<PAGE>

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

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

                                   FORM 10-K

      FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934

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

                  For the fiscal year ended December 31, 1999

                                      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 333-48817

                              PHASE METRICS, INC.
            (Exact Name of Registrant as Specified in Its Charter)

           Delaware                                           33-0328048
  (State or Other Jurisdiction                             (I.R.S. Employer
 of Incorporation or Organization)                       Identification No.)

            10260 Sorrento Valley Road, San Diego, California 92121
                   (Address of Principal Executive Offices)

                                (858) 646-4800
             (Registrant's Telephone Number, Including Area Code)

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

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

  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 a 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 the 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. [X]

  As of February 29, 2000, there were 5,609,839 shares of the registrant's
common stock outstanding. There is no established public trading market for
the registrant's common stock.

  Documents Incorporated by Reference: None

                The table of exhibits filed appears at page 54.
===============================================================================
<PAGE>

                                 PHASE METRICS

                            FORM 10-K ANNUAL REPORT

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                          Page
 <C> <C>      <S>                                                         <C>
 PART I..................................................................   1
     ITEM 1.  BUSINESS..................................................    1
     ITEM 2.  PROPERTIES................................................   25
     ITEM 3.  LEGAL PROCEEDINGS.........................................   26
     ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......   26
 PART II. ...............................................................  27
     ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED
              STOCKHOLDER MATTERS.......................................   27
     ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA......................   28
     ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
              CONDITION AND RESULTS OF OPERATIONS.......................   29
              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
     ITEM 7A. RISK......................................................   38
     ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...............   39
     ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
              ACCOUNTING AND FINANCIAL DISCLOSURE.......................   39
 PART III................................................................  40
     ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........   40
     ITEM 11. EXECUTIVE COMPENSATION....................................   43
     ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
              MANAGEMENT................................................   48
     ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............   50
 PART IV.................................................................  51
     ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
              FORM 8-K..................................................   51
</TABLE>


                                       i
<PAGE>

  This Annual Report on Form 10-K, including information incorporated herein
by reference, contains "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These statements relate to expectations concerning
matters that are not historical facts. Words such as "projects," "believes,"
"anticipates," "plans," "expects," "intends," and similar words and
expressions are intended to identify forward-looking statements. Although
Phase Metrics believes that such forward-looking statements are reasonable, it
cannot assure you that such expectations will prove to be correct. Important
language regarding factors that could cause actual results to differ
materially from such expectations are disclosed herein including, without
limitation, in the "Risk Factors" beginning on page 14. All forward-looking
statements attributable to Phase Metrics are expressly qualified in their
entirety by such language. Phase Metrics does not undertake any obligation to
update any forward-looking statements.

                                    PART I.

ITEM 1. BUSINESS

  Phase Metrics, Inc. (the "Company", "we" or "us") is a leading supplier of
technologically advanced process and production-test equipment for the data
storage industry. The Company's systems are used primarily by manufacturers of
disk drives and disk drive components (disks and read/write heads) at critical
stages of their production processes. The Company's systems, substantially all
of which incorporate significant amounts of proprietary technology and are
software intensive, include (1) media certifiers, burnishers, glide height
testers and optical scanners which are used in the production of thin-film
disks (media), (2) servowriters used in the production of disk drives and high
capacity disk cartridges, (3) flying height testers and quasi-static
magnetoresistive ("MR") head testers used in the production of read/write
heads and (4) integrated automation systems for the disk drive, disk and
read/write head test and manufacturing processes. The Company's production-
test systems (e.g., media certifiers, glide testers, flying height testers and
quasi-static MR head testers) are designed to provide in-line testing,
measurement and analysis at critical steps in the manufacturing process,
enabling manufacturers to detect defects, sort products by performance grade
and make real-time process improvement decisions that can significantly impact
product yields, time-to-market, profitability and return on investment. The
Company's process systems (e.g., servowriters and disk burnishers) perform
precise manufacturing process functions. Phase Metrics' customers include
substantially all of the world's leading data storage manufacturing companies.

 Market for Process and Production-Test Equipment

  Major manufacturers of disk drives and disk drive components require a
variety of high precision process and production-test equipment. These
technologically advanced products combine significant amounts of software with
high precision electro-mechanical componentry to provide real-time, high
throughput processing and production management capabilities. Process
equipment is used by manufacturers to perform manufacturing processes within
increasingly precise tolerances enabling the production of higher performance
data storage devices. Such process equipment includes servowriters for writing
servo tracks on nearly completed disk drives and burnishers for removing bumps
from the surface of a disk. Production-test equipment is used by manufacturers
to perform precise inline testing, measurement and analysis throughout the
manufacturing process enabling manufacturers to detect defects and make real-
time production improvement decisions that can significantly impact customers'
product yield and profitability. Production-test equipment is also used in
research and development laboratories. Production-test equipment includes
media certifiers to verify the magnetic integrity of a disk and an optical
media scanner to verify the physical integrity of the disk surface, flying
height testers to determine the height a head flies above a disk and quasi-
static MR head testers to measure MR head characteristics.

  The process and production-test equipment market for the data storage
industry is served by both merchant suppliers as well as the "captive" or
internal departments of data storage manufacturing companies that develop and
manufacture process and production-test equipment for their own use.
Historically, disk drive and disk drive

                                       1
<PAGE>

component manufacturers developed much of their own process and production-
test equipment internally and purchased a lesser amount of such equipment from
merchant suppliers. As the production process becomes more complex and
production capacity becomes more expensive to build and maintain, however,
data storage manufacturers are focusing more on their own core competencies --
product design and production -- to remain competitive. This in turn has
caused increasing reliance on merchant suppliers of process and production-
test equipment. The enabling tools developed by such merchant suppliers allow
disk drive and disk drive component manufacturers to incorporate more advanced
production techniques into their manufacturing processes and more accurately
measure the conformity of component parts of the disk drive to their
specifications.

  The process and production-test equipment industry was characterized by a
relatively fragmented group of specialized independent equipment suppliers.
These suppliers often had limited technological competence and narrow product
offerings. In addition, most of these specialized suppliers lacked the
critical mass to support extensive research and development programs and
world-wide customer service and support. As data storage manufacturers focus
more on their own core competencies in an increasingly global marketplace they
are increasingly seeking process and production-test capital equipment
suppliers that can play a strategic role in their ongoing product development
and manufacturing processes and at the same time provide world-wide service
and support.

Strategy

  The key elements of the Company's strategy are as follows:

  Maintain Leadership in Core Technologies. The Company intends to remain a
technological leader in its markets by continuing to work with customers,
academic institutions and independent third parties to identify emerging data
storage technology trends early in the development process and contribute to
the development of standards related to process and production-test for the
data storage industry. Because the Company's systems are integral to its
customers' manufacturing processes, the Company believes that it is well-
positioned to utilize its research and development resources to partner with
its customers in the development of next-generation products.

  Leverage Installed Base of Systems. The Company intends to leverage its
installed base of systems by marketing new systems to existing customers and
by continuing to develop and aggressively market system upgrade solutions in
response to rapidly changing industry requirements. In addition, because data
storage manufacturers are required to focus increasingly on their own core
competencies, the Company believes that there is an opportunity to increase
its sales by supplying certain process and production-test equipment to data
storage manufacturers that currently develop such systems internally.

  Leverage and Expand Global Infrastructure. The Company believes that it will
be able to leverage the significant investment it has made in establishing a
sales and customer service and support infrastructure in Asia to capitalize on
the increasing activity in the data storage industry in that region. As data
storage manufacturers require equipment suppliers to support their
increasingly global operations, the Company intends to continue to expand its
world-wide service and support network.

  Pursue Complementary Acquisitions. As with many other industries, data
storage manufacturers are increasingly attempting to rationalize their vendor
bases. As a result, there has been an increasing trend toward consolidation of
data storage equipment suppliers. The Company intends to continue to
capitalize on this trend by completing complementary acquisitions of
additional product lines, technologies and related businesses. The Company
believes that its market leadership position and demonstrated ability to
successfully integrate strategic acquisitions will continue to attract
additional strategic opportunities.


                                       2
<PAGE>

Products

  The Company's process and production-test products are an integral part of
the process of manufacturing disk drives, disks and read/write heads. The
Company's products address the increasingly complex disk drive and disk drive
component production processes and the constant pressure to improve
manufacturing yields. The Company's products combine substantial proprietary
technology, including extensive software, custom electronic componentry,
micro-positioning systems, high-performance air bearing spindles, optical
detectors, and various other internally designed probes required for detection
and measurement, together with commercially available components such as high
performance lasers, DC motors and optical encoders. The proprietary software
incorporated into each of the Company's products enable real-time process and
production-test capabilities without off-line processing. The Company believes
that its proprietary software offers a competitive advantage due to its
powerful signal processing and analysis capabilities, flexible user-interface,
and adaptability to specific customer applications.

  The Company's products are categorized into four principal areas: (1) disk
(media) process and production-test equipment; (2) read/write head production-
test equipment; (3) disk drive process and production-test equipment; and (4)
production automation equipment. The Company's products are predominantly used
in an in-line production mode by the Company's customers. As such, the
customers integrate the Company's products into their processes, using
multiple variations of test protocols available on the systems. The Company's
software facilitates this adaptation process and, accordingly, substantially
all of the Company's products are semi-customized to satisfy each customer's
unique product specifications and test requirements. The Company anticipates
more extensive customization of its products in the future due to the
increasing complexity of the technology and production processes for data
storage devices. Therefore, the Company continually endeavors to enhance its
products with new features and functionality. The Company has demonstrated the
ability to provide required customizations and product upgrades in response to
changes in data storage technology. With its substantial product development
and research capability and commitment to maintaining close relationships with
its customers, the Company believes it is well positioned to continue to
provide cost-effective solutions to the rapidly changing data storage
industry.

  The following tables include the Company's principal current products and
products expected to be introduced during the first six months of 2000.

