges. The Company has established
relationships with key international distributors, including among others, Canon
Sales Co., Inc. ("Canon") and Metron Technology, B.V. and Metron Technology,
Hong Kong (collectively, "Metron"). Canon has represented the Company in Japan
since 1985, and Metron has represented the Company in Europe and Korea since
1989 and 1994, respectively. Canon is a principal shareholder of the Company and
provides a representative on the Company's Board of Directors.

    The Company's distributors and independent representatives provide essential
pre- and post-sale support for the Company's products in their territories and
account for a substantial percentage of the Company's sales worldwide. The
Company believes that strong sales in the major semiconductor manufacturing
markets internationally are important to its future success. As discussed above,
all of the Company's sales in Japan are through Canon and those in Europe and
certain Asian countries are through Metron. Metron and Canon both sell the
Company's products under their own warranties and provide service and support to
their customers. Canon also customizes systems purchased from the Company for
redelivery according to Canon's customers' specifications. Sales to Canon
amounted to 32%, 12% and 25% of the Company's net sales for the years ended
September 30, 1998, 1997 and 1996, respectively. Sales to Metron amounted to 13%
and 14% of the Company's net sales for the years ended September 30, 1998 and
1996, respectively. Sales to Metron for the year ended September 30, 1997
accounted for less than 10% of the Company's net sales.

    International sales represented 53%, 31% and 54% of the Company's net sales
for the years ended September 30, 1998, 1997 and 1996, respectively. Because of
the magnitude of its international sales, the Company is subject to the normal
risks of conducting business internationally. The Company is also subject to
general geopolitical risks in connection with its international operations.
Because sales of the Company's products are denominated in United States
dollars, fluctuations in the value of the dollar could increase or decrease the
prices in local currencies of the Company's products in foreign markets and make
the Company's products relatively more or less expensive than competitors'
products that are denominated in local currencies. See Note 12 of Notes to
Consolidated Financial Statements.

    The Company currently has certain volume purchase agreements with large
domestic customers. In addition, many customer sales are made using purchase
orders. None of the Company's distributors or independent sales representatives
has the power to enter into contracts on the Company's behalf or otherwise bind
the Company.

CUSTOMERS

    The Company's end-user customers include many of the leading semiconductor
manufacturers worldwide. For the year ended September 30, 1998, Intel
Corporation ("Intel") accounted for 14% of net sales. For the year ended
September 30, 1997, Intel Corporation ("Intel") accounted for 25% of net sales
and Micron Technology, Inc. ("Micron") accounted for 10% of net sales. For the
year ended September 30, 1996, Intel accounted for 20% of net sales and NEC
accounted for 17% of net sales. No other end-user customer accounted for more
than 10% of the total sales for the fiscal years ended September 30, 1998, 1997
and 1996.

    The Company's business depends upon the capital expenditures of
semiconductor manufacturers, which in turn depend on the current and anticipated
market demand for integrated circuits, the amount of utilized equipment capacity
at semiconductor manufacturers and size of inventories at semiconductor
manufacturers. *The Company's revenue and operating results will continue to be
adversely affected if the recession in the semiconductor industry continues.

BACKLOG

    The Company's systems backlog (consisting of product scheduled for delivery
within the next twelve months) as of September 30, 1998, 1997 and 1996 was
approximately $14.9 million, $14.6 million and $8.4 million, respectively. All
orders are subject to cancellation or delay with limited or no penalty. Because
of possible changes in delivery schedules and cancellations of orders, the
Company's backlog at any particular date is not necessarily indicative of actual
sales that may occur in any succeeding period.

COMPETITION

    The semiconductor equipment industry, including the Company's segment of the
market, is intensely competitive and is characterized by rapid technological
change, product obsolescence and heightened competition in many markets. The


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Company competes with several major domestic and international semiconductor
equipment companies, most of which have substantially greater financial,
technical, marketing, distribution and other resources than the Company, as well
as broader product lines. Additionally, the Company competes with several small
semiconductor equipment companies.

    The Company's principal RTP competitors compete based upon both price and
performance, having incorporated features similar to those offered by the
Company into their RTP products, as well as features such as cluster tool
performance, which the Company did not offer until fiscal 1998. The Company
competes by providing complete process solutions to customers, including
training for customer personnel, helping identify and resolve process problems
on a continuous basis and emphasizing customer service and product quality and
reliability. *Competitive pricing pressure, in addition to the industry-wide
recession, has in certain cases necessitated and may continue to necessitate
significant price reductions by the Company and has and may continue to result
in lost orders which could adversely affect the Company's business. In addition,
many companies, particularly certain Japanese and United States companies, have
greater financial and technical resources to participate in these markets and
have broader product lines than the Company. For example, Applied Materials,
Inc. ("Applied Materials"), a large manufacturer of semiconductor manufacturing
equipment located in the United States, has entered the RTP segment of the
thermal processing market in which the Company competes, and has captured the
dominant share of the RTP market. Other manufacturers have also announced their
intention to enter the RTP market. *Some integrated circuit manufacturers may
attempt to consolidate all their capital equipment purchases through a single or
a small number of vendors. Companies with broader product lines and greater
resources may become more formidable competitors in the future.

    The Company also competes with manufacturers of batch diffusion furnaces for
application of their differing technologies in various steps of the integrated
circuit fabrication process. The Company believes that its ability to compete
depends upon its continued success in developing new product features. Moreover,
the ability to achieve process uniformity and repeatability, improve breadth of
process capability and flexibility, reduce the overall cost of ownership and
protect the Company's proprietary technology play an important role in the
Company's ability to compete.

MANUFACTURING

    Production is based upon firm customer commitments and anticipated orders
and is generally planned three to six months in advance. The Company's
manufacturing operations consist primarily of assembly, integration and final
testing of parts and subassemblies supplied by third-party suppliers, all of
which are conducted at the Company's manufacturing facility. Once the
manufacturing department has completed final testing of all electronic and
electromechanical subassemblies which make up one of the Company's products, the
completed system is tested by the Company's test engineers. To test each
product, the Company's engineer's process wafers in the system to ensure that
each system meets the customer's process specifications. To increase the
efficiency of the Company's manufacturing process, the Company selectively
utilizes outside contractors to assemble subassemblies and components. The use
of subcontractors enables the Company to focus on its design strengths, minimize
fixed costs and capital expenditures and access diverse manufacturing
technologies without bearing the full risk of obsolescence. This has allowed the
Company to increase production rates while avoiding investment in additional
facilities and minimizing inventory growth.

    Certain components and subassemblies included in the Company's products are
obtained from a single source or a limited group of suppliers and subcontractors
in order to assure overall quality and timeliness of delivery. The Company's
reliance on sole or a limited group of suppliers involves several risks,
including a potential inability to obtain adequate supplies of certain
components and reduced control over pricing and timely delivery of components.
*Although the timeliness, quality and pricing of deliveries to date from the
Company's suppliers have been acceptable and the Company believes that
additional sources of supply will be available should one or more of its
suppliers be unable to meet the Company's needs, supplies may not continue to be
available on an acceptable basis. Inability to obtain adequate supplies of
components or to manufacture such components internally could delay the
Company's ability to ship its products, which could result in the loss of
customers that may seek alternative sources of supply.

PATENTS AND OTHER PROPRIETARY RIGHTS

    The Company relies on a combination of patent, copyright, trademark and
trade secret laws, non-disclosure agreements and other intellectual property
protection methods to protect its proprietary technology. The Company believes
that the duration of its patents generally exceeds the life cycles of the
technologies disclosed and claimed therein. Though the Company has additional
patent applications pending in various foreign countries, any patents may not
result from these applications. In addition, the Company has registered the name
"Heatpulse" with the U.S. Patent and Trademark Office, restricts access to its
technology and enters into confidentiality agreements with its employees and
consultants. Finally, the 


                                       9
<PAGE>   10
Company relies on copyright protection for the software imbedded in its
Heatpulse systems. However, the Company has not registered any portion of the
software with any domestic or foreign copyright office.

    The Company's patents and other means of intellectual property protection,
including the Company's confidentiality agreements and applicable trade secret
laws, may not provide adequate protection for the Company's intellectual
property rights. Further, it is possible that others will develop, copyright or
patent similar technology or reverse engineer the Company's products. In
addition, the laws of certain territories in which the Company's products are or
may be developed, manufactured or sold, including Asia, Europe or Latin America,
may not protect the Company's products and intellectual property rights to the
same extent as the laws of the United States. While the Company intends to
continue to seek patent, copyright, trademark and trade secret protection for
its products and manufacturing technology where appropriate, the Company
believes that its success depends more on the technical expertise and innovative
abilities of its personnel, rather than the protections that these laws can
provide.

    The Company is currently involved in an intellectual property litigation. On
April 24, 1997, Applied Materials, Inc. ("Applied Materials") filed a complaint
against the Company and AST Elektronik GmbH and AST Elektronik U.S.A.
(collectively, "AST") in the United States District Court for the Northern
District of California, San Jose Division, Case No. CV97-20375 RMW. Applied
Materials subsequently amended its complaint. Applied Materials currently
alleges that the Company's products infringe on four Applied Materials patents
relating to Rapid Thermal Processing ("RTP") processes and heater head design
and seeks a permanent injunction against infringement, an award of damages for
infringement, treble damages for intentional and willful infringement,
attorneys' fees and costs of suit. On July 23, 1997, the Company answered
Applied Materials' complaint and counterclaimed for declaratory relief that the
Company's products do not infringe the patents and that the patents are invalid.
On October 3, 1997, the Company filed a counterclaim in the United States
District Court for Northern California, San Jose Division against Applied
Materials for infringement of one of the Company's RTP process patents. On
October 27, 1997, Applied Materials answered the counterclaim by alleging that
it does not infringe the Company's patent and that the patent is invalid. The
Company has filed additional patent claims against Applied Materials in Delaware
and San Jose, California, Case Nos. CA98-479 JJF (Delaware) and CV98-03044 RMW
(San Jose). By stipulation of the parties, the trial on Applied Materials claims
and the Company's counterclaims is set for July 13, 1999. Management believes
Applied Materials' claims are without merit and intends to defend the Company
vigorously, and that the Company's claims against Applied Materials are
meritorious. However, there can be no assurance that this litigation will be
resolved in favor of the Company, and, in any event, litigation could result in
significant expense to the Company and could divert the efforts of the Company's
technical and management personnel from other tasks, whether or not such
litigation is determined in favor of the Company. In particular, the Company has
incurred increased legal expenses in fiscal 1998 and expects to incur further
increased legal expenses in fiscal 1999. In the event of an adverse ruling in
any such litigation, the Company might be required to pay substantial damages,
cease the manufacture, use and sale of infringing products, discontinue the use
of certain processes or expend significant resources to develop non-infringing
technology or obtain licenses to the infringing technology.

    There can be no assurance that other third parties will not assert claims
against the Company with respect to existing or future products or technologies
or that, in case of a dispute, licenses will be available on commercially
reasonable terms, or at all, with respect to disputed third-party technology.
See Item 3, "Legal Proceedings."

    The Company has licensed to Canon certain of the Company's proprietary
technology to design and manufacture modifications to its products for resale in
Japan. In addition, the Company has transferred joint ownership of the CVD
cluster tool technology to AG Israel, together with a license of the Company's
RTP temperature measurement technology. See Part III, Item 13 "Certain
Relationships and Related Transactions."

EMPLOYEES

    As of September 30, 1998, the Company had 201 full-time employees, including
68 in engineering, research and development, 49 in manufacturing, 41 in service,
22 in marketing and sales and 21 in administration. In September 1998 the
Company had a work-force reduction of approximately 50 full-time positions. The
work-force reduction was the result of Company's declining financial
performance, which was in turn due to the industry-wide recession. None of the
Company's employees is subject to a collective bargaining agreement, and the
Company has never experienced a work stoppage. The Company believes that
relations with employees are good.

    Many of the Company's employees are highly skilled, and the Company believes
its future success will depend in part upon its ability to identify, attract and
retain such employees, particularly highly skilled design engineers involved in
new product development, for whom competition is intense. In addition, the
Company is highly dependent on the skill and experience of its CEO and Chairman
of the Board, Arnon Gat.


                                       10
<PAGE>   11
ITEM 2. PROPERTIES

    The Company leases a 153,000 square feet facility in San Jose, California
which houses the Company's management, administrative, manufacturing,
engineering, marketing, sales and customer support personnel. The lease expires
in 2002, and the Company has an option to extend the lease for an additional
five years. The Company also leases approximately 1,500 square feet of office
space for its customer support personnel in Austin, Texas, through April 1999.

    In addition, the Company leases approximately 2,800 square feet of office
space for its sales and customer support personnel in Hsin-Chu, Taiwan, Republic
of China, under a lease, which expires in July 2001.

    The Company believes that its existing facilities are suitable and adequate
to meet the Company's current requirements. The Company will continue to
consider leasing additional facilities as necessary to support its operations in
the future.

ITEM 3. LEGAL PROCEEDINGS

    The Company is currently involved in an intellectual property litigation. On
April 24, 1997, Applied Materials, Inc. ("Applied Materials") filed a complaint
against the Company and AST Elektronik GmbH and AST Elektronik U.S.A.
(collectively, "AST") in the United States District Court for the Northern
District of California, San Jose Division, Case No. CV97-20375 RMW. Applied
Materials subsequently amended its complaint. Applied Materials currently
alleges that the Company's products infringe on four Applied Materials patents
relating to Rapid Thermal Processing ("RTP") processes and heater head design
and seeks a permanent injunction against infringement, an award of damages for
infringement, treble damages for intentional and willful infringement,
attorneys' fees and costs of suit. On July 23, 1997, the Company answered
Applied Materials' complaint and counterclaimed for declaratory relief that the
Company's products do not infringe the patents and that the patents are invalid.
On October 3, 1997, the Company filed a counterclaim in the United States
District Court for Northern California, San Jose Division against Applied
Materials for infringement of one of the Company's RTP process patents. On
October 27, 1997, Applied Materials answered the counterclaim by alleging that
it does not infringe the Company's patent and that the patent is invalid. The
Company has filed additional patent claims against Applied Materials in Delaware
and San Jose, California, Case Nos. CA98-479 JJF (Delaware) and CV98-03044 RMW
(San Jose). By stipulation of the parties, the trial on Applied Materials claims
and the Company's counterclaims is set for July 13, 1999. Management believes
Applied Materials' claims are without merit and intends to defend the Company
vigorously, and that the Company's claims against Applied Materials are
meritorious. However, there can be no assurance that this litigation will be
resolved in favor of the Company, and, in any event, litigation could result in
significant expense to the Company and could divert the efforts of the Company's
technical and management personnel from other tasks, whether or not such
litigation is determined in favor of the Company. In particular, the Company has
incurred increased legal expenses in fiscal 1998 and expects to incur further
increased legal expenses in fiscal 1999. In the event of an adverse ruling in
any such litigation, the Company might be required to pay substantial damages,
cease the manufacture, use and sale of infringing products, discontinue the use
of certain processes or expend significant resources to develop non-infringing
technology or obtain licenses to the infringing technology.


     There has been substantial litigation regarding patent and other
intellectual property rights in the semiconductor industry. General Signal
Corporation has made a claim against at least two manufacturers of cluster tools
that have resulted in litigation to the effect that certain of their cluster
tool technologies infringe on General Signal patents. In 1991, at the time that
General Signal first raised patent claims in the cluster tool area, the Company
joined with six major semiconductor process tool equipment manufacturers in
forming an "Ad Hoc Committee for Defense against General Signal Cluster Tool
Patents" (the "Ad Hoc Committee"). Based in part on an opinion of patent
counsel, the members of the Ad Hoc Committee notified General Signal that the
member companies were of the opinion that the General Signal patents were
invalid based on (a) prior art, (b) inequitable conduct before the Patent &
Trademark Office and (c) estoppel as a result of General Signal's activities in
establishing standards for cluster tools and interfaces within the semiconductor
industry. The Company believes that the position taken by the Ad Hoc Committee
remains valid. Previously, the Company approached General Signal to explore
interest in licensing the same patents at issue in the General Signal
litigation. The general conditions of the license discussed by General Signal
were unacceptable to the Company. Based upon a review of the subject patents,
the Company believes that the subject patents are invalid or, if somehow found
to be valid, that the Company's cluster tool technology does not infringe.
Additionally, the Company has received an opinion of its patent counsel, to the
same effect. However, if such a claim were successfully enforced against the
Company regarding the cluster tool technology transferred to AG Israel, the
value of the Company's investment in AG Israel could diminish. The Company could
also be adversely affected as a result of the Company's liability under an
indemnity provision with AG Israel for any resulting royalties and other damages
payable.


                                       11
<PAGE>   12
    From time to time, the Company may receive or initiate claims or inquiries
against third parties for infringement of the Company's proprietary rights or to
establish the validity of the Company's proprietary rights. Such claims or
inquiries may result in litigation and could result in significant expense to
the Company and divert the efforts of the Company's technical and management
personnel from other tasks, whether or not such claims or inquiries are
determined in favor of the Company. In the event of an adverse ruling in any
such litigation, the Company might be required to pay substantial damages, cease
the manufacture, use and sale of infringing products, discontinue the use of
certain processes or expend significant resources to develop non-infringing
technology or obtain licenses to the infringing technology.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS

    Not applicable.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

COMMON STOCK TRADING RANGE

    The Company's Common Stock has been traded on the Nasdaq National Market
under the symbol AGAI since the Company's initial public offering on May 16,
1995. The following table sets forth, for the Company's Common Stock, the range
of high and low closing prices on the Nasdaq National Market for the two most
recent fiscal years.

<TABLE>
<CAPTION>
                          HIGH            LOW
                          ----            ---
<S>                      <C>            <C>  
Fiscal 1997

  1st Quarter            $7.13          $4.75
  2nd Quarter             7.00           4.88
  3rd Quarter             5.98           4.38
  4th Quarter             7.94           5.75

Fiscal 1998

  1st Quarter            $7.13          $4.13
  2nd Quarter             4.88           3.75
  3rd Quarter             3.94           1.63
  4th Quarter             3.56           2.13
</TABLE>


    The closing price of the Company's Common Stock on November 30, 1998, as
reported by the Nasdaq National Market, was $4.88.

COMMON SHAREHOLDERS OF RECORD AND DIVIDENDS

    At November 30, 1998, there were approximately 187 shareholders of record of
the Company's Common Stock, as shown in the records of the Company's transfer
agent, excluding shareholders whose stock is held in nominee or street name by
brokers. The Company has never paid dividends on its Common Stock, and its
present policy is to retain earnings to finance its future operations.