              Disk (Media) Process and Production-Test Equipment

<TABLE>
<CAPTION>
           Product           Introduction Date          Applications
  -------------------------- ----------------- ------------------------------

  <C>                        <C>               <S>
  Media Certifiers
-----------------------------------------------------------------------------
  MG4000                       February 2000   Burnishing (removes bumps and
  MC4000EPS                    February 2000   particles from the surface of
  MG4000UA                     February 2000   a finished disk)
  MC1000                        April 2000     Optical Scanning ("EPS" Option
                                               optically scans the surface of
                                               a finished disk for defects
                                               that could damage the glide
                                               head)
                                               Glide Certification (verifies
                                               that the surface of a finished
                                               disk does not have protrusions
                                               in excess of certain specified
                                               limits)
                                               Media Certification (verifies
                                               that data can be written and
                                               read from a finished disk
                                               within certain specifications)
  Optical Inspection Systems
-----------------------------------------------------------------------------
  PS5200                       January 2000    Optical Scanning (scans for
  PS5221                        April 2000     defects on disk substrates
                                               and/or finished disks)
</TABLE>



                                       3
<PAGE>

                        Head Production-Test Equipment

<TABLE>
<CAPTION>
            Product            Introduction Date         Applications
  ---------------------------- ----------------- ----------------------------
  <C>                          <C>               <S>
  Quasi-static MR Head
  Testers
-----------------------------------------------------------------------------
  MRW(Wafer-level Tester)       September 1996   Quasi-static MR Testing
  MRB(Bar-level Tester)         September 1997   (conducts critical tests at
  MRH-200(HGA-level Tester)     September 1998   the wafer, bar, slider or
  MRS-200(Slider-level tester)  September 1998   HGA level of MR head
                                                 production, including
                                                 resistance, amplitude,
                                                 asymmetry and stability
                                                 tests)
  HGA Resonance Tester
-----------------------------------------------------------------------------
  HRT-2                           April 1999     Mechanical Resonance Testing
                                                 (tests HGA for mechanical
                                                 resonance characteristics
                                                 within required
                                                 specifications)

  Flying Height Testers
-----------------------------------------------------------------------------
  DFHT IV                        January 1999    Flying Height Testing
  FH4000                        September 1996   (measures head to disk
                                                 spacing ("flying height")
                                                 under various dynamic test
                                                 conditions)


               Disk Drive Process and Production-Test Equipment

<CAPTION>
            Product            Introduction Date         Applications
  ---------------------------- ----------------- ----------------------------
  <C>                          <C>               <S>
  Servowriters
-----------------------------------------------------------------------------
  HS5100                          March 1997     Servowriting Drives
  HS6100                        September 1997   (establishes reference
  HS8000                          March 2000     tracks on hard disk drives
                                                 to provide track/head
                                                 position information
                                                 essential to operation)
                                                 Servowriting Media
                                                 (establishes reference
                                                 tracks on high capacity
                                                 removable storage devices
                                                 (cartridges), both floppy
                                                 and hard disk, to provide
                                                 track/head position
                                                 information essential to
                                                 operation)

                        Production Automation Equipment

<CAPTION>
            Product            Introduction Date         Applications
  ---------------------------- ----------------- ----------------------------
  <C>                          <C>               <S>
  Automation
-----------------------------------------------------------------------------
  Media Certifier Workcell        August 1995    Production Media Handling
                                                 (provides automated handling
  Optical Inspection Workcell    October 1997    of disks with certifiers, and
                                                 sorts disks into grades
  Distributed Automation           June 2000     according to test results)
</TABLE>

 Disk (Media) Process and Production-Test Equipment

  The Company's disk-related test and certification products are used in-line
to test, certify and sort disks. The Company believes that its disk-related
products were used to test over half of the approximately 415 million disks
produced worldwide in 1999. The Company's customers also use these products to
provide quality control and to develop new products. The Company's two media
certifier product series and its optical inspection product perform one or
more of the following functions: (1) burnishing -- removing bumps and
particles from the surface of a finished disk; (2) optical scanning --
optically scanning the surface of a finished disk for defects that could
damage the glide head; (3) glide certification -- verifying that the surface
of a finished disk does not have protrusions in excess of certain specified
limits; and (4) media certification -- verifying that data can be written and
read from a finished disk within certain specifications. The Company's disk-
related automation products provide automated handling of disks with
certifiers, and sort disks into grades according to test results. The
Company's media balance tester verifies that disk substrates or finished disks
are in balance within required specifications.

                                       4
<PAGE>

  Designed to provide maximum throughput in high-volume, tightly controlled
disk manufacturing environments, the Company's disk-related products are
selected by Phase Metrics' customers to improve product yield, quality, and
production throughput. Based in part on published industry data, the Company
believes it has the largest installed base worldwide of disk production-test
equipment with approximately 2,800 stations.

  MG Series Media Certifiers. The MG product series certifies disks to ensure
that their magnetic integrity and physical properties meet the stringent
requirements of disk drive manufacturers. The single spindle, spiral-type MG
certifier incorporates the following functions: burnishing, optical scanning
(optional), glide testing, and certifying finished disks. The MG4000 offers an
innovative MR-capable spiral certification approach, which provides high
process throughput. This MR-capable product is designed to perform over a wide
range of disk test conditions while operating at test frequencies up to 100
MHz with low-glide technology to accommodate high areal density media. The
MG4000 features a user-friendly interface, a fully programmable analog
channel, and automatic internal calibration algorithm. The MG4000 incorporates
pre-glide optical scanning of the disk, which reduces operating costs by
increasing the useful life of the glide head used in the test process.

  MC Series Media Certifiers. The recently introduced MC1000 product series
also certifies disks to ensure that their magnetic integrity and physical
properties meet the stringent requirements of disk drive manufacturers. The
MC1000 incorporates two spindles and provides the functionality provided by
the MG4000. However, the MC1000 is capable of the classic step-and-repeat
technology or spiral technology for media certification favored by certain
major customers.

  Optical Inspection Systems. The PS5200 is an optical scanning system
optimized for glass substrates and/or finished disks. The PS5200 stand-alone
system is used by hard disk drive, substrate and media manufacturers for
failure analysis in both engineering and production environments. An automated
workcell configuration provides in-line inspection to allow substrate or
finished disk manufacturers to control and improve key process steps producing
up to 500 disks per hour and resulting in higher production yields, output and
product quality. The PS5200 has industry leading submicron-level defect
detection capability and features a spiral scanning technique for high
throughput.

 Head Production-Test Equipment

  The Company's head testing products are used by leading disk drive head
manufacturers in the development, design and testing of their products to
improve manufacturing yields, product performance and reliability. The Company
estimates, based on industry sources, approximately 850 million HGAs (head
gimbal assemblies) were shipped in 1999, all of which required multiple tests
for critical performance characteristics. The majority of head tests are
completed "in-line," or during the head manufacturing process, and are
completed on 100% of the heads produced. The Company believes that it is well
positioned to benefit from this growing market by providing the following head
production-test equipment: (1) flying height testers -- which measure head
flying heights under various dynamic test conditions; (2) quasi-static MR
testers -- which conduct critical tests at the wafer, bar, slider or HGA level
of MR head production, including resistance, amplitude, asymmetry and
stability tests; and (3) HGA resonance testers -- which test HGAs for
mechanical resonance characteristics within required specifications.

  The maximum possible hard disk drive storage capacity is a function of the
signal to noise ratio provided by the read/write head and media combination.
Since head output increases exponentially as a function of the spacing between
the disk and head, head to disk spacing, i.e., flying height, is the most
critical head/disk interface parameter related to higher drive capacity. Lower
flying heads provide greater areal density by permitting higher tracks per
inch (tpi) on the disk and greater bit per inch (bpi) on each track. In 1993,
the Company established market leadership in measuring flying height by
providing the first flying height tester to accurately measure below one
microinch. The Company's flying height testers have maintained their market
leadership position and become the industry standard by providing the best
gauge repeatability and accuracy available.

                                       5
<PAGE>

  Quasi-static MR Head Testers. The Company's quasi-static MR head testers
include MRW (wafer-level tester), MRB (bar-level tester), MRS (slider-level
tester), and MRH (HGA-level tester). They are designed to provide fast,
accurate and repeatable testing of MR heads at multiple locations in the
manufacturing process from the wafer to HGA levels. With new product
production yields often below 50% in the MR head manufacturing process, the
ability to test MR elements early in the manufacturing process to identify
nonconforming products can result in significant cost savings and provide
feedback for improvement. In product development, quasi-static MR head testers
also assist in the design improvement process.

  HRT Resonance Tester. The HRT is a tester used by read/write head and
suspension manufacturers and disk drive manufacturers to check and analyze the
mechanical resonance characteristics of HGAs within required specifications.
The HRT is designed for testing resonant frequencies of the head suspension to
facilitate improved access times, and is capable of measuring mechanical
resonance in a wide range of suspension types and heads. New resonance test
demand is occurring due to higher speed drives requiring more stable
suspensions.

  Flying Height Testers. The DFHT IV flying height tester is the recognized
disk drive industry standard for flying height testing with what the Company
believes is the largest installed base in the industry. Flying height
requirements continue to be reduced which requires constant improvements in
flying height measurement technology. Featuring the Company's patented dynamic
interferometry technology, the DFHT IV provides accurate, repeatable and
correlatable flying height test measurements of both MR and inductive heads
below one microinch in both engineering and production applications. The DFHT
IV product is used by read/write head manufacturers in HGA production and
product development; hard disk drive manufacturers for research, product
development and incoming quality assurance; media manufacturers to check glide
head performance and special head manufacturers for product development and
in-line testing in manufacturing. The FH4000 flying height tester utilizes the
same technology as the DFHT IV with the addition of altitude chamber
technology, which addresses the difficult task of measuring flying height at
different atmospheric pressures to simulate altitude changes. Since altitude
can have a significant effect on flying height, this critical product provides
the Company's research and development customers with a method of analyzing
altitude effects on flying height.

 Disk Drive Process and Production-Test Equipment

  All hard disk drives and high capacity removable cartridges require
servowriting, a process whereby precision servowriting equipment establishes
reference tracks on disk drives to provide track/head position information
essential to operation. Until servo tracks are written, hard disk drives and
high capacity removable cartridges are not functional. Therefore, the
servowriter is a critical in-line process tool for completing drives and
cartridges. Historically, larger disk drive manufacturers produced their own
servowriters due to the critical nature of this equipment and the lack of
adequate outside sources for servowriting systems.

  As disk drive capacities continue to increase, the track density on disk
drives also continues to increase. The Company's research and development
efforts are designed to keep pace with this trend. Since servowriters
represent a sizable capital investment for disk drive manufacturers, there is
significant value placed on flexibility (ability to support multiple drive
programs), and upgradeability (ability to change the core positioning
technology to keep pace with increasing TPI requirements). The Company's
family of hard disk drive servowriters provide industry leading capabilities
in both of these areas. Servowriting is also a critical function in the
manufacture of high-capacity floppy disks and high-capacity removable storage
cartridges. The Company is the leading supplier of servowriters to
manufacturers in this segment of the data storage market.

  Servowriters. The HS5100 servowriter is designed for conventional hard disk
drives. The HS5100 incorporates optical encoder based positioning to 30,000
tracks per inch for higher accuracy and increased reliability. The HS5100 is
fully compatible with MR technology, utilizes a small footprint, minimizing
cleanroom capital costs, and has been designed for high throughput and yield.
The HS6100 servowriter is designed for high capacity, removable-disk storage
devices and single disk servowriting. The HS6100 combines the features of the
HS5100 with an advanced air bearing spindle with rotating speeds up to 13,000
r.p.m. for high precision spinning

                                       6
<PAGE>

of the disk during the servowriting operation. The HS6100 also employs
customized fixturing for cartridges and disks to accommodate the various
emerging standards in this segment of the data storage market. The HS8000
servowriter is designed for servowriting media external to disk drives and is
suited for very high track density servowriting up to 60,000 tracks per inch
and servo operating frequencies up to 300 MHz. The HS8000 utilizes advanced
positioning technology with optical encoders. Incorporating recently
introduced multiple disk clamping technology allows the HS8000 to be an
economic solution to servowriting in the future as the number of disks per
drive are reduced.

 Production Automation Equipment

  The Company's automation workcells are sold with the disk production-test
equipment. Disk manufacturers demand automated handling of disks to meet
requirements for throughput, quality control, cleanliness, and process
feedback. The Company's workcells provide disk manufacturers with the ability
to automatically sort product (disks) by different performance criteria for
their different customers. High throughput, flexibility, and statistical
process control features combine to provide low overall costs and high quality
control.

Customers, Marketing and Sales

  The Company sells its products to virtually every major disk drive, disk and
read/write head manufacturer in the world. The following table sets forth
certain of the Company's customers during the past two years:

<TABLE>
<CAPTION>
      Disk Drive Systems                  Disk Systems                Read/Write Head Systems       Automation
      ------------------                  ------------                -----------------------       ----------
<S>                                 <C>                               <C>                           <C>
Fuji Photo Film Company, Ltd.       HMT Technology Corporation        Fujitsu Limited               HMT Technology
Iomega Corporation                  HOYA Corporation                  Headway                        Corporation
NEC Corporation                     Hyundai Electronics America       Hutchinon Technology, Inc.    HOYA Corporation
Samsung Electronics Company, Ltd.   International Business            International Business        Seagate Technology, Inc.
Sony Corporation                      Machines Corporation              Machines Corporation        Trace Storage Technology
                                    Komag, Incorporated               Matsushita/Panasonic            USA Corporation
                                    MaxMedia Division,                  Corporation                 Western Digital Corporation
                                    Seagate Technology, Inc.          Quantum Corporation
                                    Trace Storage Technology          Read-Rite Corporation
                                      USA Corporation                 SAE Magnetics (H.K.) Ltd.
                                    Western Digital Corporation       Seagate Technology, Inc.
                                                                      TDK Corporation
</TABLE>

  There are a relatively small number of data storage manufacturers throughout
the world and the Company derives a significant portion of its net sales from
a relatively small number of customers. The Company expects that its
dependence on relatively few key customers will continue in the future.
Approximately 51.0%, 50.0% and 53.5% of the Company's net sales in 1997, 1998
and 1999, respectively, were derived from sales to its three largest customers
in each of those periods. Even though the Company's customer mix will likely
change from period to period in the future, Seagate Technology, Inc.
("Seagate"), Komag, Incorporated ("Komag"), HMT Technology Corporation ("HMT")
and Nissho Iwai High Technology Incorporated ("Nissho Iwai") have historically
accounted for a significant portion of its net sales. For 1997, 1998 and 1999,
Seagate accounted for 18.0%, 17.1%, and 36.7% respectively, of net sales;
Komag accounted for 15.9%, 4.8% and 5.3%, respectively, of net sales; HMT
accounted for 17.1%, 16.3%, and 1.0% respectively, of net sales; and Nissho
Iwai accounted for 4.8%, 4.9% and 6.2%, respectively, of net sales. For 1999,
Read-Rite Corporation accounted for 10.6% of net sales. If net sales to these
or any of its other significant customers were to decrease in any material
amount in the future, the Company's business, operating results and financial
condition would be materially adversely affected.

                                       7
<PAGE>

  A substantial majority of the Company's sales are repeat sales to long-
standing customers in the data storage industry. Frequently, multiple units
are purchased with automation as a customer either completes a major
fabrication facility or upgrades an existing installed base of the Company's
products. In most instances, the decision to purchase the Company's products
is based on the customers' comparisons of multiple performance measures,
including specifications, throughput, product yield, compatibility to the
existing installed base and overall cost of the Company's product in the
process. The purchases often involve large purchase orders, against which the
customers authorize shipment releases. Many of the Company's products sell for
between $100,000 and $200,000 per unit, with an average per unit price of
approximately $130,000.

  The Company has no long-term contracts with any of its customers. The
Company's customers often submit master purchase orders against which they
"release" specific product orders from time to time, often with little lead
time. Any cancellation, reduction, rescheduling or significant delay of orders
from significant customers could have a material adverse effect on the
Company's business, operating results and financial condition. Each of the
Company's customers has unique product specification requirements which
require the Company to provide semi-customized products. As a result, per unit
sales prices for the Company's products will generally vary by customer and
sales order. If development or service costs with respect to the customization
work are underestimated, there could be an adverse impact on the Company's
gross profits. In addition, the Company's products often require post-
installation, on-site customization and integration in order to tailor
products to customer specifications. Revenue and corresponding expenses for
such post-installation services is recognized in the period such services are
provided. Inaccurate estimation of such on-site service costs could have a
material adverse impact on the Company's business, operating results and
financial condition.

  The Company sells its products primarily through its direct sales force. The
sales process for the Company's systems focuses on responding to each
customer's specific needs. As a result, the selling process for the Company's
products is often a multi-level, long-term process involving individuals from
marketing, engineering, operations, customer service and senior management.
The Company's other sales and marketing activities include participating in
trade shows, publishing articles in trade journals, presenting at technical
meetings and conferences, participating in industry trade groups and
consortiums and distributing promotional literature.

  In 1997, 1998 and 1999, the Company's export sales to unaffiliated customers
constituted approximately 49.0%, 49.0% and 48.3% respectively, of net sales
for such periods. The export sales were primarily to domestic data storage
manufacturing companies with major production facilities located in Singapore,
Malaysia and other parts of Asia. Even though the Company exports a
significant amount of its products, the purchasing decision for such sales is
usually made by purchasing personnel located in the United States. The
Company's direct sales staff focuses on these types of sales as well as all of
the Company's sales in the United States. In Japan, Southeast Asia, China and
South Korea, the Company sells its products directly with sales and service
support from its wholly-owned foreign subsidiaries. The Company expects that
export sales will continue to represent a significant portion of its net sales
in the foreseeable future. See "Risk Factors -- Our International Operations
are Subject to Inherent Risks."

Customer Service and Support

  As of February 29, 2000, the Company had a world-wide customer service and
support staff of 45 persons, consisting of applications engineers, service
engineers and technicians. The Company believes that providing highly
responsive, uninterrupted, world-wide customer service and support is
essential to providing value-added solutions for its customers. The Company's
commitment to world-wide customer support and service is evidenced by its
sales and customer support offices in South Korea, Japan, Singapore, Malaysia
and Thailand.

  The Company has structured its direct service and support operations into
distinct service units based on its product lines. Each of these units offers
product installation, on-going process support, emergency system repair,
internal training programs, external customer training, documentation and
formation of customer user groups. In general, the Company provides a 90-day
to one-year warranty on all equipment it sells, depending on the sales
contract and geographic location of the sale.

                                       8
<PAGE>

Backlog

  The Company's sales have historically been made pursuant to purchase orders
rather than long-term contracts. These purchase orders are generally subject
to cancellation, modification, quantity reductions or rescheduling on short
notice and with little or no penalty. Certain of the Company's customers
submit master purchase orders to the Company against which they "release"
specific product orders from time to time, often with little lead time between
the order date and the expected shipment date. The Company's backlog of
purchase orders requesting delivery in the following quarter was approximately
$5.2 million as of February 29, 2000. The Company does not believe its backlog
as of any particular date is indicative of sales or operating results for any
future period.

Competition

  The disk drive process and production-test equipment industry is highly
competitive. The Company believes that the most important competitive factors
in its industry are technological innovation, equipment reliability,
throughput and uptime, customer service and support and cost of ownership. The
Company believes it competes favorably with respect to each of these factors.
In each of the Company's product lines, the Company faces substantial
competition from established merchant suppliers of process and production-test
equipment, some of which have greater financial, engineering, manufacturing,
research and development and marketing resources than the Company. For
example, the Company faces competition from Zyratex, General Disk and Hitachi
DECO for servowriters; Hitachi DECO and Sony Techtronics for disk certifiers;
Integral Solutions International and Veeco for quasi-static MR head testers;
Koyo Precision Instruments, Inc. and Zygo Corporation for flying height
testers and Technistar for automation technology. Historically, there has also
been competition from entrepreneurs with focused market knowledge and new
technology. The Company also experiences competition world-wide from Hitachi
DECO, a large, full-line manufacturer of process and production-test
equipment. Hitachi DECO, a subsidiary of Hitachi, Limited, has substantially
greater financial, technical, marketing, manufacturing, research and
development and other resources than the Company. The Company also experiences
competition from other full-line and partial-line manufacturers of process and
production-test equipment. There can be no assurance that the Company's
competitors will not develop enhancements to, or future generations of,
competitive products that will offer price or performance features superior to
the Company's products or that new competitors will not enter the Company's
markets.

  Many of the Company's competitors are investing heavily in the development
of new and enhanced products aimed at applications currently addressed by the
Company's products. The Company expects its competitors to continue to improve
the design and performance of their products and to introduce new products
with competitive price/performance characteristics. Competitive pressures
often necessitate price reductions which can adversely affect operating
results. The Company will be required to make a continued high level of
investment in product development and research, sales and marketing and
ongoing customer service and support to remain competitive. There can be no
assurance that the Company will have sufficient resources to continue to make
such investments or that the Company will be able to achieve the technological
advances necessary to maintain its competitive position.

  The Company believes that its future success will be dependent, in part,
upon its ability to compete successfully in the Japanese, South Korean and
Southeast Asian markets. The Company's largest competitor, Hitachi DECO, is
headquartered in Japan which gives it a competitive advantage over the Company
in that market to the extent buying decisions are influenced by its local
presence. In addition, the Company's ability to compete in Japan, South Korea
and Southeast Asia in the future is dependent upon continuing free trade
between these countries and the United States, the continuing ability of the
Company to develop in a timely manner products that meet the technical
requirements of its foreign customers and the continuing ability of the
Company to develop and maintain satisfactory relationships with leading
companies in the data storage industry in these areas. Moreover, the Company's
sales in these areas will be affected by the overall economies of Japan, South
Korea and Southeast Asia.