                                       12
<PAGE>   13
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA


SELECTED CONSOLIDATED FINANCIAL DATA


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
                                                                                    YEARS ENDED SEPTEMBER 30,
                                                                   ----------------------------------------------------------
(in thousands, except per share data)                                1998         1997         1996        1995        1994
                                                                   --------     --------     --------    --------    --------
<S>                                                                <C>          <C>          <C>         <C>         <C>     
Consolidated Statement of Operations Data:
              Net sales                                            $ 45,957     $ 49,604     $ 71,089    $ 62,725    $ 40,251
              Gross profit                                         $ 12,962     $ 16,907     $ 31,724    $ 29,028    $ 17,578
              Research and development                             $ 15,908     $ 14,329     $ 16,653    $  8,893    $  6,078
              Selling, general and administrative                  $  9,573     $  9,247     $ 10,204    $ 10,562    $  7,035
              Income (loss) from operations                        $(12,519)    $ (6,669)    $  4,867    $  9,573    $  4,465
              Income (loss) before income taxes                    $(12,494)    $ (6,237)    $  4,487    $  9,221    $  3,361
              Net income (loss)                                    $(14,000)    $ (4,687)    $  2,743    $  9,753    $  3,224
              Net income (loss) per share - basic                  $  (2.29)    $  (0.78)    $   0.47    $   2.22    $   1.10
              Net income (loss) per share - diluted                $  (2.29)    $  (0.78)    $   0.45    $   2.05    $   0.87
              Shares used in per share calculation - basic            6,102        5,981        5,882       4,385       2,925
              Shares used in per share calculation - diluted          6,102        5,981        6,140       4,770       3,772
</TABLE>

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
                                                                                     YEARS ENDED SEPTEMBER 30,
                                                                   ----------------------------------------------------------
(in thousands)                                                       1998         1997         1996         1995         1994
                                                                   --------     --------     --------     --------     --------
<S>                                                                <C>          <C>          <C>          <C>          <C>
Consolidated Balance Sheet Data:
              Cash, cash equivalents and short-term investments    $  1,332     $  4,157     $ 11,985     $ 18,858     $  1,598
              Working capital (deficiency)                         $  8,306     $ 22,867     $ 26,851     $ 28,649     $ (1,257)
              Total assets                                         $ 30,770     $ 42,947     $ 45,852     $ 48,825     $ 14,676
              Long-term obligations                                    --       $    275     $     11     $    193     $    691
              Convertible subordinated debentures                      --           --           --           --       $  2,107
              Minority interest in subsidiary                          --           --           --           --       $  1,979
              Shareholders' equity (deficiency)                    $ 17,902     $ 31,522     $ 35,694     $ 32,300     $ (3,740)
</TABLE>


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
                                                                                                  QUARTER ENDED
                                                                                -----------------------------------------------
(in thousands, except per share data)                                            SEP 30       JUNE 30     MARCH 31     DEC. 31
                                                                                --------     --------     --------     --------
<S>                                                                             <C>          <C>          <C>          <C>
Consolidated Statement of Operations Data: (unaudited)
1998
              Net sales                                                         $  8,179     $  8,776     $ 12,569     $ 16,433
              Gross profit                                                         1,466        1,569        3,680        6,248
              Loss from operations                                                (5,393)      (4,813)      (2,252)         (61)
              Income (loss) before income taxes                                   (5,463)      (4,837)      (2,208)          15
              Net income (loss)                                                   (6,963)      (4,837)      (2,208)           9
              Net income (loss) per share - basic                               $  (1.14)    $  (0.80)    $  (0.36)    $   --
              Net income (loss) per share - diluted                             $  (1.14)    $  (0.80)    $  (0.36)    $   --
                                                                                
1997                                                                            
              Net sales                                                         $ 15,951     $ 13,380     $ 11,140     $  9,133
              Gross profit                                                         6,762        4,935        1,811        3,399
              Loss from operations                                                  (514)      (1,255)      (3,033)      (1,867)
              Loss before income taxes                                              (439)      (1,147)      (2,923)      (1,727)
              Net loss                                                              (351)        (849)      (2,192)      (1,295)
              Net loss per share - basic                                        $  (0.06)    $  (0.14)    $  (0.37)    $  (0.22)
              Net loss per share - diluted                                      $  (0.06)    $  (0.14)    $  (0.37)    $  (0.22)
</TABLE>


                                       13
<PAGE>   14
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

FORWARD-LOOKING STATEMENTS

    Except for the historical information contained herein, the matters
discussed in this Annual Report on Form 10-K, and specifically in the Sections
entitled "Description of Business" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations", are forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended, and Section 27A of the Securities Act of 1933, as amended. These
forward-looking statements are subject to significant risks and uncertainties,
including those identified within the "Factors That May Affect Future Results"
section of "Managements Discussions and Analysis of Financial Condition and
Results of Operations." The actual results that the Company achieves may differ
materially from any forward-looking projections due to such risks and
uncertainties. The Company has identified with a preceding asterisk ("*")
various sentences within this Annual Report on Form 10-K which contain such
forward-looking statements, and words such as "believes," "anticipates,"
"expects," "future," "intends" and similar expressions are intended to identify
forward-looking statements. In addition, the section labeled "Factors That May
Affect Future Results," which has no asterisks for improved readability,
consists primarily of forward-looking statements. The Company undertakes no
obligation to publicly release the results of any revisions to these
forward-looking statements that may be made to reflect events or circumstances
after the date hereof. Readers are urged to carefully review and consider the
various disclosures made by the Company in this report and in the Company's
other reports filed with the Securities and Exchange Commission that attempt to
advise interested parties of the risks and factors that may affect the Company's
business.

FACTORS THAT MAY AFFECT FUTURE RESULTS

    POTENTIAL MERGER. On November 25, 1998, the Company announced that it is in
discussions with Steag Electronic Systems GmbH, a subsidiary of Steag AG (Essen,
Germany), concerning a possible cash acquisition of the Company. The terms and
conditions of an acquisition have not been finalized, but it is expected that an
acquisition, if it occurs, will value the equity of AG Associates in excess of
$30 million. Completion of a transaction will be subject to the negotiation of
definitive documentation, board approval and obtaining required third party and
government approvals. Consequently, there can be no assurance that an agreement
between the two companies with respect to an acquisition will be reached or that
a transaction will be completed. In addition, the Company has not yet made a
determination as to whether any business combination would be in the best
interests of its stockholders. It is the general policy of the Company not to
comment upon or disclose preliminary negotiations regarding significant
corporate transactions, and the Company intends to continue this policy in the
future; therefore, no further announcement with regards to the proposed
transaction will be made until and unless its terms have been finalized. A
potential merger also involves a number of special risks, including the
diversion of management's attention to the analysis and negotiation of the
merger, employee, customer and marketplace uncertainty regarding the impact of
the potential merger, and difficulty in presenting corporate image. These risk
factors could have a material adverse effect on the Company's business,
financial condition and results of operations.

    RAPID TECHNOLOGICAL CHANGE AND DEVELOPMENT RISKS. The Company derives
substantially all of its revenue from a single line of rapid thermal processing
products. The rapid thermal processing ("RTP") industry is subject to rapid
technological change, and the Company and its competitors continuously seek to
introduce new products that provide improved process results and manufacturing
performance at prices acceptable to RTP customers. There can be no assurance
that the Company can develop new products more quickly than its competitors or
that the Company's products will have better price/performance characteristics
than competitors' products. During the second and third quarters of fiscal 1998,
the Company shipped beta units of its new Starfire 200mm and Starfire 300mm RTP
systems, which are intended to provide RTP capabilities for the 0.18 and 0.25
micron line widths previously unavailable from the Company's products. Initial
margins on the Starfire RTP systems are expected to be lower than current
Heatpulse production systems, and the Starfire RTP systems may not achieve
market acceptance or deliver anticipated reductions in customers' cost of
ownership.

    SEMICONDUCTOR INDUSTRY VOLATILITY. The semiconductor industry has
historically been cyclical and subject to unexpected periodic downturns
associated with sudden changes in supply and demand. During fiscal 1998, the
Company's business, financial condition and operating results were adversely
impacted by a sudden downturn in the semiconductor equipment industry caused, in
part, by economic instability in Asia. This recession has had an adverse effect
on the Company's backlog. In addition, the Company's continuation of a high
level of spending on its new products and competitive pressures will continue to
affect the Company's overall profitability. The Company cannot predict industry
cycles and their effect on the RTP market, rate of orders for the Company's
products or the degree to which the Company's new products will achieve market
acceptance. In particular, the semiconductor industry may experience a prolonged


                                       14
<PAGE>   15
recession as a result of economic instability in Asia. For these reasons, the
Company's, analysts' and investors' expectations with respect to the Company's
new orders, net sales and operating results with respect to future quarters may
not be met.

    FOREIGN OPERATIONS. The Company's foreign operations are subject to certain
risks common to international operations, such as government regulations, import
restrictions, currency fluctuations, repatriation restrictions and, in certain
jurisdictions, reduced protection for the Company's copyrights and trademarks
and economic volatility. While the Company does not expect the introduction of
the Euro currency to have a significant impact on the Company's revenues or
results of operations, the Company is unable to determine what effects, if any,
the currency change in Europe will have on competition and competitive pricing
in the affected regions.

    STOCK PRICE VOLATILITY. The Company's common stock price has been and may
continue to be subject to significant volatility. For any given quarter, a
shortfall in the Company's announced revenue or earnings from the levels
expected by securities analysts or investors or sustained or increasing weakness
in the RTP market could have an immediate and adverse effect on the trading
price of the Company's common stock. The Company may not learn of, nor be able
to confirm, revenue or earnings shortfalls until late in the quarter or
following the end of the quarter. In general, the Company participates in a very
dynamic high technology industry, which can result in significant fluctuations
in the Company's common stock price at any time.

    COMPETITION. The Company's ability to compete depends upon the Company's
ability to develop new RTP product features that enhance uniformity and
repeatability, improve process capability and flexibility and reduce cost of
ownership. The Company's competitors, many of who have substantially greater
resources than the Company (such as Applied Materials and Steag/AST), also seek
to compete in these areas. In addition, the Company expects to see increased
competition from batch furnace vendors as those companies increase functionality
available in such machines. Applied Materials has made significant gains in the
Company's market and had offered certain functionality the Company was not able
to previously provide with its products, allowing Applied Materials to capture
significant customers. Applied Materials and AST are significantly larger
companies with greater resources than the Company. There are also larger
Japanese and domestic companies that possess the technical resources to enter
the RTP market.

    CLAIMS OF PATENT INFRINGEMENT. The Company is currently involved in an
intellectual property litigation. On April 24, 1997, Applied Materials filed a
complaint against the Company and AST in the United States District Court for
the Northern District of California, San Jose Division, Case No. CV97-20375 RMW.
Applied Materials subsequently amended its complaint. Applied Materials
currently alleges that the Company's products infringe on four Applied Materials
patents relating to RTP processes and heater head design and seeks a permanent
injunction against infringement, an award of damages for infringement, treble
damages for intentional and willful infringement, attorneys' fees and costs of
suit. On July 23, 1997, the Company answered Applied Materials' complaint and
counterclaimed for declaratory relief that the Company's products do not
infringe the patents and that the patents are invalid. On October 3, 1997, the
Company filed a counterclaim in the United States District Court for Northern
California, San Jose Division against Applied Materials for infringement of one
of the Company's RTP process patents. On October 27, 1997, Applied Materials
answered the counterclaim by alleging that it does not infringe the Company's
patent and that the patent is invalid. The Company has filed additional patent
claims against Applied Materials in Delaware and San Jose, California, Case Nos.
CA98-479 JJF (Delaware) and CV98-03044 RMW (San Jose). By stipulation of the
parties, the trial on Applied Materials claims and the Company's counterclaims
is set for July 13, 1999. Management believes Applied Materials' claims are
without merit and intends to defend the Company vigorously, and that the
Company's claims against Applied Materials are meritorious. However, there can
be no assurance that this litigation will be resolved in favor of the Company,
and, in any event, litigation could result in significant expense to the Company
and could divert the efforts of the Company's technical and management personnel
from other tasks, whether or not such litigation is determined in favor of the
Company. In particular, the Company has incurred increased legal expenses in
fiscal 1998 and expects to incur further increased legal expenses in fiscal
1999. In the event of an adverse ruling in any such litigation, the Company
might be required to pay substantial damages, cease the manufacture, use and
sale of infringing products, discontinue the use of certain processes or expend
significant resources to develop non-infringing technology or obtain licenses to
the infringing technology.

    INVENTORY OBSOLESCENCE. Because the Company's industry is subject to rapid
technological change, the Company has experienced, and expects to experience,
obsolescence of certain of its products as the Company and its competitors
introduce new products with improved price/performance characteristics. In
particular, the Company discontinued its Heatpulse 4100 product line in the
quarter ended March 31, 1997 and consequently wrote down $1.4 million of
inventory in that quarter. During the quarter ended June 30, 1997, the Company,
for the first time in its history, booked more orders for its Heatpulse 8800
product line than for its Heatpulse 8100 product line and this trend continued
through the 


                                       15
<PAGE>   16
fourth quarter of fiscal 1998. To the extent sales of new products do not
offset, or generate lower margins than, sales of older products, the Company's
business, results of operation and financial condition would be materially
adversely affected. In addition, the Company believes that the Heatpulse 8100
product line will ultimately become obsolete as acceptance of the Heatpulse 8800
and Starfire products increases.

    POTENTIAL FLUCTUATIONS IN OPERATING RESULTS. The Company's operating results
are subject to quarterly and other fluctuations due to a variety of factors,
including the volume and timing of orders received, potential cancellation or
rescheduling of orders, competitive pricing pressures, the Company's ability to
manage costs during periods of low or negative earnings growth, the availability
and cost of component parts and materials from the Company's suppliers, the
adequate forecasting of the mix of product demand due to production lead times
and capacity constraints, the timing of new product announcements and
introductions by the Company or its competitors, changes in the mix of products
sold, research and development expenses associated with new product
introductions, the timing and level of development costs, market acceptance of
new or enhanced versions of the Company's products, seasonal customer demand,
the cyclical nature of the semiconductor industry, the impact of the Company's
efforts to implement its evolving long-term strategy, the uncertainties of
ongoing negotiations and economic conditions generally or in various geographic
areas. In addition, because of the relatively high selling prices of the
Company's products, a significant portion of the Company's net sales in any
given period is derived from the sale of a relatively small number of units, and
a change, even though minor, in the number of units sold during a quarter can
result in a large fluctuation in net sales for the quarter.

    EMPLOYEE RISK. Competition in recruiting personnel in the semiconductor
industry is intense. The Company believes that its future success will depend in
part on its ability to recruit and retain highly skilled management, marketing
and technical personnel. The Company believes it must provide personnel with a
competitive compensation package, which necessitates the continued availability
of stock options and requires ongoing shareholder approval of the Company's
stock compensation programs.

YEAR 2000 DISCLOSURE

    A three-branch cross-functional project team has been established to address
the three primary areas of concern for the Company; infrastructure, products and
material suppliers. The Company has completed the initial assessment phase for
the three primary areas. At present, the Company is in the process of fixing and
testing non-compliant systems and products.

    READINESS. The Company identified and evaluated the internal hardware,
software and manual systems for Year 2000 compliance. These items include, but
are not limited to, Company software, network servers, desktop workstations,
telephone and Internet communications, plant security, and manufacturing and
testing equipment. Those items found to be non-compliant have been scheduled for
upgrade or contingency planning. The Company utilizes standard industry software
packages and hardware common to the semiconductor equipment industry. The
Company's primary software system, Dataworks, will undergo an upgrade in the
second quarter of fiscal 1999, which will bring that system to Year 2000
compliance.

    The Company has surveyed its supplier base. Based on the results of the
survey, and a measure of supplier importance, the Company has identified all
high-risk suppliers. Currently, the Company is performing in-depth audits of
these suppliers and developing contingency plans where required. Suppliers have
been ranked into one of the following four categories: 1) non-compliance by the
supplier will cause the Company to stop shipment of its products; 2)
non-compliance by the supplier will cause the Company to delay shipment of its
products by one week or more; 3) non-compliance by the supplier will cause the
Company to delay shipment of its products by less than one week; and 4)
non-compliance by the supplier will have no effect on shipment of the Company's
products. At this time, the Company does not anticipate any material disruption
in its operations as a result of any failure by a critical supplier.

    The Company has completed an industry standard testing procedure for the
primary products sold. Year 2000 repairs and remedial strategies, where required
and where possible, have been available to the Company's customers starting
November 1998. The Company uses Sematech's Year 2000 readiness standards and
test scenarios, which include a minimum set of tests equipment manufacturers
should perform in the evaluation of their products. The Company does not
anticipate any material disruption in its operations as a result of any failure
of Company's products to be in Year 2000 compliance.


                                       16
<PAGE>   17
    COST. At this time, the fiscal 1999 cost of repair is estimated to be less
than $200,000 for materials and services. This estimate does not include labor
applied to Year 2000 projects, though at this time no projects have been
canceled or significantly delayed due to Year 2000 efforts within the Company.
Costs incurred to this point have not exceeded $50,000, and most costs can be
expected to occur in the second and third quarters of fiscal 1999. The next
major expense will occur during the first quarter of 1999 when the Company's
primary system (Dataworks) will be upgraded. The costs are being expensed each
period as part of general and administrative expenses.

    RISK. The Company does not anticipate any material disruption in its
operations as a result of any internal or external failures due to Year 2000.
The Company is also evaluating the potential, as a worst-case scenario, the
possibility of significantly disrupting a major customer's manufacture of
semiconductor devices. Since the Company's products are integral to a much
larger manufacturing process, any undiscovered problem could significantly
disrupt processes for the Company's customers. The Company is determining the
possible exposure to material delivery disruption by auditing, in detail, what
it believes to be the 22 most critical suppliers. Even those suppliers that have
a sufficient level of Year 2000 readiness could materially affect the Company's
ability to ship product.

    CONTINGENCY PLANNING. The Company is preparing for minor delivery delays in
both the receipt of materials and shipment of product due to transportation
disruptions. At this time, it appears that the local utility providers will be
able to function without significant disruption. The Company is also preparing
plans to avoid the worst-case scenario of disrupting customer's manufacturing
process. The Company is continuing to test its equipment using guidelines from
specific key customers. The Company is also urging its customers to test
equipment, using the Sematech standard tests, to determine the behavior of the
system during all Year 2000 test dates. At present, the Company is offering
information to its customers via written and oral communications. During the
first quarter of fiscal 1999, the Company began publishing on the World Wide Web
product specific bulletins addressing Year 2000 concerns. It is the Company's
intent to educate its customers about the importance of continued Year 2000
testing within their manufacturing facilities in a manner closely approximating
actual usage. To address possible supplier disruption, the Company will
calculate safety stock levels for critical material that could allow the Company
to continue to ship product without materially impacting revenue. In the first
half of 1999, the Company will access the safety stock levels based on the most
current backlog and revenue outlook available.

RESULTS OF OPERATIONS

    The following table sets forth certain items in the Company's Consolidated
Statements of Operations as a percentage of net sales for the periods indicated.

<TABLE>
<CAPTION>
                                                   YEARS ENDED SEPTEMBER 30,
                                              ------------------------------------
                                                1998*         1997*         1996*
                                              --------      --------      --------
<S>                                           <C>           <C>           <C> 
Net sales                                          100%          100%          100%
Cost of sales                                       72            66            55
                                              --------      --------      --------
   Gross profit                                     28            34            45
                                              --------      --------      --------
Operating expenses:
   Research and development                         35            29            23
   Selling, general and administrative              21            19            14
                                              --------      --------      --------
          Total operating expenses                  55            48            37
                                              --------      --------      --------
Income (loss) from operations                      (27)          (13)            7
   Other income (expense), net                    --               1             1
   Equity in loss of unconsolidated
      subsidiary                                  --            --              (2)
                                              --------      --------      --------
Income (loss) before income taxes                  (27)          (12)            6
Provision (benefit) for income taxes                (3)           (3)            2

                                              ========      ========      ========
Net income (loss)                                  (30%)          (9%)           4%
                                              ========      ========      ========
</TABLE>

    *   Percentages may not total 100% due to rounding


                                       17
<PAGE>   18
FISCAL YEAR ENDED SEPTEMBER 30, 1998 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1997

    Net sales decreased to $46.0 million in fiscal 1998 from $49.6 million in
fiscal 1997, a decrease of 7%. Substantially all net sales were derived from RTP
operations for both periods. The sales decline in the current fiscal year was
primarily due to the decrease in unit sales of the Company's Heatpulse products,
as reflected in a decrease in sales to Intel, the Company's largest customer in
fiscal 1998 and 1997, which accounted for $6.5 million of the Company's net
sales in fiscal 1998 compared to $12.0 million in fiscal 1997. The sales decline
reflects the impact of the industry-wide recession, the negative effects of
which were first experienced by the Company in the second quarter of fiscal
1998.

    Sales to distributors were $20.9 million in fiscal 1998 compared to $9.8
million in the prior fiscal year. The Company utilizes distributors in certain
geographic regions. All of the Company's sales in Japan are through Canon, and
those in Europe and Korea are through Metron. Sales to distributors generally
result in a lower gross profit, caused by lower selling prices, which are
partially offset by reduced warranty, selling and marketing expenses. In fiscal
1998, Canon represented 32% of net sales, compared to 12% of net sales in fiscal
1997, and Metron represented 13% of net sales, compared to 8% of net sales in
fiscal 1997. International sales for the Company increased to $24.6 million in
the current fiscal year from $15.6 million in fiscal 1997, an increase of 58
percent. The increase in international sales and sales to distributors was
primarily due higher sales in Japan and Europe and lower sales domestically.
Domestic sales for the Company decreased to $21.4 million in the current fiscal
year from $34.0 million in fiscal 1997. The decrease in domestic sales is
primarily due lower sales to Intel and Micron. *Based upon the geographic
locations of semiconductor manufacturers, the Company anticipates that
international sales in general will continue to account for a significant
portion of net sales in fiscal 1999. *However, international sales as a
percentage of net sales will vary on a quarterly basis depending on the impact
of the economic instability in Asia, the timing of orders and the relative
strength of domestic sales. International sales are typically denominated in
United States dollars. *Because sales of the Company's products are denominated
in United States dollars, fluctuations in the value of the dollar could increase
or decrease the prices in local currencies of the Company's products in foreign
markets and make the Company's products relatively more or less expensive than
competitors' products that are denominated in local currencies. Inflation has
not had a material impact on the Company's net sales or results of operations.

    The Company's end-user customers include most of the leading semiconductor
manufacturers worldwide. For the year ended September 30, 1998, Intel accounted
for 14% of total net sales and Micron accounted for 7% of total net sales. For
the year ended September 30, 1997, Intel accounted for 24% of total net sales
and Micron accounted for 10% of total net sales. For the year ended September
30, 1996, Intel Corporation accounted for 20% of total net sales and NEC
accounted for 17% of total net sales. No other end-user customer accounted for
more than 10% of the total net sales for fiscal years ended September 30, 1998,
1997 and 1996. *The Company expects continued competition from competitors who
have substantially greater resources than the Company, particularly in the sale
of RTP systems designed for .18 and .25 micron applications and in 200mm and
300mm applications. In addition, the Company has experienced, and continues to
experience, competition from other RTP equipment suppliers. *These competitors'
impact on future sales cannot be estimated. *As a result of competitive
pressures, there can be no assurance that the Company will be able to retain its
strategic customers or that such customers will not cancel, reschedule or
significantly reduce the volume of orders or, in the event orders are canceled,
that such orders will be replaced by other sales. *The loss of any significant
end-user customer, even if replaced by a different significant end-user
customer, could have a material adverse effect on the Company's business,
results of operations and financial condition.

    Gross profit decreased to $13.0 million in fiscal 1998 from $16.9 million in
the prior fiscal year, a decrease of 23%, and gross profit for the fourth
quarter of fiscal 1998 decreased to $1.5 million as compared to $6.8 million in
the fourth quarter of fiscal 1997. Gross profit as a percentage of net sales
declined to 28% in the current fiscal year from 34% in fiscal 1997. Gross profit
decreased from fiscal 1997 to fiscal 1998 primarily because of decreases in unit
selling prices resulting from an increase in sales through the distribution
channel. Distributors are given a significant discount to the final price paid
by the end-user customer, which is partially offset by reduced warranty expenses
and other costs in operating expenses. Also contributing to the decrease in
gross margin in fiscal 1998 as compared to fiscal 1997 was the decrease in unit
shipments which caused the Company's fixed manufacturing costs to be spread over
fewer units. *The Company expects gross margins to improve in the next two
quarters as compared to the fourth quarter of fiscal 1998 as a result of
multiple systems orders received. *However, this expected improvement is subject
to significant risks including the degree to which orders and shipments are
affected by the economic instability in Asia and other regions, the timely
development and acceptance of new products, pricing, competition, and other risk
factors discussed above under the heading "Factors That May Affect Future
Results."

    Research and Development ("R&D") expenses increased to $15.9 million in the
current fiscal year from $14.3 million in the prior fiscal year, an increase of
11%. As a percentage of net sales, R&D expenses increased to 35% in fiscal 1998
from 


                                       18
<PAGE>   19
29% in fiscal 1997, reflecting the Company's commitment to bring new products to
market and the decrease in net sales from fiscal 1997 to fiscal 1998. During
fiscal 1998, the Company continued development on the Starfire .18 micron
platform for 200mm and 300mm RTP products, which were announced in fiscal 1997.
*The Company continues to believe that significant investment in R&D is required
to remain competitive, particularly during the current semiconductor market
slowdown and associated decrease in customers' capacity demands. * However, the
Company expects R&D costs to decline in absolute dollars over the next two
quarters as a result of a reduction in work force which took place in the fourth
quarter of fiscal 1998. *The failure of the Company to timely develop new
platforms, the failure of new platforms to meet customer expectations regarding
performance and cost or the failure of new platforms to achieve market
acceptance following product introduction would each have a material adverse
effect on the Company's business, results of operations and financial condition.
See "Factors That May Affect Future Results - Rapid Technological Change and
Development Risks." All R&D costs are expensed as incurred.

    Selling, general and administrative ("SG&A") expenses increased to $9.6
million in fiscal 1998 from $9.2 million in fiscal 1997, an increase of 4%. As a
percentage of net sales, SG&A expenses increased to 21% in fiscal 1998 from 19%
in fiscal 1997, reflecting lower sales in the more recent period. The increase
for the current fiscal year was due primarily to increased legal fees associated
with the Applied Materials intellectual property litigation, as well as lower
sales. *In fiscal 1999, SG&A spending in absolute dollars is expected to
decrease as a result of a reduction in work force which took place in the fourth
quarter of fiscal 1998; however, actual spending may fluctuate depending on,
among other things, the level of net sales and the Applied Materials
intellectual property litigation. See "Factors That May Affect Future Results -
Claims of Patent Infringement." *As a percentage of net sales, SG&A spending may
vary from quarter to quarter.

    Other income (expense), net was $25,000 in fiscal 1998 and $432,000 in
fiscal 1997, and decreased in fiscal 1998 primarily as a result of lower
interest income earned on the Company's reduced cash and investment balances as
well as increased interest expense on borrowings against the Company's line of
credit. Other income also included commissions on quartz sales of $129,000
earned in fiscal 1998 and $134,000 in fiscal 1997.

    For fiscal 1998, the Company recorded an income tax provision of $1.5
million compared to an income tax benefit of $1.5 million in fiscal 1997. In
fiscal 1998 and 1997, the effective income tax rate used to compute the
Company's income tax benefit was lower than the federal statutory rate due both
to an increase in the Company's valuation allowance as a result of management's
estimate of deferred tax assets that were more likely than not to be recognized
and other permanent items not deductible for tax purposes. In fiscal 1998, such
valuation resulted in a negative effective tax rate.

    The Company's systems backlog (consisting of product scheduled for delivery
within the next twelve months) as of September 30, 1998 was approximately $14.9
million, as compared to $14.6 million at September 30, 1997. The increase in
backlog was a result of increased orders for new Starfire products, offset in
part by decreases attributable to the effects on the worldwide semiconductor
industry of the economic crisis in Asia. The Company includes in its backlog
customer purchase orders that have been accepted and to which shipment dates
have been assigned within the next twelve months. All orders are subject to
cancellation or delay with limited or no penalty. *Because of possible changes
in the delivery schedules and additions or cancellations of orders, the
Company's backlog at any particular date is not necessarily indicative of actual
sales for any succeeding period. See "Factors That May Affect Future Results
Semiconductor Industry Volatility."

FISCAL YEAR ENDED SEPTEMBER 30, 1997 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1996

    Net sales decreased to $49.6 million in fiscal 1997 from $71.1 million in
fiscal 1996, a decrease of 30%. Substantially all net sales were derived from
RTP operations for both periods. The sales decline in the current fiscal year
was primarily due to the decrease in unit sales of the Company's Heatpulse
products, as reflected in a decrease in sales to Intel, the Company's largest
customer in fiscal 1997 and 1996, which accounted for $12.0 million of the
Company's net sales in fiscal 1997 compared to $14.0 million in fiscal 1996. The
sales decline reflects the global semiconductor industry's slowing order rate at
the end of fiscal 1996 and the beginning of fiscal 1997 and competition from two
competitors with greater financial resources than the Company.

    Sales to distributors were $9.8 million in fiscal 1997 compared to $27.0
million in the prior fiscal year. The Company utilizes distributors in certain
geographic regions. All of the Company's sales in Japan are through Canon, and
those in Europe and Korea are through Metron. Sales to distributors generally
result in a lower gross profit, caused by lower selling prices, which are
largely offset by reduced selling and marketing expenses. In fiscal 1997, Canon
represented 12% of net sales, compared to 24% of net sales in fiscal 1996, and
Metron represented 8% of net sales, compared to 14% of net sales in fiscal 1996.
The decrease in sales to distributors was primarily due the decline of the
global semiconductor industry's order rate at the end of fiscal 1996 and the
beginning of fiscal 1997. Domestic sales for the Company increased to $34.0
million in 


                                       19
<PAGE>   20
the current fiscal year from $32.5 million in fiscal 1996. The increase in
domestic sales is primarily due to increased revenues from Micron. International
sales for the Company decreased to $15.6 million in the current fiscal year from
$38.6 million in fiscal 1996, a decrease of 60 percent. The decrease of
international sales results from the decline of the global semiconductor
industry's order rate at the end of fiscal 1996 and the beginning of fiscal
1997.

    The Company's end-user customers include most of the leading semiconductor
manufacturers worldwide. For the year ended September 30, 1997, Intel accounted
for 25% of total net sales and Micron accounted for 10% of total net sales. For
the year ended September 30, 1996, Intel Corporation accounted for 20% of total
net sales and NEC accounted for 17% of total net sales.

    Gross profit decreased to $16.9 million in fiscal 1997 from $31.7 million in
the prior fiscal year, a decrease of 47%. However, gross profit for the fourth
quarter of fiscal 1997 increased to $6.8 million as compared to $2.8 million in
the fourth quarter of fiscal 1996. This increase reflects the global
semiconductor industry's gradual recovery over the course of fiscal 1997. Gross
profit decreased from fiscal 1996 to fiscal 1997 primarily as a result of
decreased sales volume. Gross profit as a percentage of net sales declined to
34% in the current fiscal year from 45% in fiscal 1996. The reduced gross profit
percentage resulted primarily from a decline in sales volume and a one-time
charge in the second quarter for obsolete inventory related to the Heatpulse
4108 product.

    Research and Development ("R&D") expenses decreased to $14.3 million in the
current fiscal year from $16.7 million in the prior fiscal year, a decrease of
14%. As a percentage of net sales, R&D expenses increased to 29% in fiscal 1997
from 23% in fiscal 1996, reflecting the Company's commitment to bring new
products to market and the decrease in net sales from fiscal 1996 to fiscal
1997. During fiscal year 1997, the Company announced the Starfire .18 micron
platform for 200mm and 300mm RTP products. All R&D costs are expensed as
incurred.

    Selling, general and administrative ("SG&A") expenses decreased to $9.2
million in fiscal 1997 from $10.2 million in fiscal 1996, a decrease of 9%. As a
percentage of net sales, SG&A expenses increased to 19% in fiscal 1997 from 14%
in fiscal 1996, reflecting lower sales in the more recent period. The decrease
in absolute dollars for the current fiscal year was due primarily to the
Company's management of expenses in response to the decline in sales, most
notably the decrease in payroll expenditures realized from the work force
reduction in July 1996, and reduced direct commissions resulting from lower net
sales in fiscal 1997 compared to fiscal 1996.

    Other income (expense), net was $432,000 in fiscal 1997 and $772,000 in
fiscal 1996, and decreased in fiscal 1997 primarily as a result of lower
interest income earned on the Company's reduced cash and investment balances.
Other income also included commissions on quartz sales of $134,000 earned in
fiscal 1997 and $190,000 in fiscal 1996.

    Equity in loss of unconsolidated subsidiary was $1.2 million for fiscal
1996. This represents the Company's share of the losses of AG Associates
(Israel) Ltd. ("AG Israel") during fiscal 1996. In May 1995, a 51% interest in
AG Israel was acquired by Clal Electronics Industries Ltd. ("Clal Electronics"),
and from June 1, 1995 to November 1997, the Company retained a 49% interest in
AG Israel. The Company has accounted for its investment on the equity method
since June 1, 1995. Prior to that, AG Israel was accounted for as a wholly owned
subsidiary of the Company and its results of operations were included in the
consolidated financial statements of the Company. In November 1997, AG Israel
completed a private placement of $13.0 million, in which the Company did not
participate. The effect of this financing was to dilute the Company's voting
interest to 28%. *Additional losses from AG Israel's operations will be recorded
only to the extent of any future investments by the Company.

    For fiscal 1997, the Company recorded an income tax benefit of $1.5 million
compared to an income tax expense of $1.7 million in fiscal 1996. In fiscal
1997, the effective income tax rate used to compute the Company's income tax
benefit was lower than the federal statutory rate due both to an increase in the
Company's valuation allowance as a result of management's estimate that deferred
tax assets were more likely than not to be recognized and other permanent items
not being deductible for tax purposes.

LIQUIDITY AND CAPITAL RESOURCES

    As of September 30, 1998, the Company had cash, cash equivalents and
short-term investments of $1.3 million compared to $4.2 million as of September
30, 1997. The decrease of $2.9 million from fiscal 1997 to 1998 was primarily
attributable to cash used in operations and capital expenditures, offset in part
by short-term borrowings. Working capital decreased to $8.3 million at September
30, 1998 from $22.9 million at September 30, 1997. During fiscal 1998, the
Company entered into a line of credit with a bank, which provides for borrowings
of up to $12,000,000, limited to 


                                       20
<PAGE>   21
outstanding accounts receivable, as defined, which expires June 23, 2000. During
the second half of fiscal 1998, the Company borrowed $5,469,000 under this line
of credit. The borrowings are collateralized by primarily all of the Company's
assets, bears interest at prime (8.25% at September 30, 1998) plus 1.0% per
annum and are due June 23, 2000. The line of credit is subject to certain
financial covenants. At September 30, 1998, the Company was in compliance with
these covenants.

    The Company's operating activities used cash of $4.4 million during fiscal
1998. The net loss of $14.0 million, decreases in accounts payable of $2.8
million and accrued liabilities of $1.1 million, were offset by decreases in
accounts receivable of $7.7 million, deferred income taxes of $2.7 million, and
depreciation expense of $2.8 million. The decrease in accounts payable was
primarily due to a decrease in fixed asset purchases and R&D spending in the
fourth quarter of fiscal 1998 compared to the fourth quarter of fiscal 1997. The
decrease in accrued liabilities was primarily due to a decrease in the warranty
reserve for, resulting from the decrease in the number of units sold under
warranty coverage, as well as reduced compensation related accruals reflecting
lower headcount as of September 30, 1998 as compared to September 30, 1997. The
decrease in accounts receivable was due to decreased sales in the fourth quarter
of fiscal 1998 compared to the fourth quarter of fiscal 1997. The decrease in
deferred income taxes was due primarily to an increase in the valuation
allowance to reduce net deferred tax assets to an amount expected more likely
than not to be recognized.

    The Company's operating activities used cash of $4.6 million during fiscal
1997. Net loss of $4.7 million, increases in accounts receivable of $4.9 million
and prepaids of $434,000, and decreases in accrued liabilities of $327,000,
customer advances of $245,000 and income taxes payable/refundable of $189,000
were offset by increases in accounts payable of $1.6 million, loss on disposal
of fixed assets of $919,000 and a decrease in deferred income taxes of $846,000.
The increase in accounts receivable was due to increasing sales in the fourth
quarter of fiscal 1997 compared to the fourth quarter of fiscal 1996. The
increase in prepaids was primarily due to the addition of an asset exchanged for
services. The decrease in customer advances was primarily due to the return of
an experimental tool and subsequent refund to the customer. The decrease in
accrued liabilities was primarily due to a decrease in the reserve for warranty
parts and labor, resulting from the decrease in the number of tools under
warranty coverage, and in a change in the calculation method of reserve
requirements. The decrease in deferred income taxes was due primarily to an
increase in the valuation allowance to reduce net deferred tax assets to an
amount expected more likely than not to be recognized. The increase in payables
was primarily due to an increase in fixed asset purchases and R&D spending in
the fourth quarter of fiscal 1997 compared to the fourth quarter of fiscal 1996.
The loss on disposal of fixed assets was primarily due to the decommission of
engineering systems. In addition, inventories remained constant despite a
write-down of $1.4 million in inventory during fiscal 1997 related to the
discontinuance of the Heatpulse 4100 product line, as the Company increased
inventories during the fourth quarter of fiscal 1997 to support anticipated Beta
testing of its Starfire products and potential net sales growth.

    Cash provided by operating activities was $673,000 during fiscal 1996. Net
income of $2.7 million, a decrease in accounts receivable of $4.9 million and
losses from equity in AG Israel of $1.2 million were offset by increases in
inventory of $3.3 million along with decreases in accounts payable of $2.4
million, accrued liabilities of $2.2 million and refundable income taxes of $2.1
million. The decrease in accounts receivable was due to increased collection
activity and declining sales during the fourth quarter of fiscal 1996. The
increase in inventory was primarily due to increased levels of raw materials in
preparation for meeting the Company's shipment targets for fiscal 1996, as well
as the stocking of offsite spares inventories. The decrease in payables was
primarily due to a decrease in purchases during the second half of fiscal 1996.
The decrease in accruals was primarily due to reduced commission expense and
other payroll accruals and lower level of operations during the second half of
1996.

    Cash provided by (used in) investing activities was ($2.4) million in fiscal
1998, $4.9 million in fiscal 1997 and ($7.3) million in fiscal 1996. Capital
expenditures of $4.1 million in fiscal 1998 were partially offset by maturities
of short-term investments. Capital expenditures and purchases of short-term
investments totaling $12.9 million were the principal uses of cash in investment
activities in fiscal 1997 and were offset by maturities of short-term
investments of $17.8 million. Capital expenditures, purchases of short-term
investments and a required $1 million equity investment in AG Israel were the
principal uses of cash in investment activities in fiscal 1996. Capital
expenditures were approximately $4.1 million in fiscal 1998, $3.5 million in
fiscal 1997 and $6.9 million in fiscal 1996. The Company leased capital
equipment with a cost of $496,000 in fiscal 1997; the Company did not enter into
any capital equipment lease agreements in fiscal 1998 or 1996. Capital
expenditures in fiscal 1998 and 1997 were made primarily to support Starfire
engineering and manufacturing requirements. Capital expenditures in fiscal 1996
were made primarily to support increased personnel levels and facilities
upgrades. The Company relocated its entire operations from Sunnyvale, California
to San Jose, California during October 1995. The cost of leasehold improvements
for this relocation was $2.2 million. *The Company expects that capital
expenditures will be approximately $4.0 million in fiscal 1999, principally to
support facilities and new product development.


                                       21
<PAGE>   22
    Financing activities provided cash of $5.6 million in fiscal 1998, primarily
from borrowings under the Company's line of credit and, to a lesser extent, the
sale of common stock to employees, offset slightly by repayments on capital
lease obligations. Financing activities provided cash of $239,000 in fiscal 1997
from the sale of common stock to employees, partially offset by repayments on
capital lease obligations. Financing activities provided cash of $316,000 in
fiscal 1996 primarily from the sale of common stock to employees and collections
of employee notes receivable, partially offset repayments of capital lease
obligations.

    *The Company believes that current cash and short-term investment balances,
together with existing sources of liquidity, will satisfy the Company's
anticipated liquidity and working capital requirements through the next twelve
months. *However, due to the uncertain nature of the industry, competitive
market conditions and the strong commitment to developing the Company's
next-generation products, liquidity and working capital are difficult to
anticipate beyond the next twelve months. *There can be no assurance that
additional financing, when required, will be available, or if available, can be
obtained on terms satisfactory to the Company. The Company reserves the right to
obtain funds for working capital or other purposes.


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK

    The Company does not hold derivative financial instruments, and as all
investments held at September 30, 1998 were purchased with a maturity of 90 days
or less, the Company is not subject to significant interest rate risk on its
investment portfolio.

    The Company's short-term borrowings against its line of credit bear interest
at the bank's prime rate plus 1%. Because the interest rate is based on the
bank's prime rate, which can fluctuate, the Company is subject to interest rate
risk on this line of credit. See Note 6 of Notes to Consolidated Financial
Statements for additional information regarding this line of credit.

FOREIGN CURRENCY RATE RISK

    As nearly all of the Company's sales and expenses are denominated in U.S.
dollars, the Company has experienced only insignificant foreign exchange gains
and losses to date, and does not expect to incur significant such gains and
losses in the next twelve months. The Company did not engage in foreign currency
hedging activities during fiscal 1998.

    On January 1, 1999, eleven of the fifteen member countries of the European
Union (the "participating countries") are scheduled to establish fixed
conversion rates between their existing sovereign currencies and the euro. For
three years after the introduction of the euro, the participating countries can
perform financial transactions in either the euro or their original local
currencies. This will result in a fixed exchange rate among the participating
countries, whereas the euro (and the participating countries currencies in
tandem) will continue to float freely against the U.S. dollar and other
currencies of non-participating countries. While the Company does not expect the
introduction of the euro currency to have a significant impact on the Company's
revenues or results of operations, the Company is unable to determine what
effects, if any, the currency change in Europe will have on competition and
competitive pricing in the effected regions.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

    The Company's Consolidated Financial Statements as of September 30, 1998 and
1997 and for the Three Years in the period ended September 30, 1998 and
Independent Auditors' Report follow. The pages of the Company's Consolidated
Financial Statements are independently numbered from this Form 10-K.