                                       9
<PAGE>

  In addition to the competition the Company faces from other merchant
manufacturers of process and production-test equipment, most of the Company's
customers develop at least a portion of their own process and production-test
equipment needs internally, especially servowriters and read/write head test
equipment. Accordingly, the Company must compete against the internal
development efforts of this captive market. Manufacturers within this captive
market are often reluctant to change their production lines to incorporate
merchant supplied process and production-test technology. Moreover, it is
possible that with the rapid changes in data storage technology, the
development of new process and production-test equipment will be so closely
linked to the Company's customers' product development cycles that certain
customers and potential customers will find it more efficient to fulfill their
own process and production-testing equipment needs internally, thereby placing
the Company at a competitive disadvantage.

Research and Development

  The market for process and production-test equipment is characterized by
rapid technological changes and product innovation. The Company continually
endeavors to understand how changing data storage technology will impact its
customers' requirements for process and production-test equipment in the
future. The Company encourages its customers to work closely with its product
development and research personnel during the development cycle of new and
enhanced data storage products. In 1996, the Company formed an advanced
research department which is responsible for working with the Company's
customers, academic institutions and independent third parties to (1) identify
emerging data storage technology trends early in the development process, (2)
identify and develop new core technologies for the Company's systems and (3)
contribute to the development of process and production-test standards for the
data storage industry. The Company believes that continued and timely
development of new products and enhancements to its existing products are
necessary to maintain its competitive position. As of February 29, 2000 the
Company employed a total of approximately 80 degreed engineers focused on
product development and research. Research and development expenses were
approximately, $43.6 million, $33.3 million and $23.4 million for 1997, 1998
and 1999, respectively. The Company anticipates that it will continue to
devote a significant amount of financial resources to product development and
research for the foreseeable future.

Manufacturing

  The Company conducts its manufacturing activities at its facilities in San
Diego, Fremont and Hayward, California. The Company's principal manufacturing
activities consist of quality assurance and assembling of components designed
and developed by the Company as well as other components and subassemblies
which are acquired from third party suppliers and then integrated into the
Company's finished products. Most of these components, including substantially
all of the electronic circuit boards and optical componentry incorporated into
the Company's systems, are made to the Company's exacting specifications.

  The Company's manufacturing strategy is to produce high precision,
technologically advanced, reliable products and replacement parts. To achieve
these goals, the Company must continually adjust to changes in technology. As
a result, the Company focuses on the engineering/manufacturing interface in
its product development efforts. The Company also continuously seeks to
improve its materials procurement and control processes to increase throughput
and reduce inventory levels. The Company enhanced its fully integrated
computer system for all materials procurement and control functions. The
Company also continues to consolidate its supplier base and increase its
utilization of third-party outsourcing arrangements for certain subassembly
and performance test functions. Such outsourcing arrangements provide for
just-in-time delivery when possible.

  In order to meet customer delivery requirements, the Company is working to
reduce the time required to manufacture its products. However, due to periodic
increases in the Company's backlog, technological advances that must be
incorporated into the Company's products, customization issues and other
reasons, the average time between order and shipment of the Company's products
may increase in the future. The Company's ability to quickly increase its
manufacturing capacity could be limited given (1) the complexity of the
manufacturing

                                      10
<PAGE>

process, especially if the Company is partially customizing its products to
its customers' specifications; (2) the lengthy lead times necessary to obtain
critical components and (3) the need for highly skilled personnel.

  In certain instances the Company relies on a single source or a limited
group of suppliers for certain components and subassemblies used in its
products. Although the Company seeks to reduce its dependence on sole and
limited source suppliers, the partial or complete loss of these sources could
have a material adverse effect on the Company's results of operations and
damage customer relationships due to the complexity of the products they
supply and the significant amount of time required to qualify new suppliers.
In addition, long lead times are often required to obtain critical components
and subassemblies used in certain of the Company's products from these and
other suppliers which could impede the Company's ability to quickly respond to
changes in demand and product specifications.

Intellectual Property and Proprietary Rights

  The Company believes that due to the rapid pace of innovation within the
data storage industry in general, the Company's protection of patent and other
intellectual property rights is less important than factors such as its
technological expertise, product innovation, the Company's installed base, the
marketing ability of its sales force and the ability to provide world-wide
support and service to its customers. The Company does attempt, however, to
protect its intellectual property rights through patents, copyrights, trade
secrets and other measures.

  The Company currently holds 57 United States patents and has applied for 55
additional patents in the United States. The Company also holds a number of
foreign patents and has filed a number of foreign patent applications. No
assurance can be given that the claims allowed on any patents held by the
Company will be sufficiently broad to protect the Company's technology.
Moreover, there can be no assurance that any patent owned by the Company will
not be invalidated, deemed unenforceable, circumvented or challenged, that the
rights granted thereunder will provide competitive advantages to the Company
or that any of the Company's pending or future patent applications will be
issued with claims of the scope sought by the Company, if at all. Furthermore,
there can be no assurance that others will not develop similar products,
duplicate the Company's products or design around the patents owned by the
Company. In addition, there can be no assurance that foreign intellectual
property laws or the Company's agreements will protect the Company's
intellectual property rights in any foreign country. Any failure to protect
the Company's intellectual property rights could have a material adverse
effect upon the Company's business, operating results and financial condition.

  Although the Company does not believe any of its products or proprietary
rights infringe the rights of third parties, there can be no assurance that
infringement claims will not be asserted against the Company in the future.
Any such claims, with or without merit, could divert the attention of
management, result in costly litigation, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may not be available on terms
acceptable to the Company, or at all. If infringement were established, the
Company could be required to pay damages or be enjoined from making, using or
selling the infringing product. Likewise, there can be no assurance that a
third party's product, if infringing on the Company's proprietary rights, may
be prevented from doing so without litigation. Any of the foregoing could have
a material adverse effect upon the Company's business, operating results and
financial condition.

  The Company requires each of its employees to enter into a proprietary
rights and non-disclosure agreement in which the employee agrees to maintain
the confidentiality of all proprietary information of the Company and, subject
to certain exceptions, to assign to the Company all rights in any proprietary
information or technology made or contributed by the employee during his or
her employment. In addition, the Company regularly enters into non-disclosure
agreements with third parties, such as consultants, potential joint venture
partners and customers. In spite of these precautions, it may be possible for
third parties to copy, develop or otherwise obtain and use the Company's
proprietary technology without authorization or to develop similar technology
independently.

                                      11
<PAGE>

Employees

  As of February 29, 2000, the Company had 244 full-time employees, including
76 in research and product development and research, 72 in manufacturing, 23
in sales and marketing, 45 in service and support, and 28 in finance,
information systems and administration activities. Many of the Company's
employees have specialized skills of significant value to the Company, and the
Company's future success will depend in large part upon its ability to attract
and retain highly skilled technical, managerial, financial and marketing
personnel, who are in great demand. The Company believes that attracting and
motivating skilled technical personnel is vital to its success and there can
be no assurance that the Company will be successful in retaining or recruiting
these and other key personnel. No employee is represented by a union or
covered by a collective bargaining agreement, and the Company has not had a
work stoppage or strike. The Company considers its employee relations to be
good.


                                      12
<PAGE>

RISK FACTORS

  You should consider carefully the following risks in your evaluation of us.
The risks and uncertainties described below are not the only ones facing our
company. Additional risks and uncertainties may also adversely impact and
impair our business. If any of the following risks actually occurs, our
business, operating results or financial condition would likely suffer.

As a Result of Adverse Industry Conditions, We Are Experiencing Liquidity
Problems and We Failed to Make the Last Interest Payment on the Notes; Unless
We Complete Our Proposed Restructuring, We May Be Forced to Seek Protection
Under the Bankruptcy Laws

  The data storage industry has experienced prolonged and intense competition,
pricing erosion and overcapacity. Such adverse market conditions have
resulted, and may in the future result, in the delay, reschedule or
cancellation of orders and fluctuation in demand for our products. These
adverse market conditions have had a material adverse effect on our results of
operations and financial condition over the last several quarters and are
expected to continue through 2000. As a result of adverse market conditions in
the data storage industry, our net sales decreased 63.7% from $105.0 million
for 1998 to $38.1 million for 1999 and we experienced net losses of $76.9
million for 1998 and $47.2 million for 1999. In addition, our earnings were
inadequate to cover our fixed charges by $69.8 million in 1998 and
$50.9 million in 1999.

  As a result of these losses and deficiencies, we were unable to make the
interest payment on the Notes due on February 1, 2000 and we are not in
compliance with certain covenants of the Notes and the Indenture governing the
Notes.

  On April 26, 2000, we announced that we had entered into an agreement in
principle with an informal committee representing approximately 81% of holders
(the "Noteholders") of the Notes to restructure the Notes. Under the
restructuring, the $110.0 million principal amount of Notes, plus accrued
interest, would be exchanged for new common stock ("New Common Stock")
representing 97.5% of our outstanding common stock after the restructuring.
Holders of our existing Senior Subordinated Convertible Notes, existing Series
A, B and C Preferred Stock and existing Common Stock would receive the
remaining 2.5% of New Common Stock, as well as warrants to purchase additional
shares representing up to 10% of our then outstanding New Common Stock upon
certain circumstances. The restructuring will not in any way affect our
obligation to pay our trade creditors or other vendors. The agreement in
principle is subject to a number of customary conditions.

  In addition, holders of all or some of the Notes will provide us with a
$10.0 million working capital credit facility (the "New Credit Facility") in
conjunction with the restructuring. The New Credit Facility will be secured by
a pledge of substantially all of our assets other than certain secured assets
and customer deposits. The commitment to provide the New Credit Facility is
subject to a number of customary conditions. There is no assurance that the
proposed restructuring will be completed as described above or at all.

  We anticipate that the restructuring will take three to five months to
complete. During that time, we will face a number of risks over which we may
have limited or no control, including the risk that trade creditors or vendors
may discontinue providing us with trade credit, the risk that our customers
may decrease the amount of business that they do with us and the risk that, in
spite of not paying interest on the Notes, we will not be able to generate the
liquidity necessary to maintain operations. In addition, we face the risk that
holders of Notes or other interests in us will refuse to accept our
restructuring proposal when made to them. For these and other reasons, we may
be forced to file for protection under Chapter 11 without the benefit of our
agreement in principle with the Noteholders, our creditors may file an
involuntary Chapter 11 case against us or we may be forced to liquidate our
business without the benefit of a reorganization.

  The accompanying financial statements do not purport to reflect or provide
for the consequences of the proposed restructuring.

  See "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Liquidity and Capital Resources."