                                       22
<PAGE>   23
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

Not applicable

PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

    The names of the current members of the Board, as well as Company's nominees
for the Board, and certain information about them as of November 30, 1998
(including their terms of service), are set forth below:

<TABLE>
<CAPTION>
Name of Director                                Age     Principal Occupation                  Director Since
----------------                                ---     --------------------                  --------------
<S>                                             <C>     <C>                                   <C> 

Arnon Gat...................................    50      Chairman of the Board of Directors         1981
                                                        and Chief Executive Officer of the
                                                        Company

Anita Gat...................................    59      Vice President Administration,             1981
                                                        Director Corporate Communications
                                                        and Secretary of the Company

Norio Kuroda (1)............................    58      Managing Director and Group Chief          1995
                                                        Executive, Optical Products Group,
                                                        Canon Sales Co., Inc.

Cecil Parker (1)(2).........................    57      Managing General Partner, Cecil            1995
                                                        Parker Associates

Joseph Savarese (2).........................    60      Vice President Business                    1998
                                                        Development, Electroglas, Inc.
</TABLE>

<TABLE>
<S>                                             <C>     <C>
Name of Non-Director Executive Officer          Age     Title
----------------                                ---     -----

Julio L. Guardado...........................    43      President and Chief Operating
                                                        Officer

Robert Bogart...............................    52      Vice President Product Development

Kirk W. Johnson.............................    41      Vice President Finance and Chief
                                                        Financial Officer

Randhir Thakur..............................    35      Vice President Technology and R&D
</TABLE>

----------
(1) Member of the Compensation Committee.
(2) Member of the Audit Committee.

    Arnon Gat co-founded the Company in October 1981. He has served as Chairman
of the Board, Chief Executive Officer and a director of the Company since
December 1981. From December 1981 to May 1994, he also served as Chief Financial
Officer of the Company, and from May 1996 to December 1996, he served as Acting
Chief Financial Officer of the Company. Prior to founding the Company, he was a
consultant at Coherent, Inc., a developer of industrial and scientific laser
technology. He holds a B.S. in electrical engineering from Israel Institute of
Technology (Technion) and an M.S. and a Ph.D. in electrical engineering from
Stanford University. While he was at Stanford, Dr. Gat was instrumental in
beginning the research and development program for laser technology and its
application to semiconductor technology. His research at Stanford is the basis
of the Company's technology. A member of the American Physical Society, the
Electromechanical Society and Metallurgic Society of the AIME, Dr. Gat has been
widely published and holds several patents in rapid thermal processing of
semiconductors. Dr. Gat is the spouse of Anita Gat.


                                       23
<PAGE>   24
    Anita Gat, a co-founder of the Company, has served as Secretary and a
director of the Company since December 1981 and as Vice President Administration
since October 1996. From January 1993 until October 1996 Ms. Gat served as Vice
President Human Resources of the Company. She also served as Director of
Corporate Communications of the Company from its formation to October 1996. Ms.
Gat is the spouse of Arnon Gat. She attended the University of Arizona.

    Norio Kuroda has served as a director of the Company since May 1995. He has
served in various capacities with Canon Sales Co., Inc. ("Canon") and its
affiliates since 1964. Canon is the exclusive distributor for all Canon products
such as copiers and cameras in Japan. Canon also imports and sells semiconductor
capital equipment. Mr. Kuroda is currently Managing Director and Group Chief
Executive Officer of Canon's Optical Products Group. From 1993 to February 1995,
Mr. Kuroda served as Managing Director and Group Chief Executive Officer of
Canon's BC Sales Group. Mr. Kuroda graduated from Tokyo University of Foreign
Studies.

    Cecil Parker has served as a director of the Company since December 1995. He
has been a Managing General Partner of Cecil Parker Associates, a consulting
practice focused on high-tech clients, since February 1988. From December 1988
to May 1989, Mr. Parker served as Vice President of Human Resources of Sematech,
the high-tech manufacturing consortium. He also served as Vice President of
Human Resources at Compaq Computer Corporation from February 1983 to January
1988. Mr. Parker holds a B.A. in business administration from the University of
Texas at Austin.

    Joseph Savarese has served as a director of the Company since March 1998. He
has been Vice President, Business Development at Electroglas, Inc., a supplier
of equipment and software to the semiconductor industry, since June 1994. Prior
to joining Electroglas, Inc, Mr. Savarese was President of Assembly
Technologies, a division of General Signal Corporation, a manufacturer serving
the process control, electrical control and industrial technology industries,
from 1989 to 1994. From 1986 to 1989, he was Chief Operating Officer of
QualCorp, Inc., a test instrumentation manufacturer, and, from 1983 to 1986, he
was Vice President, Operations for Forox Corporation, a manufacturer of
precision photographic equipment. From 1968 to 1983, he was employed by
Perkin-Elmer Corporation where he held various management positions, including
Director of Engineering and Director of Microlithography systems. Mr. Savarese
holds a B.S. in industrial engineering from New York University and an M.S. in
electrical engineering from Polytechnic Institute of Brooklyn.

    Mr. Guardado joined the Company in July 1995 as its President and Chief
Operating Officer. From July 1991 to July 1994, Mr. Guardado held the position
of Vice President and General Manager of the Monitoring Systems Division of
Nellcor, Inc., a medical instrumentation company. Before joining Nellcor, Mr.
Guardado served as Vice President and General Manager of the Raster Products
Division of CalComp, Inc., a leading supplier of computer graphics peripherals
for CAD engineering applications from October 1990 to July 1991. He received a
B.S. from the University of California Riverside in applied science/computer
science and an M.B.A. from Claremont Graduate School.

    Mr. Bogart has served as Vice President Product Development of the Company
since October 1996 and served as Vice President Programs of the Company from
August 1996 to October 1996. From January 1996 to August 1996, Mr. Bogart served
as Director, New Products of the Company. Prior to joining the Company, Mr.
Bogart served as Principal of COSINE, a consulting practice that provided
management and engineering services to a diverse array of clients, from 1993 to
1995. From 1988 to 1993, Mr. Bogart served as Vice President, Engineering of
Laserscope, a manufacturer of medical electronic equipment. He holds a B.S. in
electrical engineering from Carnegie Mellon University, an M.S. in electrical
engineering from the University of Maryland and an M.S. in administration from
George Washington University.

    Mr. Johnson as Vice President Finance and Chief Financial Officer of the
Company since June 1997. Prior to joining the Company, Mr. Johnson served at
Cypress Semiconductor Corporation, a semiconductor manufacturing company, from
March 1988 to June 1997, most recently as Corporate Controller. Mr. Johnson
holds a B.A. and an M.B.A. from Whittier College.

    Dr. Thakur has served as Vice President of Technology and R&D of the Company
since January 1998. Before joining the Company, Dr. Thakur held positions as
Process Engineer and Technology lead at Micron Technology, Inc., a semiconductor
manufacturer, from December 1991 to December 1997. He holds a B.S. in
electronics and communication engineering from Regional Engineering College,
Kurukshetra, India, an M.S. in electrical engineering from the University of
Saskatchewan, Canada, and a Ph.D. in electrical engineering from the University
of Oklahoma.

    Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
directors and executive officers, and persons who own more than 10% of the
Company's Common Stock ("10% Shareholders"), to file with the Securities and
Exchange Commission ("SEC") initial reports of ownership on a Form 3 and reports
of changes in ownership of Common 


                                       24
<PAGE>   25
Stock and other equity securities of the Company on a Form 4 or Form 5.
Officers, directors and 10% Shareholders are required by SEC regulations to
furnish the Company with copies of all Section 16(a) forms they file.

    To the Company's knowledge, based solely on review of the copies of such
reports furnished to the Company and written representations from the executive
officers and directors, the Company believes that all Section 16(a) filing
requirements applicable to its officers, directors, and 10% Shareholders were
met during fiscal 1997.

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION OF NAMED OFFICERS

    The following table sets forth all compensation awarded, earned or paid for
services rendered in all capacities to the Company during fiscal 1998, fiscal
1997 and fiscal 1996 to the Named Officers. This information includes the dollar
values of base salaries, bonus awards, the number of stock options granted and
certain other compensation, if any, whether paid or deferred. The Company does
not grant SARs and has no long-term compensation benefits other than stock
options.

                           SUMMARY COMPENSATION TABLE


<TABLE>
<CAPTION>
                                                                                           Long-term     
                                                                                          Compensation    
                                                                                          ------------ 
                                                                                             Awards       
                                                Annual Compensation                       ------------ 
                                              ----------------------                         Shares       
                                                                          Other Annual     Underlying        All Other
                                    Fiscal      Salary         Bonus      Compensation       Options       Compensation
Name and Principal Position          Year        ($)          ($)(1)           ($)             (#)              ($)
-----------------------------------------------------------------------------------------------------------------------
<S>                                 <C>       <C>           <C>           <C>              <C>             <C>
Arnon Gat........................                                                          
Chairman of the Board of             1998     $215,569      $  14,333      $5,100(2)          50,000       $    785(3)
Directors and Chief Executive        1997      200,000         23,893       5,100(2)              --            522(3)
Officer                              1996      200,000         21,500       5,100(2)                            522(3)
                                                                                           
Julio Guardado...................                                                          
President and Chief Operating        1998      189,604         72,518       5,100(2)          21,240            306(3)
Officer                              1997      175,000         24,953       5,100(2)              --            306(3)
                                     1996      206,141(5)      25,104       5,100(2)         125,000(4)         306(3)
Derek Tomlinson (8)..............                                                          
Vice President Sales and Marketing   1998      169,500         10,615       8,280(6)          25,200            198(3)
                                     1997      150,000         15,663       8,480(6)           4,743            188(3)
                                     1996      100,429         75,241       7,260(6)          18,800(4)         148(3)
Robert Bogart....................                                                          
Vice President Product Development   1998      159,750          9,505       5,100(2)          15,000            864(3)
                                     1997      153,101          5,400       5,100(2)          10,000            854(3)
                                     1996       87,522         11,333         785(2)          25,000(4)         549(3)
Kirk W. Johnson (7)..............                                                          
Vice President Finance and Chief     1998      152,599          8,082       5,100(2)              --            306(3)
Financial Officer                    1997       43,269             --       1,569(2)          60,000             94(3)
                                     1996           --             --          --                 --             --
</TABLE>

----------

(1)  Includes executive bonuses for services rendered during fiscal 1996 and
     executive and incentive bonuses for services rendered during fiscal 1997
     and 1998 but that may have been paid in a different fiscal year. Profit
     sharing is paid quarterly to all employees with at least two months'
     service with the Company in the quarter, except that officers did not
     receive profit sharing during fiscal 1996, 1997 or fiscal 1998. The amount
     to be paid to each eligible employee equals 10% of the Company's pre-tax
     profit for the quarter divided by the number of eligible employees.
(2) Represents car allowance.
(3) Represents group term life insurance paid by the Company. 
(4) Includes options granted earlier but repriced during fiscal 1996.
(5) Includes reimbursement of relocation expenses of $30,000 for Mr. Guardado.
(6) Includes a car allowance of $5,100, $5,100 and $5,100 and an office
    allowance of $3,180, $3,380 and $2,160 for fiscal 1998, fiscal 1997 and
    fiscal 1996 respectively.
(7) Mr. Johnson joined the Company in June 1997.
(8) Mr. Tomlinson resigned from the Company in October 1998.


                                       25
<PAGE>   26
    The following table sets forth information concerning option grants during
the fiscal year ended September 30, 1998 to each of the Named Officers.


                          OPTION GRANTS IN FISCAL 1998

<TABLE>
<CAPTION>
                                               Individual Grants
                           ------------------------------------------------------------
                                             % of Total                                    Potential Realizable Value
                              Number of        Options                                     at Assumed Annual Rates of
                               Shares        Granted to                                     Stock Price Appreciation 
                             Underlying       Employees                                       for Option Term (3)    
                           Options Granted    in Fiscal     Exercise Price   Expiration    --------------------------
                               (#)(1)          Year(2)       Per Share($)       Date          5%($)        10%($)
                           ---------------   ----------     --------------   ----------       -----        ------
<S>                        <C>               <C>            <C>              <C>           <C>            <C>     

Arnon Gat.............         50,000           14.6%            $6.60        11/24/02       $52,884      $153,153

Julio Guardado........         15,000            4.4              6.00        11/24/07        56,600       143,437
                                6,240            1.8              6.13        12/05/07        21,850        55,342

Derek Tomlinson (4)...         20,000            5.9              6.00        11/24/07        75,467       191,249
                                5,200            1.5              6.13        12/05/07        15,244        43,155

Robert Bogart.........         10,000            2.9              6.00        11/24/07        37,774        95,625
                                5,000            1.5              6.13        12/05/07        14,547        41,495

Kirk W. Johnson.......             --             --               --            --               --            --
</TABLE>

----------

(1) Options granted in fiscal 1998 vest at the rate of 25% of the shares subject
    to the option annually from the date of grant. The exercise price was equal
    to the fair market value of the Common Stock on the date of grant. Under the
    terms of the option plan, the Compensation Committee retains discretion,
    subject to plan limits, to modify the terms of outstanding options.
(2) Percent of total options granted to employees in fiscal year is based on a
    total of 341,612 options granted to employees during fiscal 1998.
(3) In accordance with the rules of the Securities and Exchange Commission (the
    "Commission"), the table sets forth the hypothetical gains or "option
    spreads" that would exist for the options at the end of their respective
    terms. These gains are based on assumed rates of annual compound stock price
    appreciation of 5% and 10% from the date the option was granted to the end
    of the option term. The 5% and 10% assumed annual compound rates of stock
    price appreciation are mandated by the rules of the Commission and do not
    represent the Company's estimate or projection of future Common Stock
    prices. Actual gains, if any, on option exercises are dependent on the
    future performance of the Company's Common Stock.
(9) Mr. Tomlinson resigned from the Company in October 1998.


    The following table sets forth the number of shares of Common Stock
represented by outstanding stock options held by each of the Named Officers as
of September 30, 1998 and the value of such options based on the closing price
of the Company's Common Stock at fiscal year-end ($2.125).

                       FISCAL 1998 YEAR-END OPTION VALUES

<TABLE>
<CAPTION>
                                                                                            Value of Securities
                             Shares                        Number of Shares                     Unexercised
                            Acquired                    Underlying Unexercised             In-the-Money Options
                               on         Value      Options at Fiscal Year-End(#)        at Fiscal Year-End ($)
Name                        Exercise     Realized    Exercisable     Unexercisable        Exercisable   Unexercisable
----                        --------     --------    -----------------------------        ---------------------------
<S>                         <C>          <C>         <C>             <C>                  <C>           <C>  

Arnon Gat...............       --          --           22,710           50,000               $  --         $  --

Julio Guardado..........       --          --           87,500           58,740                  --            --

Derek Tomlinson (1).....      2,000      $ 6,700        42,272           35,721                  --            --

Robert Bogart...........       --          --           15,000           35,000                  --            --

Kirk W. Johnson.........       --          --           15,000           45,000                  --            --
</TABLE>

----------

(1) Mr. Tomlinson resigned from the Company in October 1998.


                                       26
<PAGE>   27
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

    Since January 1998, the Compensation Committee of the Board of Directors has
consisted of Messrs. Kuroda and Parker. In December 1997, the Compensation
Committee of the Board of Directors consisted of Mr. Parker. From December 1995
to November 1997, the Compensation Committee of the Board of Directors consisted
of Messrs. Moore and Parker. From May 1995 to December 1995, the Compensation
Committee consisted of Messrs. Kuroda and Moore. None of Messrs. Kuroda, Parker
or Moore has been, or is, an officer or an employee of the Company. Prior to
that time the members of the Compensation Committee were Arnon Gat and Anita
Gat, both of whom are executive officers of the Company. No past or current
member of the Compensation Committee has ever had a relationship that would
constitute an interlocking relationship with the Company and executive officers
or directors of another entity.

EMPLOYMENT AGREEMENTS

    The Company has entered into an employment agreement with Mr. Guardado,
dated July 20, 1995, which specifies that he will be paid a base salary of
$14,585 per month (calculating to $175,000 annually) and will be eligible for a
bonus of up to 45% of annual base salary based on the Company meeting
performance goals to be agreed upon by Mr. Guardado with the Company's Chief
Executive Officer prior to the beginning of each fiscal year. In addition,
pursuant to the agreement, the Company has reimbursed Mr. Guardado $30,000 for
his actual and reasonable expenses to relocate to the San Jose area. The Company
and Mr. Guardado must each give the other six months' notice of termination of
Mr. Guardado's employment. In addition to other fringe benefits offered to the
Company's employees generally and pursuant to the terms of Mr. Guardado's
employment agreement, in July 1995, Mr. Guardado was granted an option to
purchase up to 100,000 shares of the Company's Common Stock under the 1993 Plan
exercisable at $21.63 per share. In June 1996, this option grant was repriced
and is now exercisable at $7.125 per share. In connection with Mr. Guardado's
employment agreement, in August 1995, the Company advanced Mr. Guardado $60,000
pursuant to a promissory note that bears interest at the rate of 8.75% per
annum. During fiscal 1996, Mr. Guardado paid down the note, and the note had a
remaining balance of $25,655 plus accrued interest of $2,085 as of July 1997. In
fiscal 1997, the Company extended the note until July 1998 and added a provision
to the note specifying that all payments and interest due on the note would be
canceled if Mr. Guardado is employed by the Company through July 1998.
Accordingly, the note was canceled in fiscal 1998.

    In fiscal 1997, the executive officers of the Company each entered into an
employment agreement with the Company that provides for one year of salary
continuation and up to two years of option vesting following the closing of
certain change of control transactions.

DIRECTORS' COMPENSATION

    One outside Director received $6,500 cash compensation in fiscal 1998 for
serving as a member of the Company's Board of Directors. In addition, Directors
are reimbursed for their expenses in attending meetings of the Board and of
Committees of the Board. Outside Directors (directors who are not employed by
the Company or any of its subsidiaries and who do not represent a corporate
strategic partner of the Company) are eligible for automatic option grants under
the 1994 Directors Stock Option Plan (the "Directors Plan"). The Directors Plan
provides for the automatic grant of an option up to 5,000 shares when an
individual first becomes an Outside Director. If the individual is still an
Outside Director on each anniversary of the date he or she joined the Board, he
or she is automatically granted an additional option for 1,000 shares. All
options granted under the Directors Plan have an exercise price equal to the
fair market value of the Company's common stock on the date of grant, become
exercisable at a rate of 25% of the shares each year, and expire five years
after the date of grant. During fiscal 1998, the following options were granted
under the Directors Plan to Outside Directors of the Company: in December 1997,
the Company granted an option to purchase 1,000 shares of Common Stock to Cecil
Parker, and in April 1998, the Company granted an option to purchase 5,000
shares of Common Stock to Joseph Savarese. In addition, in April 1998, the
Company granted options to purchase 5,000 shares of Common Stock to each Cecil
Parker and Joseph Savarese from the 1993 Stock Option Plan. All other options
currently held by directors were granted prior to the time the Directors Plan
was adopted.


                                       27
<PAGE>   28
    The following options were held by the Company's directors as of September
30, 1998:


<TABLE>
<CAPTION>
                                   Number of                                                            Termination
Name                                Shares      Exercise Price     Grant Date         Plan Type             Date
----                               ---------    --------------     ----------         ---------         -----------
<S>                                <C>          <C>                <C>             <C>                  <C>

Arnon Gat..................          18,750          $3.30          01/14/94         1993 Plan(1)         01/14/99
                                      3,960          $8.36          10/01/94         1993 Plan(2)         10/01/99
                                     50,000          $6.60          11/24/97         1993 Plan(3)         11/24/02
                                                                                                        
Anita Gat..................          18,750          $3.30          01/14/94         1993 Plan(1)         01/14/99
                                      2,319          $8.36          10/01/94         1993 Plan(2)         10/01/99
                                      6,900         $15.29          12/19/95         1993 Plan(3)         12/19/00
                                      7,800          $7.50          03/18/96         1993 Plan(3)         03/18/01
                                      5,164          $5.78          11/04/96         1993 Plan(3)         11/04/01
                                     10,000          $6.60          11/24/97         1993 Plan(3)         11/24/02
                                      5,100          $6.74          12/5/97          1993 Plan(3)         12/05/02
                                                                                                        
Cecil Parker...............           5,000         $16.71          12/06/95       Directors Plan(4)      12/06/00
                                      1,000          $6.38          01/27/97       Directors Plan(4)      01/27/02
                                      1,000          $5.56          12/8/97        Directors Plan(4)      12/08/02
                                      5,000          $3.94           4/3/98          1993 Plan(3)         04/03/03
                                                                                                        
Joseph Savarese............           5,000          $3.94           4/2/98        Directors Plan(4)      04/02/03
                                      5,000          $3.94           4/3/98          1993 Plan(3)         04/03/03
</TABLE>

----------

(1) Granted under the Company's 1993 Stock Option Plan. These options vested as
    to 50% of the shares subject to the option on May 23, 1996 and at the rate
    of 25% of the shares subject to the option annually thereafter. Since these
    option holders also hold more than 10% of the Company's stock, the exercise
    price was equal to 110% of the fair market value of the Common Stock on the
    date of grant as required by applicable tax laws.
(2) Granted under the Company's 1993 Stock Option Plan. These options are 100%
    vested. Since these option holders also hold more than 10% of the Company's
    stock, the exercise price was equal to 110% of the fair market value of the
    Common Stock on the date of grant as required by applicable tax laws.
(3) Granted under the Company's 1993 Stock Option Plan. These five-year options
    vest as to 25% of the shares each year after the date of grant. Since these
    option holders also hold more than 10% of the Company's stock, the exercise
    price was equal to 110% of the fair market value of the Common Stock on the
    date of grant as required by applicable tax laws.
(4) Granted under the Directors Plan. These five-year options vest as to 25% of
    the shares each year after the date of grant.

REPORT OF THE COMPENSATION COMMITTEE REGARDING EXECUTIVE COMPENSATION

    The Compensation Committee of the Board of Directors, comprised of two
non-employee directors, determines and administers the Company's executive
compensation policies and programs.

Compensation Policy

    The Company applies a consistent philosophy to compensation for all
employees, including senior management. The premise of this philosophy is to pay
for performance. The Committee's primary objectives in determining compensation
policies are: (1) to maintain competitive, progressive programs to attract and
retain key executive talent and foster teamwork and to motivate executive
officers by appropriately rewarding such individuals for their achievements; and
(2) to provide incentives which focus executive efforts on short-term and
long-term strategic goals for the Company by closely aligning their financial
interests with shareholder interests. To attain these goals, the Committee has
designed the Company's executive compensation program to include salary, an
executive incentive plan, stock options and participation in benefit plans
generally available to other employees.

    The Compensation Committee of the Board reviews base salary levels for
officers annually. The Compensation Committee establishes the general
compensation policy of the Company for all executive officers and sets specific
salary and stock option levels.


                                       28
<PAGE>   29
    To arrive at total compensation, the Company's human resources department
provides the Compensation Committee with market data from published surveys
which track high technology companies. The Company's executive level positions,
including the Chief Executive Officer ("CEO"), were matched to comparable survey
positions and competitive market compensation levels to determine base salary,
target incentives and target total cash compensation. A custom analysis of
market stock option practices of select industry group companies was provided to
the Compensation Committee. The analysis provided the database of companies
constituting the industry group, an overview of market practices and option
grants in equivalent shares for new hire and ongoing grants.

    The executive compensation survey data are reviewed with the CEO for each
executive level position and, with respect to the CEO's compensation, are
reviewed by the Board. The CEO's salary was based on competitive market
conditions as described below.

Fiscal Year 1998 Executive Compensation

    The practice of the Company during fiscal 1998 has been to establish base
salaries at the approximate median of comparative positions included in the
executive compensation survey data. The foregoing information, along with the
CEO's recommendations of base salary for fiscal 1998 for each executive officer,
was presented to the Compensation Committee at the time salary levels were
approved and again for particular executive officers at various times throughout
the year when the executive officer was promoted or other changes in the
officer's status were made. At that time, the Committee reviewed the
recommendations outlined above and established a base salary level for the
executive officer in question.

    The Committee believes that the compensation of the CEO and other executive
officers should be influenced by the Company's overall performance. As a result,
once base salary was determined, an additional portion of the compensation of
each executive was contingent upon corporate and individual performance under
the Company's bonus compensation plan for each officer. Under these plans, cash
awards may be made to employees based upon the Company's overall performance
measured by the Company's pre-tax income and based upon individual performance
in achieving certain milestones set by the officer and the CEO (in the case of
the CEO, set by the CEO and the Compensation Committee). Executive officer bonus
distributions for fiscal 1998 have, together, totaled $148,499.

    Finally, the Committee believes that stock options play an important role in
attracting and retaining qualified personnel because they provide personnel with
a reward directly tied to increased stock values. Stock options are granted at
fair market value to executive officers when they first join the Company. During
fiscal 1998, an option was initially granted to one executive officer for the
purchase in the aggregate of up to 50,000 shares of the Company's Common Stock.
In individual cases, follow-on options are granted, again at fair market value
on the date of grant, to executives after the initial options are partially or
fully vested. Both initial and follow-on options are granted based upon the
Committee's analysis of equity incentives offered to executives in equivalent
positions by similar companies with whom the Company competes for available
executive talent and, with respect to follow-on options, the CEO's determination
of whether or not the executive officer's performance warrants an additional
grant. Nine follow-on options were granted in fiscal 1998 to four executive
officers and one former executive officer (who resigned in October 1998).

CEO Compensation

    The Committee applies the foregoing principles and policies in determining
the compensation of the Chief Executive Officer, Dr. Arnon Gat. In determining
Dr. Gat's base salary and bonus, the Committee examined compensation levels for
other chief executive officers in high technology firms within and outside the
industry.

    Dr. Gat received a salary of $215,569 during fiscal 1998, a time period in
which the Company experienced a net loss of $14.0 million compared to a net loss
of $4.7 million in fiscal 1997, and in which revenue decreased to $46.0 million
from $49.6 million in the prior fiscal year. The Committee believes that, for
the near term, increases in revenue and net earnings are the primary metrics for
the Chief Executive Officer. Based on reports of compensation levels for chief
executive officers in similar sized companies, the Committee set Dr. Gat's bonus
target at 55% of his annual salary. During fiscal 1998, the Company did not meet
Dr. Gat's bonus target for the combination of increases in revenue and net
earnings due to the Company's low revenue levels and its net loss. Based on the
Company's performance, the Committee approved the payment to Dr. Gat of a cash
bonus for fiscal 1998 of $14,333, which equals 6.6% of his fiscal 1998 salary.

                                               COMPENSATION COMMITTEE
                                               Norio Kuroda
                                               Cecil Parker


                                       29
<PAGE>   30
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

    The following table sets forth certain information, as of November 30, 1998
with respect to the beneficial ownership of the Company's Common Stock by: (a)
each shareholder known by the Company to be the beneficial owner of more than
five percent of the Company's Common Stock; (b) each director and nominee; (c)
the Chief Executive Officer and the four other most highly compensated executive
officers who were serving as executive officers at the end of fiscal 1998
(together, the "Named Officers"); and (d) all current officers and directors as
a group. Unless otherwise noted, the address of each named beneficial owner is
that of the Company.

<TABLE>
<CAPTION>
Name and Address                                             Number of Shares     Percent of Beneficial
of Beneficial Owner                                               Owned                Ownership(1)
-------------------                                          ----------------     ---------------------
<S>                                                          <C>                  <C>

Arnon and Anita Gat (2).................................         1,135,155                 18.1%

Norio Kuroda (3)........................................           604,166                  9.7

Canon Sales Co., Inc. (3)...............................           604,166                  9.7

Nippon Typewriter Corporation (3).......................           604,166                  9.7

Investment Company of Bank Hapoalim (4).................           559,228                  9.0

Clal Electronics Industries Ltd. (5)....................           550,000                  8.9

Julio Guardado (6)......................................            92,810                  1.5

Derek Tomlinson (7).....................................            47,704                  *

Robert Bogart (8).......................................            23,500                  *

Kirk W. Johnson (9).....................................            15,000                  *

Randhir Thakur (10).....................................            12,500                  *

Cecil Parker (11).......................................             2,750                  *

All current officers and directors
   as a group - 8 persons (12)..........................         1,887,631                 29.4%
</TABLE>

----------

* Less than 1%

(1) Unless otherwise indicated below, the persons named in the table have sole
    voting and sole investment power with respect to all shares beneficially
    owned, subject to community property laws where applicable. Percentage of
    beneficial ownership is based on 6,202,743 shares of Common Stock
    outstanding as of November 30, 1998.

(2) Represents 937,153 shares of Common Stock held jointly by Arnon and Anita
    Gat, 62,500 shares held by Arnon Gat as Trustee of a trust benefiting Dr.
    Gat's son, 62,500 shares held by Anita Gat as trustee of a trust benefiting
    Dr. and Ms. Gat's minor daughter and 73,002 shares subject to options held
    by Dr. or Ms. Gat that are exercisable within 60 days after November 30,
    1998. These shares are listed as beneficially owned by both Arnon and Anita
    Gat, who disclaim beneficial ownership to all shares other than those they
    hold jointly and, as to shares subject to unexercised options, those each
    such person has a right to purchase under his or her options. Does not
    include 550,000 shares held by Clal Electronics Industries Ltd. ("Clal
    Electronics") as to which Dr. and Ms. Gat may be deemed to share voting
    power due to the existence of certain voting agreements but as to which Dr.
    and Ms. Gat disclaim beneficial ownership. See "Certain Relationships and
    Related Transactions -- Agreements with Clal Electronics," below. Dr. Gat is
    Chairman of the Board of Directors and Chief Executive Officer of the
    Company, and Ms. Gat is Vice President Administration, Secretary and a
    director of the Company.

(3) Represents 487,962 shares held by Canon and 116,204 shares held by Nippon
    Typewriter Corporation, a subsidiary of Canon. These shares are listed as
    beneficially owned by both Canon (for which Norio Kuroda serves as Managing
    Director and Group Chief Executive Officer of the Optical Products Group)
    and by Nippon Typewriter Corporation. Mr. Kuroda is a director of the
    Company. He disclaims beneficial ownership of these shares. The address for
    Mr. Kuroda and Canon is 11-28, Mita 3-Chome, Minato-Ku, Tokyo 109, Japan.
    The address for Nippon Typewriter Corporation is 11-12, Kyobashi 1-Chome,
    Chuo-Ku, Tokyo, Japan.

(4) Represents 559,228 shares held of record by this shareholder as of November
    30, 1998. Does not include 550,000 shares held by Clal Electronics, as to
    which this shareholder may be deemed to share voting power due to the
    ownership by Bank Hapoalim B.M. ("Bank Hapoalim") of shares of affiliates of
    Clal Electronics but as to which this shareholder disclaims beneficial
    ownership. Bank 


                                       30
<PAGE>   31
    Hapoalim has a partial ownership interest in Investment Company of Bank
    Hapoalim ("Hapoalim Investment Co."), and representatives of Bank Hapoalim
    serve on the Board of Directors of Hapoalim Investment Co. Accordingly, Bank
    Hapoalim may be deemed to beneficially own the shares of the Company's
    Common Stock owned by Hapoalim Investment Co. The address of Bank Hapoalim
    and Hapoalim Investment Co. is 3 Daniel Frisch St., Tel Aviv 64731, Israel.

(5) Does not include 1,010,155 shares (including shares issuable upon exercise
    of options that are exercisable within 60 days after November 30, 1998) held
    by Arnon Gat and Anita Gat, as to which this shareholder may be deemed to
    share voting power due to the existence of certain voting agreements, but as
    to which this shareholder disclaims beneficial ownership. See "Certain
    Relationships and Related Transactions -- Agreement with Clal Electronics"
    below. The address of Clal Electronics is Clal House 5 Druyanov St., Tel
    Aviv 63143, Israel.

(6) Represents 92,810 shares subject to options exercisable within 60 days after
    November 30, 1998. Mr. Guardado is President and Chief Operating Officer of
    the Company.

(7) Represents 5,432 shares held by Mr. Tomlinson and 42,272 shares subject to
    options exercisable within 60 days after November 30, 1997. Mr. Tomlinson ,
    who was Vice President Sales and Marketing of the Company, resigned from the
    Company in October 1998.

(8) Represents 500 shares held by Mr. Bogart and 23,000 shares subject to
    options exercisable within 60 days after November 30, 1998. Mr. Bogart is
    Vice President Product Development of the Company.

(9) Represents 15,000 shares subject to options exercisable within 60 days after
    November 30, 1998. Mr. Johnson is the Company's Vice President Finance and
    Chief Financial Officer.

(10) Represents 12,500 shares subject to options exercisable within 60 days
     after November 30, 1998. Mr. Thakur is the Company's Vice President
     Technology and R&D.

(11) Represents 4,500 shares subject to options exercisable within 60 days after
     November 30, 1998. Mr. Parker is a director of the Company.

(12) Includes 263,084 shares subject to options exercisable within 60 days after
     November 30, 1998 (represented by the options listed in notes 2, 6, 7, 8,
     9, 10 and 11).


ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    See "Executive Compensation -- Directors' Compensation" above for a
description of directors' compensation arrangements and "Executive Compensation
-- Employment Agreements" above for a description of compensation-related
agreements entered into by the Company with its officers.

    Other than these compensation arrangements, since October 1, 1996, there has
not been, nor is there currently proposed, any transaction or series of
transactions to which the Company was or is to be a party in which the amount
involved exceeds $60,000 and in which any director, executive officer, or holder
of more than 5% of the Company's Common Stock had or will have a direct or
indirect material interest except for the transactions described below.

CANON SALES CO., INC. ("CANON")

    In July 1989, Canon, Appex Corporation and Nippon Typewriter Corporation
(collectively, the "Purchasers") entered into Stock Purchase Agreements with the
Company. Under the Stock Purchase Agreements, the Purchasers acquired
approximately 799,999 shares of the Common Stock of the Company, or 37% of the
then-outstanding shares of the Company's Common and Preferred Stock for an
aggregate purchase price of approximately $3.8 million. In connection with such
purchase, the Purchasers were granted incidental registration rights at the
Purchasers' expense to include their shares in any registration of shares held
by shareholders in an amount up to 37% of the shares registered. Subsequent to
the purchase, Norio Kuroda's predecessor, who was then Managing Director of
Canon, was elected to the Company's Board of Directors. Mr. Kuroda, Managing
Director of Canon's Optical Product Group, now serves on the Company's Board of
Directors, although there is no obligation on the Company's part to nominate a
representative of Canon.

    In January 1994, the Company entered into an Improvements License Agreement
with Canon under which the Company granted Canon a non-exclusive,
non-transferable (except in a merger or sale of assets), royalty-free, fully
paid license to use the Company's technology (a) to make modifications to rapid
thermal processing ("RTP") systems purchased from the Company and to distribute
such modified units in Japan under any separate distribution arrangement that
may exist between the Company and Canon from time to time and (b) to manufacture
prototypes of component parts of RTP systems but only if such parts are
integrated into a system purchased from the Company. Title to the resulting
modifications is held jointly by Canon and the Company without the right to sell
or transfer rights in the same.


                                       31
<PAGE>   32
    In connection with the 1989 transactions described above, Canon entered into
an agreement (renewed in 1994) to act as the Company's exclusive distributor in
Japan. Sales to Canon amounted to $14.8 million under this arrangement in fiscal
1998.

AGREEMENTS WITH CLAL ELECTRONICS

    Pursuant to an agreement among the Company, Dr. Arnon Gat, the Company's
Chairman of the Board, a director and a principal shareholder of the Company,
Anita Gat, an executive officer, director and principal shareholder of the
Company, AG Associates (Israel) Ltd, then a 49%-owned subsidiary of the Company
("AG Israel"), Rapro Technology Inc., a wholly owned subsidiary of the Company
("Rapro"), and Clal Electronics, Clal Electronics acquired approximately 544,000
shares (then 9.9%) of the Company's outstanding shares of Common Stock from
existing shareholders. After May 15, 1998, Clal Electronics may increase its
ownership in the Company up to 12% and, if its ownership exceeds 10%, it has the
right to nominate a member for election to the Company's Board of Directors. In
the interim, Clal Electronics has the right to nominate an observer to attend
meetings of the Company's Board of Directors.

    Clal Electronics and its assignees have also been granted the right to
require the Company to register the shares of the Company's Common Stock sold in
1995 to Clal Electronics with the Securities and Exchange Commission and to
include such shares in any registration planned by the Company. These
registration rights were granted in order to enable the holder of the shares to
sell such shares in the public market and are exercisable at the expense of the
holders of the shares to be registered.

AGREEMENTS BETWEEN AG ISRAEL AND THE COMPANY

    In March 1996, the Company and AGI, Inc., the wholly owned subsidiary of AG
Israel, entered into a Transition Services Agreement whereby the Company
provides certain services to AGI, Inc. These services include: (1) providing
employment, operational and human resources services under the direction of AGI,
Inc., utilizing, in all cases, records and procedures separate from those of the
Company; (2) providing accounts payable services to AGI, Inc., and, at the
request of AGI, Inc., collecting accounts receivable and paying accounts payable
for AGI, Inc.; and (3) providing such other services as shall be agreed to by
the parties. As consideration for these services, AGI, Inc. pays to the Company
the incremental direct costs and out-of-pocket expenses derived directly from
the provision of the services. During fiscal 1998, AGI Israel incurred expenses
payable to the Company of $342,702 under the Transition Services Agreement. The
Transition Services Agreement has an indefinite term, but either party may
cancel any or all service or services provided pursuant to the Transition
Services Agreement on 90-days prior notice. As of September 30, 1998, $91,000
was outstanding under the Transition Services Agreement by AG Israel.

The Company also subleases to AGI, Inc. 3,148 square feet of space that is part
of the Company's principal executive office facility. The rental charge is
$7,500 per month under the terms of a Sublease, dated, for reference purposes
only, August 20, 1996, among the Company, AGI, Inc. and AG Israel as guarantor
of AGI, Inc.'s obligations. The Sublease terminates on November 30, 1998, unless
sooner terminated as provided in the Sublease, except that AGI, Inc. has the
option through October 2001 to extend and renew the Sublease upon the same terms
and conditions and at the same rental rate (as such may be adjusted) for
consecutive one year additional terms. As of December 15, 1998, AGI, Inc. has
not exercised it's option to extend, however, is anticipated that the extension
will be finalized prior to December 31, 1998.

    In January 1997, the Company and AG Israel entered into a Technology
Agreement whereby the Company granted to AG Israel a license to use new
technology generated under the Company's next generation rapid thermal
processing research and development program in return for AG Israel's obligation
to pay the Company up to $2 million in royalties on AG Israel's sale of products
incorporating certain of the Company's technology. No royalties were due under
this Technology Agreement in fiscal 1998.

    During fiscal 1997, AG Israel completed a private placement of its ordinary
shares in which the Company did not participate, reducing the Company fully
diluted equity interest in AG Israel from approximately 45% to 25.2% and the
Company's voting interest in AG Israel from 49% to 28%. At that time, the
Company, Clal Electronics and AG Israel also modified certain additional
existing agreements as follows:

(1) Fields of Use. During 1995 and until May 15, 2002, AG Israel and the Company
    had agreed to operate to the exclusion of the other in a defined "Field of
    Use." The Fields of Use for each of AG Israel and the Company were clarified
    during fiscal 1997 to make certain that both parties would be allowed to
    compete in certain chemical vapor 


                                       32
<PAGE>   33
    deposition applications and that both parties could develop technology
    involving certain integrated circuit manufacturing processes. The effect of
    this clarification was to reduce the scope of both the Company's and AG
    Israel's exclusive Fields of Use and increase the number of markets and
    applications, including certain cluster tool applications, in which the
    Company and AG Israel can compete.

(2) Options on AG Israel Stock. A five-year option held by the Company to
    purchase the Clal Electronics' ownership interest in AG Israel at a
    specified price, and a right of the Company to require the sale of such
    interest to the Company if AG Israel should become inactive, were each
    terminated.

(3) AG Israel Corporate Governance. Certain 1995 agreements between Clal
    Electronics and the Company concerning the management, board representation
    and obligations to continue to fund AG Israel were terminated. In connection
    with AG Israel's 1997 closing of its new round of financing, Clal
    Electronics and AG Associates entered into an agreement with the new AG
    Israel investors concerning the corporate governance of AG Israel, replacing
    the 1995 corporate governance agreements. Under the new agreement, the
    Company is entitled to appoint up to two directors of AG Israel until its
    initial public offering. Dr. Gat serves as one of the directors.

(10) AG Israel Indemnities. During 1995, at the time Clal Electronics invested
     in AG Israel, the Company, Dr. Gat, and Rapro made certain warranties to,
     and promised to indemnify, AG Israel and Clal Electronics with respect to
     the status and condition of the technology that is currently jointly owned
     by AG Israel and the Company. During 1997, these warranties and indemnities
     were amended to release Dr. Gat from any obligation thereunder and to
     remove Clal Electronics as a beneficiary thereof, leaving the Company as
     the sole obligor thereunder and AG Israel as the sole beneficiary.