                                      13
<PAGE>

Existing Financing Covenants Impose Restrictions on our Operations Which we
May Not Be Able to Comply with Due to Reasons Beyond our Control

  The Indenture related to the Notes contains a number of covenants that
significantly restrict our operations, such as our ability to:

  . incur indebtedness;

  . make prepayments of certain indebtedness;

  . pay dividends;

  . make investments;

  . engage in transactions with stockholders and affiliates;

  . create liens;

  . sell assets; and

  . engage in mergers and other consolidations.

Proceeds May Not Be Available to Make Payments to Holders of the Notes Due to
Senior Rights of Other Existing and Future Indebtedness

  As of December 31, 1999, the Notes and the Note Guarantees were effectively
subordinated to approximately $1.5 million of secured indebtedness under our
capital lease obligations.

  If we incur any additional senior indebtedness in the future that is not
subordinated to the indebtedness outstanding under the Notes, even if such
indebtedness were not secured, the holders of such debt would be entitled to
share ratably with the holders of the Notes in any proceeds distributed in
connection with any insolvency, liquidation, reorganization, dissolution or
other winding-up of our business. This may have the effect of reducing the
amount of proceeds available to pay to holders of the Notes upon the
occurrence of any such events.

  Our Non-Guarantor Subsidiaries have not guaranteed our obligations under the
Notes. As of and for the year ended December 31, 1999, the operating results
and assets of the Non-Guarantor Subsidiaries were material to our results of
operations and assets on a consolidated basis, net of intercompany
eliminations. See Note 14 of Notes to Consolidated Financial Statements. The
total assets, total liabilities, net sales and net income (loss) of the Non-
Guarantor Subsidiaries as a percentage of our consolidated total assets, total
liabilities, net sales and net income (loss) as of and for the year ended
December 31, 1998, were 6.7%, 0.5%, 11.1% and 0.0%, respectively and as of and
for the year ended December 31, 1999, were 14.8%, 0.2%, 18.9% and 4.2%,
respectively.

We Have Experienced Significant Losses

  We incurred net losses of approximately $5.5 million, $76.9 million and
$47.2 million for 1997, 1998 and 1999, respectively. Such losses and accrual
of certain preferred stock dividends and accretion for the redemption value
and dividends of such preferred stock have contributed to a retained deficit
of approximately $154.2 million as of December 31, 1999. In addition, we used
cash for operating activities of approximately $6.4 million, $12.0 million and
$13.1 million for 1997, 1998 and 1999, respectively. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

                                      14
<PAGE>

Our Operating Results are Subject to Wide Variations and Continued Losses

  In the past, we have experienced wide fluctuations in our quarterly and
annual operating results and have experienced net losses for the past several
quarters. We may continue to experience net losses and fluctuations in our
business due to a number of factors, not all of which are in our control.
These factors include, without limitation, the following:

  .the continuing adverse market conditions in the data storage industry;

  . the size, timing and rescheduling or cancellation of orders from, and
    shipments to, major customers;

  . the timing of introductions of our new products and product enhancements
    or our competitors' introduction of new products or product enhancements;

  . our ability to develop, introduce and market new, technologically
    advanced products;

  . the cyclicality of the data storage industry;

  . the rescheduling or cancellation of capital expenditures by our
    customers;

  . variations in our customer base and product mix;

  . the level of any of our significant volume pricing discounts;

  . the availability and cost of key production materials and components;

  . our ability to effectively manage our inventory and control costs;

  . the financial stability of our major customers;

  . personnel changes;

  . expenses associated with acquisitions;

  . restructurings;

  . fluctuations in amortization and write-downs of intangible assets; and

  . foreign currency exchange rate fluctuations and general economic factors
    in the United States and certain foreign countries, including Japan,
    South Korea, Singapore, Malaysia, Thailand and other parts of Southeast
    Asia.

  The data storage industry has experienced prolonged and intense competition,
pricing erosion and overcapacity. Such adverse market conditions have
resulted, and may in the future result, in the delay, reschedule or
cancellation of orders and fluctuation in demand for our products. These
adverse market conditions have had a material adverse effect on our results of
operations and financial condition over the last several quarters and are
expected to continue through 2000.

  We had net sales of $184.7 million in 1997 compared to $105.0 million in
1998 and $38.1 million in 1999. We had EBITDA (as described in Footnote 5 in
"Selected Consolidated Financial Data") of $24.1 million in 1997 compared to
$(40.3) million in 1998 and $(24.4) million in 1999. Cash used for operating
activities was $12.0 million for 1998 and $13.1 million for 1999. Period to
period fluctuations in operations impacting these amounts were the net losses
for 1998 and 1999, a decrease in amortization and write downs of intangible
assets, a decrease in deferred income tax assets in 1998, decreases in
accounts receivable and inventories, an increase in 1998 income taxes
receivable compared to a decrease in 1999 and decreases in accrued expenses.
Cash used for operating activities increased from $6.4 million for 1997 to
$12.0 million for 1998. Period to period fluctuations in operations impacting
these amounts were the net losses for 1997 and 1998, a decrease in
amortization and write downs of intangible assets, a decrease in deferred
income tax assets, a smaller increase period to period in accounts receivable,
a decrease in 1998 inventories compared to an increase in 1997 and increases
in 1998 income taxes receivable and accrued expenses compared to decreases in
1997. The net loss of $76.9 million for 1998 decreased to a net loss of $47.2
million for 1999. This decrease was primarily due to decreases in research

                                      15
<PAGE>

and development expenses, selling, general and administrative expenses,
amortization and write-downs of intangible assets, the settlement charge, the
restructuring charges, interest expense and the extraordinary loss, partially
offset by a decrease in net sales and related gross margin. The net loss of
$5.5 million for 1997 increased to a net loss of $76.9 million for 1998. This
increase was primarily due to decreased net sales, lower gross profit margins,
the restructuring charges, the settlement charge, increased interest expense
and the extraordinary loss partially offset by decreases in research and
development and selling, general and administrative expenses. See "Selected
Consolidated Financial Data" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

  Quarterly results in the future may fluctuate due to the factors discussed
above or other factors. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."

Dependence on and Cyclicality of Data Storage Industry May Lead to Continued
Losses

  Our business depends almost entirely upon capital expenditures by our
customers, which in turn depend upon market demand for their products. Our
industry is cyclical and historically has experienced varying growth rates and
periods of oversupply causing higher than anticipated inventory levels and
intense price competition. The data storage industry is currently experiencing
intense competition, significant price erosion and overcapacity. As a result
of these adverse market conditions, there is significantly reduced demand for
our products. These adverse market conditions in the disk storage industry
generally, and the slowdown in our customers' orders in the last several
quarters has had a material adverse effect on our business, operating results
and financial condition. It is likely that these adverse market conditions
will continue for the foreseeable future and, as a result, our customers will
likely continue to delay or cancel orders for our products and our business,
operating results and financial condition will be materially adversely
affected. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."

We Have Had to Restructure Operations and May Have to Again in the Future

  The data storage industry has experienced intense competition, pricing
erosion and overcapacity. Such adverse market conditions have resulted, and
may in the future result, in the delay, reschedule or cancellation of orders
and fluctuation in demand for the our products. These adverse market
conditions have had a material adverse effect on the our results of operations
and financial condition over the last several quarters and are expected to
continue through 2000. In June 1998, we implemented a workforce reduction of
approximately 155 employees, relocated and consolidated much of our Concord,
California operations to our Fremont, California facility and consolidated our
San Diego facility. In November 1998, we reduced our workforce by
approximately 60 employees and consolidated our Fremont, California
facilities. In the second quarter of 1999 we further consolidated a
significant portion of our Fremont facilities, and in July 1999, implemented a
workforce reduction of approximately 25 employees. Due to the continued
effects of the weakness in demand for data storage products, in the fourth
quarter of 1999, we consolidated our Fremont facilities and implemented a
workforce reduction of approximately 24 employees.

  In the second quarter of 1998, we recorded $3.0 million of restructuring
charges. The significant components included $0.9 million for employee
severance costs, $2.0 million in asset impairment costs related to property,
plant and equipment obsoleted due to restructuring activities, and $0.1
million of other costs. In the fourth quarter of 1998, we recorded $1.1
million of restructuring charges. The significant components included
$0.3 million for employee severance costs, $0.6 million in asset impairment
costs related to property, plant and equipment obsoleted due to restructuring
activities and $0.2 million of other costs. In the second quarter of 1999, we
recorded $2.0 million of restructuring charges. The significant components
included $0.7 million for future lease costs of consolidated facilities and
$1.3 million in asset impairment costs related to facilities consolidation. In
the fourth quarter of 1999, we recorded a restructuring charge of $1.1
million. The significant components included $0.6 million for employee
severance costs, $0.4 million for future lease costs of consolidated
facilities and $0.1 million in asset impairment costs related to facilities
consolidation. While the Company believes its cost-cutting measures are
appropriate given the Company's current and anticipated levels of net sales,
there can

                                      16
<PAGE>

be no assurance that such measures will be sufficient and that additional
cost-cutting measures will not be necessary, or that the 1998 and 1999
restructuring activities or future cost-cutting measures will not have a
material adverse effect on the Company's ability to increase its net sales.

If We Are Not Able to Adapt to Rapid Technological Change, We May Lose
Customers

  Rapid technological changes and evolving industry standards characterize the
data storage industry. Our customers frequently introduce new products and
enhancements, with relatively short product life cycles, typically between
nine and 18 months. In addition, our customers often develop multiple products
simultaneously, such that new products could be introduced as frequently as
every three months. Our customers' new product introductions typically result
in new technological challenges for us, both with respect to our installed
base and with respect to our next generation products. As a result, we must
continue to enhance our existing products and develop and manufacture new
products with improved capabilities. These technological changes require us to
make substantial investments in research and development. Although we
continually develop new products, there can be no assurance that we will be
able to accurately anticipate technological advances in the disk drive market
and develop products incorporating such advances in a timely manner or at all.
Our failure to develop, manufacture and market new or enhanced products, would
have a material adverse effect on our business, operating results and
financial condition. In addition, we are highly dependent on our close working
relationships with our key customers to advance our technologies. The
termination of any one of these key relationships could have a material
adverse effect on our ability to anticipate and develop necessary
technological changes to our products.

  Our customers are constantly striving to improve their production processes,
including improving the manufacturing of substrates, the deposition of
material on the substrate, the finish processing of magnetic media, and head
fabrication. If our customers modify their own design and internal production
processes without our products, demand for our equipment would likely decline.
Further, unless we are able to effectively respond to such changes,
manufacturing process changes for disk drives, disks and read/write heads
could also have a material adverse effect on our business, operating results
and financial condition.