PART IV

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

        (a) (1) Financial Statements: See Index to Financial Statements, page
                36.
            (2) Financial Statement Schedules: See Index to Financial Statement
                Schedules, page 36.
            (3) Exhibits: See Index to Exhibits, pages 37-38.

        (b) No reports on Form 8-K were filed during the quarter ended September
            30, 1998.


                                       33
<PAGE>   34
                                   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 in the City of San
Jose, State of California, on the 29th day of December, 1998.


                                AG ASSOCIATES, INC.


                                By:  /s/ Kirk W. Johnson
                                   ---------------------------------------------
                                Kirk W. Johnson, Vice President, Finance & Chief
                                Financial Officer (Duly Authorized and
                                Principal Financial and Accounting Officer)

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

<TABLE>
<CAPTION>
             Signatures                              Title                                     Date
             ----------                              -----                                     ----
<S>                                     <C>                                               <C>


      /s/ Arnon Gat, Ph.D.              Director, Chairman of the Board and               December 22, 1997
-------------------------------         Chief Executive Officer (Principal 
          Arnon Gat, Ph.D.              Executive Officer)                 
                                        


       /s/ Kirk W. Johnson              Vice President, Finance & Chief Financial         December 22, 1997
-------------------------------         Officer (Principal Financial and Accounting
           Kirk W. Johnson              Officer)                                   
                                        


         /s/ Anita Gat                  Director, Vice President Administration           December 22, 1997
-------------------------------         and Secretary
             Anita Gat                 


        /s/ Norio Kuroda                Director                                          December 22, 1997
-------------------------------
            Norio Kuroda


        /s/ Cecil Parker                Director                                          December 22, 1997
-------------------------------
            Cecil Parker
</TABLE>


                                       34
<PAGE>   35
                               AG ASSOCIATES, INC.

                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                                     Page(s) in
                                                                                                     Consolidated
                                                                                                       Financial
                                                                                                      Statements
                                                                                                     ------------
<S>                                                                                                  <C>
Independent Auditors' Report                                                                              F-1
Consolidated Balance Sheets - September 30, 1998 and 1997                                                 F-2 
Consolidated Statements of Operations - Years Ended September 30, 1998, 1997 and 1996                     F-3 
Consolidated Statements of Shareholders' Equity - Years Ended September 30, 1998, 1997 and 1996           F-4 
Consolidated Statements of Cash Flows - Years Ended September 30, 1998, 1997 and 1996                     F-5 
Notes to Consolidated Financial Statements                                                             F-6 - F-18
</TABLE>


                     INDEX TO FINANCIAL STATEMENT SCHEDULES

<TABLE>
<CAPTION>
                                                                                                          Page
                                                                                                          ----
<S>                                                                                                       <C>
Report of Independent Auditors on Financial Statement Schedule                                             S-1
Schedule II: Valuation and Qualifying Accounts                                                             S-2
</TABLE>


                                       35
<PAGE>   36






                               AG ASSOCIATES, INC.

                     CONSOLIDATED FINANCIAL STATEMENTS AS OF
                     SEPTEMBER 30, 1998 AND 1997 AND FOR THE
               THREE YEARS IN THE PERIOD ENDED SEPTEMBER 30, 1998
                        AND INDEPENDENT AUDITORS' REPORT







<PAGE>   37
INDEPENDENT AUDITORS' REPORT


To the Board of Directors and Shareholders of 
  AG Associates, Inc.:

We have audited the accompanying consolidated balance sheets of AG Associates,
Inc. and its subsidiary (the Company) as of September 30, 1998 and 1997 and the
related consolidated statements of operations, shareholders' equity and cash
flows for each of the three years in the period ended September 30, 1998. 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 in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of AG Associates, Inc. and its
subsidiary 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.



DELOITTE & TOUCHE LLP

San Jose, California
October 23, 1998


<PAGE>   38
AG ASSOCIATES, INC.

CONSOLIDATED  BALANCE  SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                                                    SEPTEMBER 30,
                                                                            -----------------------------
ASSETS                                                                         1998               1997
                                                                            ----------         ----------
<S>                                                                         <C>                <C>       

Current assets:
  Cash and equivalents                                                      $    1,332         $    2,485
  Short-term investments                                                          --                1,672
  Receivables (net of allowances of $650 in 1998 and $903 in 1997)               5,681             13,415
  Inventories                                                                   11,843             11,676
  Income taxes refundable                                                        1,291              1,652
  Deferred income taxes                                                           --                2,221
  Prepaid expenses and other current assets                                      1,027                896
                                                                            ----------         ----------

           Total current assets                                                 21,174             34,017

Property and equipment, net                                                      9,596              8,493

Deferred income taxes                                                             --                  437
                                                                            ----------         ----------

Total assets                                                                $   30,770         $   42,947
                                                                            ==========         ==========


LIABILITIES  AND  SHAREHOLDERS'  EQUITY

Current liabilities:
  Short-term borrowings                                                     $    5,469         $     --
  Accounts payable                                                               3,506              6,272
  Accrued liabilities                                                            3,631              4,684
  Current portion of capital lease obligations                                     262                194
                                                                            ----------         ----------

           Total current liabilities                                            12,868             11,150

Capital lease obligations                                                         --                  275

Commitments and contingences (Notes 7, 13 and 14)

Shareholders' equity:
  Common stock, no par value: 25,000,000 shares authorized;
    shares outstanding: 1998 - 6,202,743; 1997 - 6,061,196                      36,509             36,139
  Net unrealized loss on short-term investments                                   --                  (10)
  Accumulated deficit                                                          (18,607)            (4,607)
                                                                            ----------         ----------

           Total shareholders' equity                                           17,902             31,522
                                                                            ----------         ----------

Total liabilities and shareholders' equity                                  $   30,770         $   42,947
                                                                            ==========         ==========
</TABLE>


                See Notes to Consolidated Financial Statements.


                                      F-2
<PAGE>   39
AG ASSOCIATES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


<TABLE>
<CAPTION>
                                                                               Years Ended September 30,
                                                                    ------------------------------------------------
                                                                       1998               1997               1996
                                                                    ----------         ----------         ----------
<S>                                                                 <C>                <C>                <C> 
Net sales (including sales to a shareholder/distributor of
   $14,848, $5,719 and $17,333)                                     $   45,957         $   49,604         $   71,089
Cost of sales                                                           32,995             32,697             39,365
                                                                    ----------         ----------         ----------

  Gross profit                                                          12,962             16,907             31,724
                                                                    ----------         ----------         ----------

Operating expenses:
  Research and development                                              15,908             14,329             16,653
  Selling, general and administrative                                    9,573              9,247             10,204
                                                                    ----------         ----------         ----------

     Total operating expenses                                           25,481             23,576             26,857
                                                                    ----------         ----------         ----------

Income (loss) from operations                                          (12,519)            (6,669)             4,867
                                                                    ----------         ----------         ----------

Other income and expense:
  Interest income                                                          100                377                708
  Interest expense                                                        (191)               (71)               (59)
  Equity in loss of unconsolidated subsidiary                             --                 --               (1,152)
  Other, net                                                               116                126                123
                                                                    ----------         ----------         ----------

Income (loss) before provision (benefit) for income taxes              (12,494)            (6,237)             4,487

Provision (benefit) for income taxes                                     1,506             (1,549)             1,744
                                                                    ----------         ----------         ----------

Net income (loss)                                                   $  (14,000)        $   (4,688)        $    2,743
                                                                    ==========         ==========         ==========

Basic net income (loss) per share                                   $    (2.29)        $    (0.78)        $     0.47
                                                                    ==========         ==========         ==========
Diluted net income (loss) per share                                 $    (2.29)        $    (0.78)        $     0.45
                                                                    ==========         ==========         ==========

Shares used in basic per share computations                              6,102              5,981              5,882
                                                                    ==========         ==========         ==========
Shares used in diluted per share computations                            6,102              5,981              6,140
                                                                    ==========         ==========         ==========
</TABLE>


                See Notes to Consolidated Financial Statements.


                                      F-3
<PAGE>   40
AG ASSOCIATES, INC.

CONSOLIDATED  STATEMENTS  OF  SHAREHOLDERS'  EQUITY
(DOLLARS IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                                                                 
                                                                                                                 
                                                                                    Notes                        
                                                    Common Stock                 Receivable            Deferred  
                                          -------------------------------           From                Stock    
                                             Shares             Amount          Shareholders        Compensation 
                                          ------------       ------------       ------------        ------------ 
<S>                                       <C>                <C>                <C>                 <C>          

BALANCES, October 1, 1995                    5,836,399       $     35,135       $        (92)       $        (81)

Common stock issued under
   employee stock purchase plan                 52,694                310               --                  --   
Exercise of options                             54,410                195               --                  --   
Amortization of deferred
   stock compensation                             --                 --                 --                    64 
Net unrealized loss on
   short-term investments                         --                 --                 --                  --   
Cancellation of notes receivable                  --                 --                   92                --   
Net income                                        --                 --                 --                  --   
                                          ------------       ------------       ------------        ------------ 

BALANCES, September 30, 1996                 5,943,503             35,640               --                   (17)

Common stock issued under
   employee stock purchase plan                 61,781                256               --                  --   
Exercise of options                             55,912                243               --                  --   
Amortization of deferred
   stock compensation                             --                 --                 --                    17 
Net loss                                          --                 --                 --                  --   
                                          ------------       ------------       ------------        ------------ 

BALANCES, September 30, 1997                 6,061,196             36,139               --                  --   

Common stock issued under
   employee stock purchase plan                126,828                320               --                  --   
Exercise of options                             14,719                 50               --                  --   
Net unrealized gain on
   short-term investments                         --                 --                 --                  --   
Net loss                                          --                 --                 --                  --   
                                          ------------       ------------       ------------        ------------ 

BALANCES, September 30, 1998                 6,202,743       $     36,509       $       --          $       --   
                                          ============       ============       ============        ============ 
</TABLE>


<TABLE>
<CAPTION>
                                             Net                                              
                                        Unrealized                                           
                                          Loss on             Retained                        
                                           Short-              Earnings            Total      
                                            Term            (Accumulated        Shareholders' 
                                         Investments          Deficit)             Equity
                                        ------------        ------------        ------------
<S>                                     <C>                 <C>                 <C>         

BALANCES, October 1, 1995               $       --          $     (2,662)       $     32,300

Common stock issued under
   employee stock purchase plan                 --                  --                   310
Exercise of options                             --                  --                   195
Amortization of deferred
   stock compensation                           --                  --                    64
Net unrealized loss on
   short-term investments                        (10)               --                   (10)
Cancellation of notes receivable                --                  --                    92
Net income                                      --                 2,743               2,743
                                        ------------        ------------        ------------

BALANCES, September 30, 1996                     (10)                 81              35,694

Common stock issued under
   employee stock purchase plan                 --                  --                   256
Exercise of options                             --                  --                   243
Amortization of deferred
   stock compensation                           --                  --                    17
Net loss                                        --                (4,688)             (4,688)
                                        ------------        ------------        ------------

BALANCES, September 30, 1997                     (10)             (4,607)             31,522

Common stock issued under
   employee stock purchase plan                 --                  --                   320
Exercise of options                             --                  --                    50
Net unrealized gain on
   short-term investments                         10                --                    10
Net loss                                        --               (14,000)            (14,000)
                                        ------------        ------------        ------------

BALANCES, September 30, 1998            $       --          $    (18,607)       $     17,902
                                        ============        ============        ============
</TABLE>


                See Notes to Consolidated Financial Statements.


                                      F-4
<PAGE>   41
AG ASSOCIATES, INC.

CONSOLIDATED  STATEMENTS  OF  CASH  FLOWS
(IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                                               YEAR ENDED SEPTEMBER 30,
                                                                                  ------------------------------------------------
                                                                                     1998               1997               1996
                                                                                  ----------         ----------         ----------
<S>                                                                               <C>                <C>                <C>       
Cash flows from operating activities:
  Net income (loss)                                                               $  (14,000)        $   (4,688)        $    2,743
  Reconciliation to net cash provided by (used in) operating activities:
    Depreciation and amortization                                                      2,777              2,746              2,078
    Loss on disposal of fixed assets                                                     187                662               --
    Equity in loss of unconsolidated subsidiary                                         --                 --                1,152
    Deferred income taxes                                                              2,658                846                400
    Deferred stock compensation and stock issued for services rendered                  --                   17                 64
    Other                                                                               --                 --                   17
    Changes in assets and liabilities:
      Receivables                                                                      7,734             (4,855)             4,948
      Inventories                                                                       (167)                (8)            (3,274)
      Prepaid expenses and other current assets                                         (131)              (177)                94
      Accounts payable                                                                (2,766)             1,603             (2,372)
      Accrued liabilities                                                             (1,053)              (327)            (2,159)
      Customer advances                                                                 --                 (245)              (905)
      Income taxes payable/refundable                                                    361               (189)            (2,113)
                                                                                  ----------         ----------         ----------
           Net cash provided by (used in) operating activities                        (4,400)            (4,615)               673
                                                                                  ----------         ----------         ----------

Cash flows from investing activities:
  Purchases of short-term investments                                                   (513)            (9,474)            (3,199)
  Maturities of short-term investments                                                 2,195             17,791              3,800
  Investment in AG Israel                                                               --                 --               (1,000)
  Capital expenditures                                                                (4,067)            (3,452)            (6,852)
                                                                                  ----------         ----------         ----------

           Net cash provided by (used in) investing activities                        (2,385)             4,865             (7,251)
                                                                                  ----------         ----------         ----------

Cash flows from financing activities:
  Short-term borrowing                                                                 5,469               --                 --
  Repayments of capital lease obligations                                               (207)              (260)              (281)
  Sales of common stock                                                                  370                499                505
  Collection of notes receivable                                                        --                 --                   92
                                                                                  ----------         ----------         ----------

           Net cash provided by financing activities                                   5,632                239                316
                                                                                  ----------         ----------         ----------

Net increase (decrease) in cash and equivalents                                       (1,153)               489             (6,262)

Cash and equivalents at beginning of period                                            2,485              1,996              8,258
                                                                                  ----------         ----------         ----------

Cash and equivalents at end of period                                             $    1,332         $    2,485         $    1,996
                                                                                  ==========         ==========         ==========

Supplemental schedule of noncash investing and financing activities:
  Assets acquired under capital leases                                            $     --           $      496         $     --
                                                                                  ==========         ==========         ==========
  Exchange of equipment for services                                              $     --           $      257         $     --
                                                                                  ==========         ==========         ==========

Supplemental disclosure of cash flow information:
  Cash paid for interest                                                          $       77         $       71         $       50
                                                                                  ==========         ==========         ==========
  Cash paid (refunded) for income taxes                                           $   (1,519)        $   (2,096)        $    3,207
                                                                                  ==========         ==========         ==========
</TABLE>


                See Notes to Consolidated Financial Statements.


                                      F-5
<PAGE>   42
AG ASSOCIATES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996

1.    ORGANIZATION  AND  SIGNIFICANT  ACCOUNTING  POLICIES

      ORGANIZATION - AG Associates, Inc. (the Company) was incorporated in
      California in October 1981. The Company designs, manufactures, markets and
      supports advanced single-wafer, rapid thermal processing (RTP) equipment
      used in the manufacture of integrated circuits. The Company's products,
      marketed under the Heatpulse(R) and Starfire(TM) names, utilize high
      intensity light to precisely heat a single silicon wafer which results in
      a chemical process needed to produce an integrated circuit. These products
      are manufactured at the Company's California location and sold primarily
      to semiconductor manufacturers through a direct sales force in the United
      States and through foreign distributors.

      CONSOLIDATION - The consolidated financial statements include the accounts
      of AG Associates, Inc. and its wholly owned subsidiary, Rapro Technology,
      Inc. (Rapro). All significant intercompany balances and transactions have
      been eliminated. The Company accounts for its minority interest in AG
      Israel using the equity method.

      CONCENTRATION OF CREDIT RISK - Financial instruments that potentially
      subject the Company to a concentration of credit risk consist primarily of
      cash, cash equivalents and short-term investments, as well as accounts
      receivable. The Company has placed the majority of its cash, cash
      equivalents and short-term investments with high-quality financial
      institutions.

      The Company sells its products primarily to large companies in the
      semiconductor industry. Credit risk is further mitigated by the Company's
      credit evaluation process. The Company does not require collateral or
      other security to support receivables. The Company maintains allowances
      for potential credit losses

      FINANCIAL STATEMENT 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, liabilities, revenues and expenses. Such estimates
      include the level of the allowance for potentially uncollectible
      receivables, inventory reserves for obsolete, slow moving or non-salable
      inventory, certain accruals and estimated costs for installation, warranty
      and other customer support obligations. Actual results could differ from
      these estimates.

      SIGNIFICANT RISKS AND UNCERTAINTIES - The Company participates in the
      dynamic high technology industry and believes that changes in any of the
      following areas could have a material adverse effect on the Company's
      future financial position or results of operations: advances and trends in
      new technologies; competitive pressures in the form of new products or
      price reductions on current products; changes in product mix; changes in
      the overall demand for products and services offered by the Company;
      changes in certain strategic partnerships or customer relationships;
      litigation or claims against the Company based on intellectual property,
      patent, products, regulatory or other factors; risks associated with
      changes in domestic and international economic and/or political conditions
      or regulations; availability of necessary components, and the Company's
      ability to attract and retain employees necessary to support its growth.

      FAIR VALUE OF FINANCIAL INSTRUMENTS - The estimated fair value of
      financial instruments have been determined by the Company, using available
      market information and valuation methodology considered to be appropriate.
      However, considerable judgement is required in interpreting market data to
      develop the estimates of fair value. The use of different market
      assumptions and/or estimation methodologies could have a material effect
      on estimated fair value amounts. The estimated fair value of the Company's
      financial instruments at September 30, 1998 and 1997 was not materially
      different from the values presented in the consolidated balance sheets.


                                      F-6
<PAGE>   43
      CASH EQUIVALENTS - Cash equivalents are highly liquid debt instruments
      acquired with a maturity of three months or less at date of purchase.

      SHORT-TERM INVESTMENTS - As of September 30, 1997, the Company has
      classified short-term corporate debt securities and adjustable rate
      preferred stock investments as "available for sale" securities, and the
      carrying value of these securities is fair market value, as determined by
      quoted market prices. Net unrealized gains and losses on these investments
      have been recorded as a separate component of shareholders' equity.

      INVENTORIES - Inventories are stated at the lower of cost (first-in,
      first-out) or market. The Company reviews the levels of its inventories in
      light of current and forecasted demand to identify and provide reserves
      for obsolete, slow-moving, or non-salable inventory.

      PROPERTY AND EQUIPMENT - Property and equipment are stated at cost.
      Depreciation is provided using the straight-line method over estimated
      useful lives of three to five years. Equipment under capital lease and
      leasehold improvements are amortized over the shorter of there estimated
      useful lives or the lease term.

      STOCK-BASED COMPENSATION - The Company accounts for stock-based awards to
      employees using the intrinsic value method in accordance with Accounting
      Principles Board Opinion No. 25, "Accounting for Stock-Based
      Compensation."

      REVENUE RECOGNITION - Sales are generally recognized upon shipment.
      Estimated costs for installation, warranty and other customer support
      obligations, which are considered insignificant, are accrued in the period
      that sales are recognized. Revenue related to services provided to
      customers outside the warranty period are generally recognized when the
      services are performed.

      RESEARCH AND DEVELOPMENT - All research and development costs are expensed
      as incurred. The Company's products include certain software applications.
      The costs to develop such software have not been capitalized as the
      Company believes its current software development process is essentially
      completed concurrent with the establishment of the technological
      feasibility of the software and/or development of the related hardware.

      INCOME TAXES - The Company provides for income taxes using the asset and
      liability approach defined by Statement of Financial Accounting Standards
      No. 109 (SFAS 109), "Accounting for Income Taxes."

      NET INCOME (LOSS) PER SHARE - The Company has adopted Statement of
      Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128").
      SFAS 128 requires a dual presentation of basic and diluted earnings per
      share ("EPS"). Basic EPS excludes dilution and is computed by dividing net
      income (loss) by the weighted average number of common shares outstanding
      during the period. Diluted EPS reflects the potential dilution that could
      occur if securities or other contracts to issue stock were exercised or
      converted into common stock. Prior period amounts have been restated to
      reflect the adoption of SFAS 128. The Company has excluded stock options
      of 2,580 and 433,013 respectively from the computation of diluted earnings
      per share for 1998 and 1997 because such securities are anti-dilutive for
      these periods. See Note 8 for further information on stock options
      outstanding.


                                      F-7
<PAGE>   44
      The following table sets forth the computation of basic and diluted
      earnings per share (in thousands, except per share data):


<TABLE>
<CAPTION>
                                                                                        YEAR ENDED SEPTEMBER 30,
                                                                          -----------------------------------------------------
                                                                               1998                1997                1996
                                                                          -------------       -------------       -------------
<S>                                                                       <C>                 <C>                 <C>          

      Net income (loss)                                                   $     (14,000)      $      (4,688)      $       2,743
                                                                          =============       =============       =============
      Shares used in basic per share computations (weighted  average
         shares outstanding)                                                      6,102               5,981               5,882
      Potential dilution from options                                              --                  --                   258
                                                                          -------------       -------------       -------------
      Shares used in diluted per share computations                               6,102               5,981               6,140
                                                                          =============       =============       =============

      Basic net income (loss) per share                                   $       (2.29)      $       (0.78)      $        0.47
                                                                          =============       =============       =============
      Diluted net income (loss) per share                                 $       (2.29)      $       (0.78)      $        0.45
                                                                          =============       =============       =============
</TABLE>


      RECENTLY ISSUED ACCOUNTING STANDARDS - In June 1997, the FASB issued SFAS
      No. 130, "Reporting Comprehensive Income," which requires an enterprise to
      report, by major components and as a single total , the change in its net
      assets during the period from nonowner sources; and No. 131, "Disclosures
      about Segments of an Enterprise and Related Information," which
      establishes annual and interim reporting standards for an enterprise's
      business segments and related disclosures about its products, services,
      geographic areas and major customers. Adoption of these statements will
      not impact the Company's financial position, results of operations or cash
      flows. Both statements are effective for fiscal years beginning after
      December 15, 1997.

      In June 1998, the Financial Accounting Standards Board issued SFAS No. 133
      "Accounting for Derivative Instruments and Hedging Activities". SFAS No.
      133 establishes accounting and reporting standards for derivative
      instruments, including certain derivative instruments embedded in other
      contracts, (collectively referred to as derivatives) and for hedging
      activities. It requires that an entity recognize all derivatives as either
      assets or liabilities in the statement of financial position and measure
      those instruments at fair value. For a derivative not designated as a
      hedging instrument, changes in the fair value of the derivative are
      recognized in earnings in the period of change. This statement will be
      effective for all annual and interim periods beginning after June 15,
      1999. Adoption of this statement will not have a material effect on the
      Company's financial position, results of operations or cash flows.

      In March 1998, the American Institute of Certified Public Accountants
      issued Statement of Position ("SOP") No. 98-1, "Software for Internal
      Use," which provides guidance on accounting for the cost of computer
      software developed or obtained for internal use. SOP No. 98-1 is effective
      for financial statements for fiscal years beginning after December 15,
      1998. Adoption of this statement is not expected to have a material impact
      on the Company's financial position, results of operations or cash flows.


                                      F-8
<PAGE>   45
2.    INVESTMENTS

      There were no short-term investments held at September 30, 1998.
      Short-term investments at September 30, 1997 consisted of (in thousands):

<TABLE>
<CAPTION>
                                                                       GROSS            GROSS             FAIR
                                                    AMORTIZED       UNREALIZED        UNREALIZED         MARKET
1997                                                  COST             GAINS            LOSSES            VALUE
                                                  ------------     ------------      ------------      ------------
<S>                                               <C>              <C>               <C>               <C>         

      Available-for-sale investments:
        Adjustable rate preferred stocks          $        500     $       --        $       --        $        500
        Corporate debt securities                        1,182             --                 (10)            1,172
                                                  ------------     ------------      ------------      ------------

                                                  $      1,682     $       --        $        (10)     $      1,672
                                                  ============     ============      ============      ============
</TABLE>


      There were no material realized gains or losses for the years ended
      September 30, 1998 and 1997.

3.    INVENTORIES

      Inventories consist of (in thousands):

<TABLE>
<CAPTION>
                                      SEPTEMBER 30,
                               -----------------------------
                                   1998             1997
                               ------------     ------------
<S>                            <C>              <C>         

      Raw materials            $      6,814     $      7,500
      Work-in-process                 5,029            4,176
                               ------------     ------------

                               $     11,843     $     11,676
                               ============     ============
</TABLE>

      Inventories are shown net of reserves for obsolete, slow-moving, and
      non-salable inventory of $2,347,000 and $3,666,000 at September 30, 1998
      and 1997, respectively.

4.    PROPERTY  AND  EQUIPMENT

      Property and equipment consist of (in thousands):

<TABLE>
<CAPTION>
                                                                 SEPTEMBER 30,
                                                         -------------------------------
                                                             1998               1997
                                                         ------------       ------------
<S>                                                      <C>                <C>         

      Machinery and equipment                            $     13,392       $     10,289
      Furniture and fixtures                                      928                888
      Leasehold improvements                                    3,574              2,893
      Construction in progress                                    759              1,315
                                                         ------------       ------------

      Total                                                    18,653             15,385
      Accumulated depreciation and amortization                (9,057)            (6,892)
                                                         ------------       ------------

      Property and equipment, net                        $      9,596       $      8,493
                                                         ============       ============
</TABLE>


                                      F-9
<PAGE>   46
5.    ACCRUED  LIABILITIES

      Accrued liabilities consist of (in thousands):

<TABLE>
<CAPTION>
                                                SEPTEMBER 30,
                                         --------------------------
                                            1998            1997
                                         ----------      ----------
<S>                                      <C>             <C>       

      Compensation and benefits          $    1,633      $    1,827
      Warranty reserve                          901           1,687
      Other                                   1,097           1,170
                                         ----------      ----------

                                         $    3,631      $    4,684
                                         ==========      ==========
</TABLE>

6.    BORROWING ARRANGEMENTS

      The Company has a line of credit with a bank, which provides for
      borrowings of up to $12,000,000, limited to outstanding accounts
      receivable, as defined, which expires June 23, 2000. As of September 30,
      1998, the Company had borrowed $5,469,000 under this line of credit. The
      borrowings are collateralized by primarily all of the Company's assets,
      bear interest at prime (8.25% at September 30, 1998) plus 1.0% per annum
      and are due June 23, 2000. The line of credit is subject to certain
      financial covenants including a minimum net worth covenant of $15,000,000.
      At September 30, 1998, the Company was in compliance with these covenants.

7.    LEASES

      Equipment with a cost and accumulated amortization of $496,000 and
      $234,000 at September 30, 1998, respectively, ($1.3 million and $818,000
      at September 30, 1997) has been leased under capital leases. The Company
      is subject to certain financial covenants under the equipment lease
      including, a minimum net worth covenant of $15,000,000 and an adjusted
      minimum profit number.

      In 1995, the Company entered into a seven-year lease, with an option for a
      five-year extension, for a 115,000 square foot office and manufacturing
      facility, located in San Jose, California. An option to expand the San
      Jose facilities by approximately 38,000 was exercised by the Company
      effective in October 1998.

      Future minimum annual capital and operating lease commitments at September
      30, 1998 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                 OPERATING           CAPITAL
                                                                   LEASES             LEASES
                                                                 ---------          --------
<S>                                                              <C>                <C>     

      1999                                                       $   1,804          $    181
      2000                                                           1,916                99
      2001                                                           1,971                --
      2002                                                           2,000                --
      2003                                                             167                --
                                                                 ---------          --------
      
      Total minimum lease payments                               $   7,858          $    280
                                                                 =========
      Amount representing interest                                                       (18)
                                                                                    --------
      
      Present value of minimum lease payments                                       $    262
                                                                                    ========
</TABLE>

      Rent expense for operating leases was approximately $1,280,000, $1,240,000
      and $1,134,000 for the years ended September 30, 1998, 1997 and 1996,
      respectively.


                                      F-10
<PAGE>   47
8.    SHAREHOLDERS' EQUITY

      NOTES RECEIVABLE FROM SHAREHOLDERS

      Certain notes had been received from officers for the acquisition of
      shares of common stock. All notes were canceled as of September 30, 1996.

      STOCK OPTION AND PURCHASE PLANS

      Under the Company's stock option plans (the Plans), 1,500,000 shares of
      Common Stock are reserved for the grant of incentive or non-statutory
      stock options and the direct award or sale of shares to employees,
      directors, contractors and consultants. Under the Plans, options are
      granted at fair value at the date of grant as determined by the Board of
      Directors. Generally, such options become exercisable over periods of one
      to four years and expire ten years from the grant date.

      Option activity under the Plans was as follows:

<TABLE>
<CAPTION>
                                                                                                 WEIGHTED
                                                                                                  AVERAGE
                                                                            NUMBER            EXERCISE PRICE
                                                                           OF SHARES             PER SHARE
                                                                        ------------          --------------
<S>                                                                     <C>                   <C>     

      Outstanding, October 1, 1995                                           718,977             $  10.70
                                                                                            
      Granted (weighted average fair value of $3.19 per share)               868,363             $   8.87
      Exercised                                                              (54,410)            $   4.01
      Canceled                                                              (725,014)            $  13.85
                                                                        ------------        
                                                                                            
      Outstanding, September 30, 1996 (229,979 exercisable                                  
        at a weighted average price of $6.44)                                807,916             $   6.31
                                                                                            
      Granted (weighted average fair value of $2.43 per share)               385,680             $   6.09
      Exercised                                                              (55,912)            $   4.14
      Canceled                                                              (170,777)            $   6.59
                                                                        ------------        
                                                                                            
      Outstanding, September 30, 1997 (194,426 exercisable                                  
        at a weighted average price of $5.91)                                966,907             $   6.31
                                                                                            
      Granted (weighted average fair value of $2.85 per share)               341,612             $   5.24
      Exercised                                                              (14,719)            $   3.38
      Canceled                                                              (238,589)            $   6.29
                                                                        ------------        
                                                                                            
      Outstanding, September 30, 1998 (426,150 exercisable                                  
        at a weighted average price of $6.08)                              1,055,211             $   6.00
                                                                        ============    
</TABLE>

      At September 30, 1998, 743,382 options were available for future grant.

      As of September 30, 1998, options to purchase 48,500 shares were
      outstanding to non-employees and directors (granted outside the directors
      stock option plan) at prices ranging from $3.60 to $16.71.

      In June 1996, the Company canceled options to purchase 495,439 shares of
      common stock exercisable at $7.38 to $33.19 per share and issued
      replacement options with an exercise price of $7.21 per share.


                                      F-11
<PAGE>   48
      In connection with certain grants of certain stock options to employees in
      fiscal 1994, the Company had recorded $230,000 for the difference between
      the deemed fair value for accounting purposes and the option price as
      determined by the Board at the date of grant. Of such amount, $102,000
      related to option grants which had previously vested and accordingly were
      expensed in fiscal 1994; the remaining $128,000 was presented as a
      reduction of shareholders' equity was being amortized over the 48-month
      vesting period of the related stock options. Amortization of deferred
      stock compensation for 1997 and 1996 was $17,000 and $64,000,
      respectively.

      In November 1994, the Company reserved 50,000 shares for a directors stock
      option plan. Options to purchase 12,000 shares at prices ranging from
      $3.94 to $16.71 have been issued and are outstanding under this plan as of
      September 30, 1998.


                                      F-12
<PAGE>   49
      Additional information regarding options outstanding as of September 30,
      1998 is as follows:

<TABLE>
<CAPTION>
                                               OPTIONS OUTSTANDING   
                                            -------------------------     OPTIONS EXERCISABLE
                                              WEIGHTED                   ----------------------
                                               AVERAGE       WEIGHTED                  WEIGHTED
                                              REMAINING       AVERAGE                   AVERAGE
         RANGE OF              NUMBER        CONTRACTUAL     EXERCISE      NUMBER      EXERCISE
     EXERCISE PRICES        OUTSTANDING     LIFE (YEARS)       PRICE     EXERCISABLE     PRICE
     ----------------       -----------     ------------     --------    -----------   --------
<S>                         <C>             <C>              <C>         <C>           <C>

     $1.750 - $5.250           347,370           7.19         $4.16        142,668       $3.83
     $5.310 - $7.000           327,729           7.57         $6.20         60,668       $6.23
          $7.125               238,882           6.89         $7.13        170,798       $7.13
     $7.130 - $25.790          141,230           7.48         $8.17         52,016       $8.66
                                                                                        
                            -----------                                  ---------      
                                                                                        
     $1.750 - $25.790        1,055,211           7.28         $6.00        426,150       $6.08
                            ===========                                  =========      
</TABLE>

      EMPLOYEE STOCK PURCHASE PLAN - In November 1994, the Company reserved
      250,000 shares for sale under the 1994 Employee Stock Purchase Plan,
      designed to qualify under Internal Revenue Code Section 423(b). Stock may
      be offered for purchase by employees at a price equal to 85% of the lower
      of the market value of the stock at the beginning or end of each six-month
      offer period, subject to annual limitation. In fiscal 1998, 1997 and 1996,
      126,828, 61,781 and 52,694 shares were issued at weighted average prices
      of $2.52, $4.15 and $5.87 under this Plan for net proceeds to the Company
      of $320,000, $243,000 and $310,000. The weighted average fair market value
      of the fiscal 1998, 1997 and 1996 awards was $1.86, $1.54 and $4.57 per
      share, respectively.

      ADDITIONAL STOCK PLAN INFORMATION - The Company continues to account for
      its stock-based awards using the intrinsic value method in accordance with
      Accounting Principles Board No. 25, "Accounting for Stock Issued to
      Employees," and its related interpretations. Accordingly, no compensation
      expense has been recognized in the financial statements for employee stock
      arrangements.

      Statement of Financial Accounting Standards No. 123, "Accounting for
      Stock-Based Compensation" (SFAS 123), requires the disclosure of pro forma
      net income (loss) as if the Company had adopted the fair value method as
      of the beginning of fiscal 1996. Under SFAS 123, the fair value of
      stock-based awards to employees is calculated through the use of option
      pricing models, even though such models were developed to estimate the
      fair value of freely tradable, fully transferable options without vesting
      restrictions, which significantly differ from the Company's stock option
      awards. These models also require subjective assumptions, including future
      stock price volatility and expected time to exercise, which greatly affect
      the calculated values. The Company's calculations were made using the
      Black-Scholes option pricing model with the following weighted average
      assumptions: expected life, 4 years; risk-free interest rates, 5.51% in
      1998, 6.14% in 1997 and 6.04% in 1996; volatility, 70% in 1998, 40% in
      1997 and 40% in 1996 and no dividends during the expected term. The
      Company's calculations are based on a single option valuation approach,
      and forfeitures are recognized as they occur. For purposes of pro forma
      disclosures, the estimated fair value of the options is amortized to
      expense over the options' vesting period. However, the impact of
      outstanding non-vested stock options granted prior to 1996 has been
      excluded from the pro forma calculation; accordingly, the 1998, 1997 and
      1996 pro forma adjustments are not indicative of future period pro forma
      adjustments when the calculation will apply to all applicable stock
      options.


                                      F-13
<PAGE>   50
      The Company's pro forma information follows:


<TABLE>
<CAPTION>
                                                                                   YEAR ENDED SEPTEMBER 30,
                                                                 ----------------------------------------------------------
                                                                     1998                   1997                   1996
                                                                 ------------           ------------           ------------
<S>                                                              <C>                    <C>                    <C>         
                                                                            (In thousands, except per share data)

      Net income (loss) - as reported                            $    (14,000)          $     (4,688)          $      2,743
                                                                 ============           ============           ============

      Net income (loss) - pro forma                              $    (14,621)          $     (5,097)          $      2,222
                                                                 ============           ============           ============

      Basic net income (loss) per share - as reported            $      (2.29)          $      (0.78)          $       0.47
                                                                 ============           ============           ============
      Diluted net income (loss) per share - as reported          $      (2.29)          $      (0.78)          $       0.45
                                                                 ============           ============           ============

      Basic net income (loss) per share - pro forma              $      (2.40)          $      (0.85)          $       0.38
                                                                 ============           ============           ============
      Diluted net income (loss) per share - pro forma            $      (2.40)          $      (0.85)          $       0.36
                                                                 ============           ============           ============
</TABLE>

9.    INCOME TAXES

      Income (loss) before provision (benefit) for income taxes consists of the
      following (in thousands):

<TABLE>
<CAPTION>
                                   YEARS ENDED SEPTEMBER 30,
                        ------------------------------------------------
                            1998               1997               1996
                        ----------         ----------         ----------
<S>                     <C>                <C>                <C>       

      Domestic          $  (12,494)        $   (6,237)        $    5,639
      Foreign                 --                 --               (1,152)
                        ----------         ----------         ----------

      Total             $  (12,494)        $   (6,237)        $    4,487
                        ==========         ==========         ==========
</TABLE>


      The provision (benefit) for income taxes consists of (in thousands):

<TABLE>
<CAPTION>
                                                               YEARS ENDED SEPTEMBER 30,
                                                    ----------------------------------------------
                                                       1998              1997              1996
                                                    ----------        ----------        ----------
<S>                                                 <C>               <C>               <C>       
      Federal:
        Current                                     $   (1,152)       $   (2,197)       $    1,253
        Deferred                                         1,922               772               334
                                                    ----------        ----------        ----------

                                                           770            (1,425)            1,587
      State:
        Current                                           --                (198)               91
        Deferred                                           736                74                66
                                                    ----------        ----------        ----------

      Provision (benefit) for income taxes          $    1,506        $   (1,549)       $    1,744
                                                    ==========        ==========        ==========
</TABLE>


                                      F-14
<PAGE>   51
      A reconciliation between the Company's effective tax rate and the U.S.
      statutory rate is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                            YEARS ENDED SEPTEMBER 30,
                                                                  ----------------------------------------------
                                                                     1998              1997              1996
                                                                  ----------        ----------        ----------
<S>                                                               <C>               <C>               <C>       

      Tax at federal statutory rate                               $   (4,373)       $   (2,121)       $    1,570
      State taxes                                                       --                  (1)               87
      Foreign sales corporation benefit                                 --                --                (220)
      Foreign losses not deductible                                     --                --                 403
      Other                                                               58              (302)              (28)
      Deferred tax assets not recognized in current year               3,163              --                --
      Increase (decrease) in valuation allowance                       2,658               875               (68)
                                                                  ----------        ----------        ----------

      Provision (benefit) for income taxes                        $    1,506        $   (1,549)       $    1,744
                                                                  ==========        ==========        ==========
</TABLE>

The components of the net deferred tax assets as of September 30 were as follows
(in thousands):

<TABLE>
<CAPTION>
                                                                         1998               1997
                                                                      ----------         ----------
<S>                                                                   <C>                <C>     
      Deferred tax assets:
        Net operating loss carryforwards                              $    4,765         $     --
        Net operating loss and credit carryforwards of Rapro               1,408              1,408
        Credit carryforwards                                               2,240                861
        Reserves not currently deductible for tax purposes                 2,042              2,235
        Book depreciation over tax depreciation                              690                437
                                                                      ----------         ----------

      Gross deferred tax assets                                           11,145              4,941

      Valuation allowances:
        Rapro net operating loss and credit carryforwards                 (1,408)            (1,408)
        Other                                                             (9,737)              (875)
                                                                      ----------         ----------

      Net deferred tax assets                                         $     --           $    2,658
                                                                      ==========         ==========
</TABLE>

      Realization of the tax benefit related to the Company's deferred tax
      assets is dependent upon the generation of future taxable income. Due to
      significant net losses incurred through September 30, 1998 and uncertainty
      surrounding the utilization of deferred tax assets, management reevaluated
      its deferred tax assets and has provided a full valuation allowance at
      September 30, 1998 of $9,737,000, which increased from $875,000 at
      September 30, 1997. The valuation allowance at September 30, 1998 and 1997
      of $1,408,000 relates to amounts arising from Rapro's preacquisition
      carryforwards. These carryforwards expire in 2006.

      Net operating loss carryforwards for federal and state tax purposes
      available to offset future taxable income were $12,675,000 and $5,725,000,
      respectively, at September 30, 1998. The federal and state net operating
      loss carryforwards expire through 2018 and 2003, respectively. At
      September 30, 1998, the Company also had general business credits for
      federal and state tax purposes of $1,492,000 and $748,000, respectively,
      available to offset future taxable income. The federal credits expire
      through 2018 and the state credits have no expiration. The extent to which
      the loss and the credit carryforward can be used to offset taxable and tax
      liabilities, respectively, may be limited depending on the extent of
      ownership change with in any three-year period.