  Future technological innovations may reduce demand for disk drives.
Competing technologies to disk drive based data storage exist, including solid
state memory (flash memory), tape memory and re-writable optical technology
(CD and DVD technology). Although the current core technology for rotating
magnetic disk drive data storage has been the predominant technology in the
industry for many years, it is likely that some day this technology will be
replaced by an alternate technology. Our products may not be adaptable to any
successor technology. Our business, operating results and financial condition
could be materially adversely affected by any significant migration toward
technology that would replace disk drives as a computer data storage medium.

Because We Depend on a Small Number of Customers, Any Decrease in Net Sales to
or a Loss of a Customer Will Have a Significant Negative Impact on Our
Business

  There are a relatively small number of data storage manufacturers throughout
the world and the Company derives a significant portion of its net sales from
a relatively small number of customers. The Company expects that its
dependence on relatively few key customers will continue in the future.
Approximately 51.0%, 50.0% and 53.5% of the Company's net sales in 1997, 1998
and 1999, respectively, were derived from sales to its three largest customers
in each of those periods. Even though the Company's customer mix will likely
change from period to period in the future, Seagate Technology, Inc.
("Seagate"), Komag, Incorporated ("Komag"), HMT Technology Corporation ("HMT")
and Nissho Iwai High Technology Incorporated ("Nissho Iwai") have historically
accounted for a significant portion of its net sales. For 1997, 1998 and 1999,
Seagate accounted for 18.0%, 17.1%, and 36.7% respectively, of net sales;
Komag accounted for 15.9%, 4.8% and 5.3%, respectively, of net sales; HMT
accounted for 17.1%, 16.3%, and 1.0% respectively, of net sales; and Nissho
Iwai accounted for 4.8%, 4.9% and 6.2%, respectively, of net sales. For 1999,
Read-Rite Corporation accounted for 10.6% of net sales. If net sales to these
or any of its other significant customers were to decrease in any material
amount in the future, the Company's business, operating results and financial
condition would be materially adversely affected.

                                      17
<PAGE>

  In general, we do not enter into long-term purchase agreements with our
customers. If completed orders are not replaced on a timely basis by new
orders from the same or other customers, our net sales would be materially
adversely affected. In addition, the following could have a material adverse
effect on our business, operating results and financial condition:

  . the loss of a key customer;

  . any reduction, cancellation or rescheduling of an order from any key
    customer, including reductions, delays or cancellations due to customer
    departures from recent buying patterns; and

  . economic or competitive conditions in our industry.

  Any failure to collect payment or delay in collecting payment on accounts
receivable from customers could have a material adverse effect on our
business, operating results and financial condition. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

  There has been a trend toward consolidation in the disk drive industry and
we expect this trend to continue. Some of our customers have been, and may
continue to be acquired by competitors, causing further consolidation.
Previous acquisitions in the disk drive industry have often caused the
purchasing departments of the combined companies to reevaluate their
purchasing decisions. Such acquisitions may result in a change in a current
customer's purchasing habits, including a loss of the customer, a decrease in
orders from that customer or a rescheduling or cancellation of orders
previously made by a customer. Moreover, acquisitions involving existing
customers may cause the concentration of our customer revenues to increase
thereby increasing our dependence on fewer customers.

We Have a High Risk of Inventory Obsolescence Which can Adversely Affect
Operating Results by Increasing Cost of Sales

  Due to the cyclical nature of and rapid technological change in our
industry, our inventory is subject to substantial risk of obsolescence. To
address these risks, we monitor our inventories on a periodic basis and
provide inventory write-downs intended to cover these risks. Despite our
precautions, we may be required to take significant inventory charges which,
in turn, could materially and adversely affect our business, operating results
and financial condition due to the following:

  . our dependence on a few customers and a limited number of product
    programs for each customer;

  . the magnitude of our commitment to support our customers' programs;

  . our limited remedies in the event a customer cancels or materially
    reduces one or more product orders; and

  . the possibility that a customer may experience financial difficulties.

  The significant downturn in the data storage industry negatively impacted
our operations, and for the years ended December 31, 1998 and 1999, the
Company recorded $19.8 million and $5.0 million, respectively in charges to
cost of sales to write down excess and obsolete inventory. We may be required
to take additional inventory write-downs in the future due to our inability to
obtain necessary product acceptance, or due to further cancellations by
customers.

Our Industry is Highly Competitive

  The disk drive process and production-test equipment industry is highly
competitive. In each of our product lines, we face substantial competition
from established merchant suppliers of process and production-test equipment,
some of which have greater financial, engineering, manufacturing, research and
development and marketing resources. For example, we face competition from
Zyratex, General Disk and Hitachi DECO for servowriters; Hitachi DECO and Sony
Techtronics for disk certifiers; Integral Solutions International and Veeco

                                      18
<PAGE>

for quasi-static MR head testers; Koyo Precision Instruments, Inc. and Zygo
Corporation for flying height testers, and Technistar for automation
technology. Historically, there has also been competition from entrepreneurs
with focused market knowledge and new technology. We experience intense
competition world-wide from Hitachi DECO, a large, full-line manufacturer of
process and production-test equipment. Hitachi DECO has substantially greater
financial, technical, marketing, manufacturing, research and development and
other resources. We also experience competition from other full-line and
partial-line manufacturers of process and production-test equipment. Our
competitors may develop enhancements to, or future generations of, competitive
products that will offer price or performance features superior to our
products, or new competitors may enter our markets. Finally, as many of our
competitors are based in foreign countries, they have cost structures and
equipment prices based on foreign currencies. Accordingly, currency
fluctuations could cause our dollar-priced products to be less competitive
than our competitors' products priced in other currencies.

  Many of our competitors are investing heavily in the development of new and
enhanced products aimed at applications currently addressed by our products.
We expect our competitors to continue to improve the design and performance of
their products and to introduce new products with competitive
price/performance characteristics. Competitive pressures often necessitate
price reductions which can adversely affect operating results. We will be
required to make significant investments in product development and research,
sales and marketing and ongoing customer service and support to remain
competitive. We cannot be certain that we will have sufficient resources to
continue to make such investments or that we will be able to achieve the
technological advances necessary to maintain our competitive position.

  We believe that our future success will be dependent, in part, upon our
ability to compete successfully in the Japanese, South Korean and Southeast
Asian markets. Our largest competitor, Hitachi DECO, is headquartered in Japan
which gives it a competitive advantage in that market to the extent buying
decisions are influenced by Hitachi DECO's local presence. In addition, our
ability to compete in Japan, South Korea and Southeast Asia in the future is
dependent upon continuing free trade between these countries and the
United States, our continuing ability to develop in a timely manner products
that meet the technical requirements of our foreign customers and our
continuing ability to develop and maintain satisfactory relationships with
leading companies in our industry in these areas. Moreover, our sales in these
areas will be affected by the overall economies of Japan, South Korea and
Southeast Asia. To the extent that recent economic troubles in Asian markets
have negatively impacted the capacity expansion and upgrade plans of our
customers or potential customers in affected regions, then such economic
troubles have also negatively impacted our operations. With respect to
existing customers, we do not believe that such Asian economic troubles have
had a significant impact on our operations. With respect to potential
customers, we are unable to quantify the impact that such Asian economic
troubles will have on our operations.

  In addition to the competition from our competitors, most of our customers
develop at least a portion of their own process and production-test equipment
needs internally, especially servowriters and read/write head test equipment.
Accordingly, we must compete against the internal development efforts of this
captive market. Manufacturers within this captive market are often reluctant
to change their production lines to incorporate merchant-supplied process and
production-test technology. Moreover, rapid changes in data storage
technology, and the development of new process and production-test equipment
may be so closely linked to our customers' product development cycles that
certain customers and potential customers will find it more efficient to
develop their own process and production-testing equipment needs internally,
thereby placing us at a competitive disadvantage.

  Because of the foregoing competitive factors, we may not be able to compete
successfully in the future. Increased competitive pressure could cause us to
lower our prices which would have an adverse effect on our business, financial
condition and results of operations.

                                      19
<PAGE>

Because We Sell a Small Number of Products, A Reduction in Demand For Any One
of These Products May Have a Significant Negative Effect on Our Business

  We derive revenues primarily from sales of our process and production-test
systems and parts for such systems. Our products can generally be categorized
into four principal areas:

  . disk (media) testing and processing;

  . read/write head testing;

  . disk drive processing; and

  . automation.

  We derive a significant portion of our net sales from a relatively small
number of products. In 1997, 1998 and 1999, we derived approximately 58.9%,
54.1% and 20.6% of our net sales, respectively, from sales of our media
certifier products (excluding parts and service). Additionally, in 1999 we
derived approximately 12.2% and 8.1% of our net sales from our Quasistatic and
Flying Height products, respectively. Although we expect that net sales from
our media certifier products, including our MG series and our MC series, will
continue to account for a substantial portion of our total net sales in the
foreseeable future, we realize that the downturn in the data storage industry
is caused, in part, by the overcapacity of media certifiers in the market
today. Any material reduction in demand for our media certifier products would
have a material adverse effect on our business, operating results and
financial condition.

We May Not Be Able to Adequately Protect Our Proprietary Technology or May Be
Subject to Claims of Infringement

  Our success is heavily dependent upon the establishment and maintenance of
proprietary technologies. We currently attempt to protect our intellectual
property rights through patents, copyrights, trade secrets and other measures.
These efforts may not be adequate to prevent misappropriation by third parties
and may not be adequate under the laws of some foreign countries which may not
protect our proprietary rights to the same extent as do laws of the United
States. Our competitors may be able to independently develop products that are
substantially equivalent or superior to our products, or design around our
patents. Any such adverse circumstances could have a material adverse effect
on our business, operating results and financial condition.

  Although we do not believe any of our products or proprietary rights
infringe the rights of third parties, infringement claims may be asserted
against us in the future. Any such claims, with or without merit, could divert
the attention of management, result in costly litigation, cause product
shipment delays or require us to enter into royalty or licensing agreements.
Such royalty or licensing agreements, if required, may not be available on
acceptable terms, or at all. If infringement were established, we could be
required to pay damages or be enjoined from making, using or selling the
infringing product. Likewise, a third party's product, if infringing on our
proprietary rights, may not be prevented from doing so without litigation. Any
of the foregoing could have a material adverse effect on our business,
operating results and financial condition.

  We cannot be certain that the claims allowed on any of our patents will be
sufficiently broad to protect our technology. Moreover, any patent we own
could be invalidated, deemed unenforceable, circumvented or challenged. Also,
we cannot be certain that our patent rights will provide us competitive
advantages or that any of our pending or future patent applications will be
issued with claims of the scope that we desire, if at all. Furthermore, others
may develop similar products, duplicate our products or design around the
patents we own. In addition, foreign intellectual property laws or our
agreements may not protect our intellectual property rights in any foreign
country. Any failure to protect our intellectual property rights could have a
material adverse effect on our business, operating results and financial
condition.