                                      F-15
<PAGE>   52
10.   EMPLOYEE BENEFIT PLAN

      The Company has a 401(k) tax-deferred savings plan under which
      participants may contribute up to 15% of their compensation, subject to
      certain Internal Revenue Service limitations. The Company has not
      contributed to the Plan to date.

11.   SIGNIFICANT CUSTOMERS AND RELATED PARTY TRANSACTIONS

      The Company leased a facility during fiscal years 1996 from a shareholder.
      Rent expense related to this lease for 1996 was $72,000. The Company did
      not lease from this shareholder in 1998 or 1997.

      Sales and accounts receivable related to significant customers were:

<TABLE>
<CAPTION>
                                                                           SALES AS A PERCENTAGE
                                               ACCOUNTS                      OF NET REVENUES
                                              RECEIVABLE                       YEARS ENDED
                                             SEPTEMBER 30,                    SEPTEMBER 30,
                                       -----------------------    --------------------------------------
                                          1998         1997          1998          1997          1996
                                       ----------   ----------    ----------    ----------    ----------
<S>                                    <C>          <C>           <C>           <C>           <C> 

      Distributor/shareholder              19%           *            32%           12%           25%
      Distributor                          15            *            13             *            14
      Intel                                11           15%           14            25            20
      Cypress Semiconductor                13            *             *             *             *
      Anadigics Inc.                       12            *             *             *             *
      Micron                                *           23             *            10             *
      Masca                                 *           10             *             *             *
      NEC                                   *            *             *             *            17
</TABLE>


      *  Less than 10% of net revenues or accounts receivable

12.   GEOGRAPHIC AND CUSTOMER INFORMATION

      Information concerning the Company's operations by geographic area as of
      and for the three years ended September 30, 1998 follows (in thousands).

<TABLE>
<CAPTION>
                                                      YEAR ENDED SEPTEMBER 30,
                                            --------------------------------------------
                                               1998             1997             1996
                                            ----------       ----------       ----------
<S>                                         <C>              <C>              <C>       
      Net sales:
        From the United States to:
          United States                     $   21,374       $   34,007       $   32,460
          Japan                                 14,848            5,719           19,263
          Europe                                 6,115            3,566           10,108
          Taiwan                                 1,452            2,785            7,044
          Other Far East countries               2,168            3,527            2,214
                                            ----------       ----------       ----------

                                            $   45,957       $   49,604       $   71,089
                                            ==========       ==========       ==========
</TABLE>

      Export revenues as a percentage of net sales were 53%, 31% and 54% in
      1998, 1997 and 1996, respectively.

13.   AG ISRAEL

      In 1992, the Company established AG Israel for the purpose of developing,
      manufacturing and marketing platforms for moving and controlling silicon
      wafers for the semiconductor industry. During fiscal 1993, the Company
      sold an approximate 49.9% interest in AG Israel to Hapoalim Investment Co.
      and Yozma Venture Capital (Yozma). The Company retained a 50.1% voting
      interest. Hapoalim Investment Co. and Yozma 


                                      F-16
<PAGE>   53
      had the right to convert all of their interests in AG Israel to shares of
      the Company's common stock. Accordingly, the Company had recognized 100%
      of AG Israel's losses since its inception.

      In April 1994, the Company obtained the right to induce conversion of this
      minority interest at any time. In return, Hapoalim Investment Co.
      purchased the shares held by Yozma and the Company revised the exchange
      rate at which Hapoalim Investment Co. could exchange its interest in AG
      Israel from $9.20 to $7.36 per share, and also revised the conversion rate
      of the debentures from $9.20 to $7.36. The Company also modified the terms
      of the warrant held by Hapoalim Investment Co., decreasing the exercise
      price to the lower of $9.15 or 80% of the price of the shares in an
      initial public offering. The fair value at April 1994 of these revisions
      to the exchange rate, conversion rate and warrant price were estimated to
      be $400,000 and was included in other expense.

      In February 1995, the Company exercised its exchange right and issued
      271,739 shares of common stock to acquire all of the outstanding shares of
      AG Israel. Also, in February 1995, the Company entered into an agreement
      for the sale of the controlling interest in the research, development and
      other business operations of its Rapro and AG Israel operations. Under the
      agreement, effective upon the close of the Company's initial public
      offering in May 1995, the Company contributed rights to the chemical vapor
      deposition (CVD) and cluster tool technologies, certain assets and
      liabilities of Rapro and cash of $500,000 to AG Israel. AG Israel issued
      stock equal to a 51% interest to Clal Electronics Industries Ltd. (Clal
      Electronics) in exchange for $2,500,000. In addition, Clal Electronics had
      agreed to permit reimbursement to the Company for advances made to AG
      Israel subsequent to September 30, 1994 through the closing of this
      transaction in May 1995; such reimbursements totaled $521,000. AG Israel
      is devoting its principal efforts to the development of cluster tools
      using the technologies received from the Company; the Company and Clal
      Electronics paid AG Israel an additional $1,000,000 and $2,000,000,
      respectively, under the agreement. The Company had a right for a five-year
      period to repurchase Clal Electronics interest in AG Israel and to
      terminate the joint ownership of the technology for a repurchase price
      equal to 100% of amounts contributed to AG Israel by Clal Electronics plus
      simple interest at 25% of such contributions for each year from the date
      the contribution was made, plus, under certain circumstances, $500,000
      (the "Clal" option). The Company also entered into a voting agreement with
      Clal Electronics that covers, among other items, rights to elect directors
      of AG Israel and rights of each of the parties to acquire additional
      shares of AG Israel.

      Pursuant to the terms of the agreement, Clal Electronics acquired
      approximately 544,000 shares (9.9%) of the Company's outstanding shares of
      common stock from existing shareholders of the Company. After three years,
      Clal Electronics may increase its ownership in the Company up to 12% and,
      if its ownership exceeds 10%, Clal Electronics has the right to nominate a
      member for election to the Company's Board of Directors.

      As a result of AG Israel's stock sale, the Company accounted for its 49%
      investment in AG Israel using the equity method from June 1, 1995. In
      November 1997, AG Israel completed a private placement equity financing of
      $13 million in which the Company did not participate. As a result of the
      financing, the Company's voting interest was diluted to 28% and its fully
      diluted ownership interest to 25.2%. Also at that time, the Clal option
      was terminated, the Company, Clal Electronics and new AG Israel investors
      entered into a new shareholders agreement containing, among other things,
      the rights of the parties to elect directors of AG Israel and terminated
      the prior voting agreement between the Company and Clal Electronics.


                                      F-17
<PAGE>   54
      Condensed summary financial information (unaudited) of AG Israel is as
      follows (in thousands):

<TABLE>
<CAPTION>
      As of September 30:                          1998               1997               1996
                                                ----------         ----------         ----------
<S>                                             <C>                <C>                <C>
         Current assets                         $    7,643         $    7,961
         Total assets                               11,008             11,919
         Current liabilities                         2,302              5,407
         Noncurrent liabilities                      1,673              1,977

      For the year ended September 30:
         Net sales                              $    5,458         $      322         $    2,997
         Total expenses                              7,568              6,292              5,522
                                                ----------         ----------         ----------

         Net loss                               $   (2,110)        $   (5,970)        $   (2,525)
                                                ==========         ==========         ==========
</TABLE>


14.   CONTINGENCIES

      The Company is currently involved in an intellectual property litigation.
On April 24, 1997, Applied Materials, Inc. ("Applied Materials") filed a
complaint against the Company and AST Elektronik GmbH and AST Elektronik U.S.A.
(collectively, "AST") in the United States District Court for the Northern
District of California, San Jose Division, Case No. CV97-20375 RMW. Applied
Materials subsequently amended its complaint. Applied Materials currently
alleges that the Company's products infringe on four Applied Materials patents
relating to Rapid Thermal Processing ("RTP") processes and heater head design
and seeks a permanent injunction against infringement, an award of damages for
infringement, treble damages for intentional and willful infringement,
attorneys' fees and costs of suit. On July 23, 1997, the Company answered
Applied Materials' complaint and counterclaimed for declaratory relief that the
Company's products do not infringe the patents and that the patents are invalid.
On October 3, 1997, the Company filed a counterclaim in the United States
District Court for Northern California, San Jose Division against Applied
Materials for infringement of one of the Company's RTP process patents. On
October 27, 1997, Applied Materials answered the counterclaim by alleging that
it does not infringe the Company's patent and that the patent is invalid The
Company has filed additional patent claims against Applied Materials in Delaware
and San Jose, California, Case Nos. CA98-479 JJF (Delaware) and CV98-03044 RMW
(San Jose). By stipulation of the parties, the trial on Applied Materials claims
and the Company's counterclaims is set for July 13, 1999. Management believes
Applied Materials' claims are without merit and intends to defend the Company
vigorously, and that the Company's claims against Applied Materials are
meritorious. However, there can be no assurance that this litigation will be
resolved in favor of the Company, and, in any event, litigation could result in
significant expense to the Company and could divert the efforts of the Company's
technical and management personnel from other tasks, whether or not such
litigation is determined in favor of the Company. In particular, the Company has
incurred increased legal expenses in fiscal 1998 and expects to incur further
increased legal expenses in fiscal 1999. In the event of an adverse ruling in
any such litigation, the Company might be required to pay substantial damages,
cease the manufacture, use and sale of infringing products, discontinue the use
of certain processes or expend significant resources to develop non-infringing
technology or obtain licenses to the infringing technology.

There has been substantial litigation regarding patent and other intellectual
property rights in the semiconductor industry. General Signal Corporation has
made a claim against at least two manufacturers of cluster tools that have
resulted in litigation to the effect that certain of their cluster tool
technologies infringe on General Signal patents. In 1991, at the time that
General Signal first raised patent claims in the cluster tool area, the Company
joined with six major semiconductor process tool equipment manufacturers in
forming an "Ad Hoc Committee for Defense against General Signal Cluster Tool
Patents" (the "Ad Hoc Committee"). Based in part on an opinion of patent
counsel, the members of the Ad Hoc Committee notified General Signal that the
member companies were of the opinion that the General Signal patents were
invalid based on (a) prior art, (b) inequitable conduct before the Patent &
Trademark Office and (c) estoppel as a result of General Signal's activities in
establishing standards for cluster tools and interfaces within the semiconductor
industry. The Company believes that the position taken 


                                      F-18
<PAGE>   55
by the Ad Hoc Committee remains valid. Previously, the Company approached
General Signal to explore interest in licensing the same patents at issue in the
General Signal litigation. The general conditions of the license discussed by
General Signal were unacceptable to the Company. Based upon a review of the
subject patents, the Company believes that the subject patents are invalid or,
if somehow found to be valid, that the Company's cluster tool technology does
not infringe. Additionally, the Company has received an opinion of its patent
counsel, to the same effect. However, if such a claim were successfully enforced
against the Company regarding the cluster tool technology transferred to AG
Israel, the value of the Company's investment in AG Israel could diminish. The
Company could also be adversely affected as a result of the Company's liability
under an indemnity provision with AG Israel and Clal Electronics Industries,
Ltd. for any resulting royalties and other damages payable.

From time to time, the Company may receive or initiate claims or inquiries
against third parties for infringement of the Company's proprietary rights or to
establish the validity of the Company's proprietary rights. Such claims or
inquiries may result in litigation and could result in significant expense to
the Company and divert the efforts of the Company's technical and management
personnel from other tasks, whether or not such claims or inquiries are
determined in favor of the Company. In the event of an adverse ruling in any
such litigation, the Company might be required to pay substantial damages, cease
the manufacture, use and sale of infringing products, discontinue the use of
certain processes or expend significant resources to develop non-infringing
technology or obtain licenses to the infringing technology.

15.   SUBSEQUENT EVENT

      Not applicable


                                      F-19
<PAGE>   56
INDEPENDENT AUDITORS' REPORT ON SCHEDULE


We have audited the consolidated financial statements of AG Associates, Inc. as
of September 30, 1998 and 1997 and for each of the three years in the period
ended September 30, 1998 and have issued our report thereon dated October 23,
1998; such financial statements and report are included in this 1998 Annual
Report on Form 10-K. Our audits also included the financial statement schedule
of AG Associates, Inc., listed in Item 14(a)2. Such financial statement schedule
is the responsibility of the Company's management. Our responsibility is to
express an opinion based on our audits. In our opinion, such financial
statements schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.



DELOITTE & TOUCHE LLP

San Jose, California
October 23, 1998


                                      S-1
<PAGE>   57
                               AG ASSOCIATES, INC.

                                   SCHEDULE II
                        VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                           Charged            Charged
                                           Balance at      to Costs           to Other                        Balance at
                                            Beginning        and             Accounts-                            End
            Description                     of Period      Expenses           Describe         Deductions     of Period
      -----------------------------        ----------     ----------         ----------        ----------     ----------  
<S>                                        <C>            <C>                <C>               <C>            <C>

      ALLOWANCE FOR DOUBTFUL
           ACCOUNTS

      Year Ended September 30, 1998        $      903     $     (200)(2)     $    --           $     53       $     650
                                                                                                             
      Year Ended September 30, 1997               903           --                 --               --              903
                                                                                                             
      Year Ended September 30, 1996             1,456           --                 --               553(1)          903
                                                                                                             
      -----------------------------                                                                          
                                                                                                             
      INVENTORY RESERVES                                                                                     
                                                                                                             
      Year Ended September 30, 1998        $    3,666     $     --           $     --          $  1,319(5)    $   2,347
                                                                                                             
      Year Ended September 30, 1997             3,289          2,377               --             2,000(5)        3,666
                                                                                                             
      Year Ended September 30, 1996             2,669          1,385               --               765(4)        3,289
                                                                                                             
      -----------------------------                                                                          
                                                                                                             
      WARRANTY RESERVES                                                                                      
                                                                                                             
      Year Ended September 30, 1998        $    1,687     $    1,782         $     --          $  2,568(3)    $     901
                                                                                                             
      Year Ended September 30, 1997             2,440          2,710               --             3,463(3)        1,687
                                                                                                             
      Year Ended September 30, 1996             2,651          3,713               --             3,924(3)        2,440
      -----------------------------                                                                          
</TABLE>

(1) Represents writeoffs of uncollectible accounts
(2) Represents reversal of prior year accruals.
(3) Represents actual warranty expense incurred
(4) Represents write offs of inventories
(5) Represents scrap of obsolete parts and devaluation of inventory


                                      S-2
<PAGE>   58
                               AG ASSOCIATES, INC.

                                INDEX TO EXHIBITS

EXHIBIT
NUMBER                              EXHIBITS
-------                             --------

3.01(1)        Registrant's Amended and Restated Articles of Incorporation
3.02(1)        Certificates of Amendment to Registrant's Articles of
               Incorporation
3.03(1)        Form of Registrant's Amended and Restated Articles of
               Incorporation filed upon closing of initial public offering
3.04(1)        Registrant's Amended and Restated Bylaws
4.01(1)        Form of Specimen Certificate for Registrant's Common Stock
10.01(1)(*)    Registrant's 1982 Stock Option Plan, as amended, and forms of
               related documents
10.02(2)(*)    Registrant's 1993 Stock Option Plan and related documents
10.03(1)(*)    Registrant's 1994 Directors Stock Option Plan and related
               documents
10.04(1)(*)    Registrant's 1994 Employee Stock Purchase Plan
10.05(1)       Form of Indemnification Agreement entered into by Registrant with
               each of its directors and executive officers
10.06(1)       Contract by and between Registrant, AG Associates (Israel)
               Limited and Investment Company of Bank of Hapoalim, Ltd. dated
               January 8, 1993, as amended
10.07(1)       Form of Convertible Debenture issued by Registrant to Investment
               Company of Bank Hapoalim on January 8, 1993 and February 21, 1993
10.08(1)       Security Agreement, dated January 8, 1993 by and between
               Registrant and Investment Company of Bank Hapoalim
10.09(1)       Investment Representation Letter, dated February 21, 1995, from
               Investment Company of Bank Hapoalim, Ltd. to Registrant
10.10(1)       Registration Rights Agreement, dated February 26, 1995, by and
               among Investment Company of Bank Hapoalim, Clal Electronics
               Industries, Ltd. and Registrant
10.11(1)       Voting Agreement, dated February 26, 1995, by and among
               Registrant, Investment Company of Bank Hapoalim, Arnon Gat and
               Anita Gat
10.12(1)       International Distributor Agreement, dated December 12, 1985, by
               and between AG Associates Foreign Sales, Inc. and Canon Sales
               Co., Inc as amended
10.13(1)       Stock Purchase Agreement, dated July 28, 1989, by and among
               Registrant, Canon Sales Co., Inc. and Nippon Typewriter
               Corporation
10.14(1)       Stock Purchase Agreement, dated August 30, 1989, by and between
               Registrant and Appex Corporation
10.15(1)       Technology Transfer and License Agreement by and between
               Registrant and Canon Sales Co., Inc. dated July 28, 1989, as
               amended
10.16(1)       Improvement License Agreement, dated March 14, 1994, by and
               between Registrant and Canon Sales Co., Inc.
10.17(1)       Purchase Agreement, dated June 23, 1993, by and between
               Registrant and Equipe
10.18(1)       Agreement, dated February 27, 1995, by and among, Registrant,
               Clal Electronics Industries Ltd., AG Associates (Israel) Ltd.,
               Arnon Gat, Anita Gat and Rapro Technology Inc.
10.19(1)       Amendments and PreClosing Agreement among the parties to the
               Agreement filed as Exhibit 10.26 to the Registration Statement,
               dated April 13, 1995, April 18, 1995, April 20, 1995, and April
               24, 1995, respectively
10.20(1)       Amendment to Convertible Debentures, dated April 25, 1995,
               between Investment Company of Bank Hapoalim and Registrant
10.21(3)       Lease Agreement, dated July 21, 1995, by and between Registrant
               and South Bay/Fortran, including amendment one, dated October 6,
               1995
10.22(3)(*)    Letter Agreement and Promissory Note with Julio L. Guardado,
               dated July 20, 1995


<PAGE>   59
EXHIBIT
NUMBER         EXHIBITS (CONTINUED)
-------        --------------------


10.23(4)       Transition Services Agreement, dated as of March 25, 1996, by and
               between Registrant, AG Israel and AGI, Inc.
10.24(5)       Technology Agreement, dated January 28, 1997, by and between the
               Registrant and AG Israel and AGI, Inc.
10.25(5)       Amendment Agreement, dated August 7, 1997, by and between the
               Registrant and AG Israel and AGI, Inc.
10.26(5)       Clarification of Field of Use, dated August 7, 1997, by and
               between the Registrant and AG Israel and AGI, Inc.
10.27(5)       Shareholders Agreement, dated August 7, 1997, by and between the
               Registrant and AG Israel and AGI, Inc.
10.28(5)       Registration Rights Agreement, dated August 7, 1997, by and
               between the Registrant and AG Israel and AGI, Inc.
10.29(5)(*)    Form of Executive Employment Agreement with the Registrants
               Executive Officers
10.30(6)       Loan and Security Agreement, dated June 23, 1998, by and between
               Registrant and Silicon Valley Bank
10.31(7)       International Representative Agreement, dated September 13, 1996,
               by and between the Registrant and Silicon International, Hong
               Kong
10.32(7)       International Distributor Agreement, dated October 16, 1998, by
               and between the Registrant and Metron Technology, B.V.
10.33(7)       International Distributor Agreement, dated October 16, 1998, by
               and between the Registrant and Metron Technology, Hong Kong
10.34(7)       First Amendment to Security Agreement, dated December 18, 1998,
               by and between the Registrant and Heller Financial
23.01(7)       Consent of Deloitte & Touche LLP, Independent Auditors
27.01(7)       Financial Data Schedule (EDGAR only)


----------
(1)   Incorporated by reference to the Registrant's Registration Statement on
      Form S-1 (File No. 33-90382) filed with and declared effective by the
      Securities and Exchange Commission on May 15, 1995.
(2)   Incorporated by reference to the Registrant's Registration Statement on
      Form S-8 (File No. 333-02360) filed with and declared effective by the
      Securities and Exchange Commission on March 14, 1996.
(3)   Incorporated by reference to the Registrant's Annual Report on Form 10-K
      for the Fiscal Year Ended September 30, 1995.
(4)   Incorporated by reference to the Registrant's Annual Report on Form 10-K
      for the Fiscal Year Ended September 30, 1996.
(5)   Incorporated by reference to the Registrant's Annual Report on Form 10-K
      for the Fiscal Year Ended September 30, 1998.
(6)   Incorporated by reference to the Registrant's Quarterly Report on Form
      10-Q for the Quarterly Period Ended June 30, 1998.
(7)   Filed herewith
(*)   Management contract or compensatory plan or arrangement