  We require each of our employees to enter into a proprietary rights and non-
disclosure agreement in which the employee agrees to maintain the
confidentiality of all of our proprietary information and, subject to certain
exceptions, to assign to us all rights in any proprietary information or
technology made or contributed by the

                                      20
<PAGE>

employee during his or her employment. In addition, we regularly enter into
non-disclosure agreements with third parties, such as consultants, potential
joint venture partners and customers. In spite of these precautions, it may be
possible for third parties to copy, develop or otherwise obtain and use our
proprietary technology without authorization or to develop similar technology
independently.

The Complexity and Customization of our Products May Lead to Technical
Difficulties and Unanticipated Costs

  Our products have a large number of components and are highly complex. We
have experienced and may continue to experience manufacturing delays due to
technical difficulties. In addition, many of our products must be semi-
customized to meet individual product specification requirements. The
customization of a customer order may require new technical capabilities not
previously incorporated successfully into our products. As a result, we may be
unable to complete our customers' customized development or technical
specifications in a timely manner. Any significant failure in this regard
would have a material adverse effect on our business, operating results and
financial condition as well as our customer relationships. In addition, due to
the semi-customized nature of many of our products, we have incurred and may
continue to incur substantial unanticipated costs in a product's development
and production which cannot be passed on to the customer. Such unanticipated
costs include the increased cost of components due to expediting charges,
other purchasing inefficiencies and greater than expected engineering, quality
control, installation, upgrade, post-installation service and support and
warranty costs. The occurrence of any of these events could materially
adversely affect our business, operating results and financial condition.

  In certain instances we rely on a single source or a limited group of
suppliers for certain components and subassemblies used in our products. The
partial or complete loss of these sources could have at least a temporary
material adverse effect on our results of operations and damage customer
relationships due to the complexity of the products they supply and the
significant amount of time required to qualify new suppliers. In addition,
long lead times are often required to obtain critical components and
subassemblies used in certain of our products from these and other suppliers
which could impede our ability to quickly respond to changes in demand and
product specifications.

  Shortages of critical components and subassemblies used in our products have
occurred in the past and may occur in the future. Also, the availability of
materials may have longer lead times. In addition, our manufacture and timely
delivery of products is often dependent on the ability of certain suppliers to
deliver subassemblies and other components in a timely manner. The failure of
such suppliers to deliver these components in a timely manner may delay our
product delivery until alternative sourcing may be developed. Alternative
sources may not be located in time to avoid penalties or cancellation of our
product orders. If a significant order or orders were cancelled for this
reason it could have a material adverse effect on our business, operating
results and financial condition. Further, a significant increase in the price
of one or more components used to produce our products would increase our
production costs. See "Business -- Manufacturing."

Risk of Natural Disasters

  We conduct our manufacturing activities at our facilities in San Diego,
Fremont and Hayward, California. Our manufacturing facilities are located in
seismically active areas. A major catastrophe (such as an earthquake or other
natural disaster) or other long-term disruption in our manufacturing
activities could result in a prolonged interruption of our business. See
"Business -- Manufacturing."

                                      21
<PAGE>

Risks Associated with Acquisitions

  While we currently have no commitments, agreements or understandings with
respect to any future acquisitions, our business strategy includes the
expansion of our business, products lines and technology through acquisitions.
We regularly review various acquisition prospects, including companies,
technologies or products complementary to our business and periodically engage
in discussions regarding such possible acquisitions. Acquisitions involve
numerous risks, including:

  . evaluating new technologies;

  . difficulties in the assimilation of the operations, products, personnel
    and cultures of the acquired companies;

  . the ability to manage geographically remote units;

  . the diversion of management's attention from other day-to-day business
    concerns;

  . the risks of entering markets in which we have limited or no direct
    experience;

  . the potential loss of key employees of the acquired companies;

  . dilutive issuances of equity securities;

  . the incurrence of additional debt;

  . reduction of existing cash balances; and

  . amortization expenses related to goodwill and other intangible assets and
    other charges to operations that may materially adversely affect our
    results of operations.

  Moreover, any equity or debt financings proposed in connection with any
acquisition may not be available to us on acceptable terms or at all, when,
and if, suitable strategic acquisition opportunities arise. Although
management expects to carefully analyze any opportunity before committing our
resources, there can be no assurance that any completed acquisition will
result in long-term benefits or that our management will be able to manage
effectively the resulting business. See "Business -- Competition."

  We recorded write-downs totaling approximately $2.0 million and $1.0 million
for 1997 and 1999, respectively. For 1997 these writedowns related to
impairment losses on certain purchased technology recorded primarily in
connection with our acquisitions of assets of Air Bearing Incorporation (ABI)
and for 1999 these writedowns related to impairment losses on non-compete
agreements in connection with the acquisition of Santa Barbara Metric, Inc.
(SBM). The impairment losses in 1997 were generally the result of post-
acquisition technological changes that were developed independently of
purchased technologies, causing a decline in the carrying values of such
purchased technologies. The write down in 1999 was due to the discontinued
sale of products acquired in connection with SBM. Such impairments may occur
in the future and future acquisitions may result in similar write-downs of
acquired assets. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and note 1 of Notes to Consolidated
Financial Statements.

Any Future Inability to Obtain Additional Financing Will Have a Significant
Negative Effect on Our Business

  To achieve our long-term strategic objectives and maintain our competitive
position, we will need additional financial resources over the next several
years to fund acquisitions, service debt, make capital expenditures, fund
working capital and pay for research and development. We are continually
investing in new technologies and our international infrastructure and, as a
result, our fixed costs may increase in the foreseeable future, depending on
the timing of any recovery in demand for our products. Our fixed costs may
also increase if we expand our infrastructure in South Korea, Japan, other
parts of Asia, or other locations. Any liquidity deficiency in the future
could delay or change our future plans, including curtailing potential
acquisitions, capital expenditures, facilities expansion and research and
development expenditures, which could materially adversely affect our ability
to pay our debts (including indebtedness and interest under the Notes) and our
business, operating results and financial condition.

                                      22
<PAGE>

  We continue to have limited cash resources and significant future
obligations. The precise amount and timing of our capital needs will depend
upon a number of factors, including:

  . the market demand for our products;

  . the availability of strategic opportunities;

  . the progress of our product development efforts;

  . technological challenges in connection with existing and future products;
    and

  . the success of our working capital and inventory management.

  We may not be able to obtain additional financing as needed on acceptable
terms or at all. If we are unable to obtain sufficient capital, potential
acquisitions, capital expenditures, facilities expansion and research and
development expenditures would be materially and adversely affected. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."

  In August 1998, we issued and sold an aggregate of 6,360,000 shares of our
Series C Preferred Stock in our Series C Financing for $25.4 million in
proceeds. Immediately following the consummation of the Series C Financing, we
used $7.1 million of the proceeds from the offering to repay all outstanding
indebtedness under the credit facility that we entered into in January 1998
(the "New Credit Facility") and subsequently terminated such facility. As of
the date of this filing, we have no revolving or other type of credit facility
for working capital. In September 1998, one of the investors in the Series C
Financing purchased an additional 1,250,000 shares of Series C Preferred Stock
for an aggregate of $5.0 million.

  We believe that cash generated from operations, borrowings under the New
Credit Facility and existing cash balances will be adequate to fund our
operations for at least the next 12 months. While operating activities may
provide cash in certain periods, we may require additional sources of
financing. We may also from time to time consider additional acquisitions of
complementary businesses, products or technologies, which may require
additional financing. Additional sources of funding could include additional
debt and/or equity financings. We will continue to have limited capital
resources and significant future obligations and expect that we will require
additional capital to support future growth, if any. There can be no assurance
that we will be able to obtain alternative sources of financing on favorable
terms, if at all, at such time or times as we may require such capital. See
"Risk Factors--Because We Have a Substantial Amount of Indebtedness, We May Be
Unable to Pay Interest or Principal on the Senior Notes."

Because We Depend on Key Personnel, the Loss of Any One of Them Could Have a
Material Adverse Effect on Our Business

  Our future performance depends in significant part upon the continued
service of our chief executive officer, other senior management personnel and
our key technical personnel. We are dependent on our ability to identify,
hire, train, retain and motivate high quality personnel, especially highly
skilled engineers involved in the ongoing developments required to develop and
enhance our products and introduce new and enhanced future products and
applications. Our industry is characterized by a high level of employee
mobility and aggressive recruiting of skilled personnel. Our employees may
terminate their employment at any time. Accordingly, there can be no assurance
that any of our current employees will continue to work for us. The loss of
key employees could have a material adverse effect on our business, operating
results and financial condition. We have an employment agreement with our
chief executive officer, but we do not maintain key-man life insurance with
respect to such individual. The employment agreement is terminable at will by
either party upon 30-days written notice and contains a covenant not to
compete during the term of the agreement and for two years thereafter. See
"Business-- Employees" and "Executive Compensation -- Compensation Plans and
Arrangements -- Employment Contracts and Change in Control Arrangements."

                                      23
<PAGE>

Our International Operations are Subject to Inherent Risks

  Our sales and operating activities outside of the United States are subject
to inherent risks, including:

  . fluctuations in the value of the United States dollar relative to foreign
    currencies;

  . tariffs;

  . quotas;

  . taxes and other market barriers;

  . political, economic and monetary instability;

  . restrictions on the export or import of technology;

  . potentially limited intellectual property protection;

  . difficulties in staffing and managing international operations; and

  . potentially adverse tax consequences.

  These factors could have a material adverse effect on our business,
operating results or financial condition. In addition, although most of our
export sales are denominated in United States dollars, such sales may not be
denominated in dollars in the future. As a result, currency exchange
fluctuations in countries where we conduct business could have a material
adverse effect on our business, operating results and financial condition. In
this regard, several Asian countries, including South Korea, Japan and
Thailand, have historically experienced significant economic downturns and
significant declines in the value of their currencies to the U.S. dollar. Due
to these conditions, some of our customers may delay, reschedule or cancel
significant current or future product orders. If any such orders are delayed,
rescheduled or cancelled, our business, operating results and financial
condition would be adversely affected. To the extent that historical economic
troubles in Asian markets have negatively impacted the capacity expansion and
upgrade plans of our customers or potential customers in affected regions,
then such economic troubles have also negatively impacted our operations. With
respect to existing customers, we do not believe that such Asian economic
troubles have had a significant impact on our operations. With respect to
potential customers, we are unable to quantify the impact that such Asian
economic troubles will have on our operations.

Because We are Subject to Many Environmental Regulations, Any Violation will
Subject us To Significant Liabilities

  We are subject to a variety of governmental regulations relating to the use,
storage, discharge, handling, emission, generation, manufacture, treatment and
disposal of toxic or other hazardous substances, chemicals, materials or
waste. We believe that we are in compliance, in all material respects, with
such regulations. Any failure to comply with current or future regulations
could result in civil penalties or criminal fines being imposed upon us, or
our officers, directors or employees, suspension of production, alteration of
our manufacturing process or cessation of operations. Such regulations could
require expensive remediation or abatement actions to comply with
environmental regulations. Any failure to properly manage the use, disposal or
storage of, or adequately restrict the release of, hazardous or toxic
substances could subject us to significant liabilities.

The Notes Could be Voided or Subordinated if Certain Circumstances Existed at
the Time We Incurred Such Indebtedness

  Under applicable provisions of federal bankruptcy law or comparable
provisions of state fraudulent transfer laws, if, among other things, we or
any Subsidiary Guarantor, at the time we incurred the indebtedness evidenced
by the Notes or the Note Guarantees, as the case may be, (1) (a) was or is
insolvent or rendered insolvent by reason of such occurrence or (b) was or is
engaged in a business or transaction for which the assets remaining with us or
such Subsidiary Guarantor constituted unreasonably small capital or (c)
intended or intends to incur,

                                      24
<PAGE>

or believed or believes that we would incur, debts beyond our ability to pay
such debts as they mature and (2) we or such Subsidiary Guarantor received or
receives less than reasonably equivalent value or fair consideration for the
incurrence of such indebtedness or providing such guarantees, then the Notes
and the Note Guarantees could be voided or claims in respect of the Notes or
the Note Guarantees could be subordinated to all other debts of ours or such
Subsidiary Guarantor, as the case may be. In addition, our payment of interest
and principal pursuant to the Notes or the payment of amounts by a Subsidiary
Guarantor pursuant to a Note Guarantee could be voided and required to be
returned to the person making such payment, or to a fund for the credit of our
creditors or such Subsidiary Guarantor, as the case may be.

  The measures of insolvency for purposes of the foregoing considerations will
vary depending upon the law applied in any proceeding with respect to the
foregoing. Generally, however, we or a Subsidiary Guarantor would be
considered insolvent if (1) the sum of our debts, including contingent
liabilities, were greater than the saleable value of all our assets at a fair
valuation or if the present fair saleable value of our assets were less than
the amount that would be required to pay our probable liabilities on our
existing debts, including contingent liabilities, as they become absolute and
mature or (2) we could not pay our debts as they become due.

  On the basis of historical financial information, recent operating history
as discussed in "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and other factors, we and each Subsidiary Guarantor
believe that, after giving effect to the indebtedness incurred in connection
with the Original Note Offering, we were not insolvent, did not have
unreasonably small capital for the business in which we were engaged and had
not incurred debts beyond our ability to pay debts as they mature. There can
be no assurance, however, as to what standard a court would apply in making
such determinations or that a court would agree with our or such Subsidiary
Guarantor's conclusions.

We May Not Be Able to Make Required Payments Upon a Change of Control

  The Indenture provides that, upon the occurrence of a Change of Control, we
will be required to make an offer to repurchase all of the Notes issued and
then outstanding under the Indenture at a purchase price equal to 101% of
their principal amount plus any accrued and unpaid interest and Liquidated
Damages, to the date of repurchase. If a Change of Control were to occur, it
is unlikely that we would be able to repay all of our obligations, the Notes
and any other indebtedness that may become payable in such event without
refinancing our obligations. We may not be able to obtain any such financing
on commercially reasonable terms, or at all, and consequently we cannot give
any assurance that we would be able to repurchase any of the Notes upon a
Change of Control.

There Is No Active Trading Market for the Notes

  No established trading market exists for the Notes. We do not intend to list
the Notes on any securities exchange or to seek admission thereof to trading
in the National Association of Securities Dealers Automated Quotation System.
Although DLJ has advised us that it currently intends to make a market in the
Notes, DLJ is not obligated to do so and may discontinue such market making at
any time without notice. In addition, such market making activity will be
subject to the limits imposed by law. If a trading market does not develop or
is not maintained, holders of the Notes may experience difficulty in reselling
the Notes or may be unable to sell them at all. If a market for the Notes
develops, any such market may be discontinued at any time. Accordingly, there
can be no assurance as to the development or liquidity of any market for the
Notes.

ITEM 2. PROPERTIES

  The Company leases buildings with a total of approximately 41,000 square
feet in San Diego, California under a lease expiring in December, 2001; 72,000
square feet under leases expiring in August 2003 in Fremont, California; and
two buildings with a total of 12,000 square feet in buildings under month-to-
month leases in Hayward, California. The Company conducts manufacturing and
research and development at all of these sites and also has service and
support capabilities at each of these locations, except Hayward. The Company's

                                      25
<PAGE>

domestic sales and marketing functions are headquartered in its Fremont and
San Diego facilities. For its Pacific Rim operations, the Company also leases
1,900 square feet in Tokyo, Japan; 2,700 square feet in AnSen City, South
Korea; 5,000 square feet in Singapore; 800 square feet in Thailand and 500
square feet in Malaysia. These facilities are primarily used as technical,
applications, and sales and service support centers for the Company's Pacific
Rim customers. The Company believes that its facilities are adequate for its
current level of business and does not anticipate any material difficulty in
renewing any of its leases as they expire or securing replacement facilities,
in each case on commercially reasonable terms.

ITEM 3. LEGAL PROCEEDINGS

  The Company is also subject to various other legal matters in the normal
course of its business. While the results of litigation and claims cannot be
predicted with certainty, the Company believes that the final outcome of these
other matters will not have a material adverse effect on its business,
operating results or financial condition.

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

  No matters were submitted to a vote of security holders during the quarter
ended December 31, 1999.

                                      26
<PAGE>

                                   PART II.

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

Market Information

  There is no established public trading market for Phase Metrics common
stock.

Holders

  The number of holders of Phase Metrics common equity securities as of
February 29, 2000 was 111.

Dividend Policy

  Phase Metrics' ability to declare and pay dividends on its common stock is
restricted by certain covenants in the Indenture. Phase Metrics intends to
retain all of its earnings to finance the development and growth of its
business. Accordingly, Phase Metrics does not anticipate that any dividends
will be declared on its common stock for the foreseeable future.

Recent Sales of Unregistered Securities

  None.


                                      27
<PAGE>

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
                                         Year Ended December 31,
                               -----------------------------------------------
                               1995(1)   1996(1)     1997      1998     1999
                                      (in thousands, except ratios)
<S>                            <C>       <C>       <C>       <C>       <C>
Consolidated Statement of
 Operations Data:
 Net sales.................... $116,894  $190,773  $184,660  $104,994  $38,068
 Gross profit(2)..............   52,128    86,912    83,366    11,826    4,437
 Operating expenses(3)........   40,161    98,332    81,131    64,215   38,904
 Income (loss) from
  operations..................   11,967   (11,420)    2,235   (52,389) (34,467)
 Interest expense.............    5,625     8,448    11,573    14,456   13,809
 Income (loss) before income
  taxes and extraordinary
  items.......................    6,193   (19,842)   (9,812)  (66,506) (47,202)
 Income tax expense
  (benefit)(4)................    1,524    (8,974)   (4,268)    9,000       --
 Income (loss) before
  extraordinary items.........    4,669   (10,868)   (5,544)  (75,506) (47,202)
 Extraordinary loss, net of
  income taxes................       --    (1,122)       --    (1,345)      --
 Net income (loss)............    4,669   (11,990)   (5,544)  (76,851) (47,202)
Other Data:
 Cash provided by (used for)
  operating activities........   18,300   (21,402)   (6,392)  (11,962) (13,063)
 Cash provided by (used for)
  investing activities........  (11,102)  (40,885)  (17,169)   10,156   (1,453)
 Cash provided by (used for)
  financing activities........   (3,099)   60,008    23,883    23,478   (1,302)
 EBITDA(5)....................   27,864    21,533    24,107   (40,333) (24,369)
 Depreciation, amortization
  and write-downs of
  intangible assets...........   15,897    32,953    21,872    12,056    9,024
 Acquisition of property,
  plant and equipment.........    9,135    24,564    17,091     1,492    2,029
 Ratio of earnings to fixed
  charges(6)..................     1.2x        --        --        --       --
</TABLE>

<TABLE>
<CAPTION>
                                              December 31,
                              ------------------------------------------------
                                1995      1996      1997      1998      1999
                                             (in thousands)
<S>                           <C>       <C>       <C>       <C>       <C>
Consolidated Balance Sheet
 Data:
 Cash and cash equivalents... $  5,016  $  2,737  $  2,977  $ 24,714    $8,942
 Working capital.............   (5,774)   42,681    66,075    45,883     8,214
 Total assets................  119,896   154,013   154,730    96,115    46,651
 Long-term debt, including
  current portion............   30,239    96,020   121,057   116,631   115,736
 Redeemable preferred stock..    3,314     6,314     9,237    42,543    46,265
 Stockholders' equity
  (deficit)(2)(3)(4).........    3,592    (9,031)  (17,873)  (97,157) (147,878)
</TABLE>
-------
(1) Between June 1995 and December 1996, Phase Metrics completed six
    acquisitions, including Helios, Incorporated ("Helios") in June 1995,
    Applied Robotic Technologies, Inc. ("ART") in July 1995, certain net
    assets of Tahoe Instruments ("Tahoe") in July 1995, Air Bearings,
    Incorporated ("ABI") in January 1996, Santa Barbara Metric, Inc. ("SBM")
    in December 1996 and a portion of the business of Kirell Development, Inc.
    ("Kirell") in December 1996. Each of these acquisitions was accounted for
    as a purchase for financial reporting purposes, and, as a result, Phase
    Metrics' consolidated statements of operations include the operating
    results of Helios, ART, Tahoe, ABI, SBM and a portion of the business of
    Kirell from their respective acquisition dates.

(2) In connection with the negative impact on Phase Metrics' operations of the
    adverse market conditions in the data storage industry, for the years
    ended December 31, 1998 and 1999, the Company recorded $19.8 million and
    $5.0 million, respectively, in charges to cost of sales to write down
    excess and obsolete inventory.

(3) Phase Metrics incurred $4.2 million and $3.1 million of restructuring
    costs in 1998 and 1999, respectively, primarily related to employee
    severance costs and asset impairment resulting from workforce reductions
    and facility consolidations.

(4) In connection with the negative impact on Phase Metrics' operations of the
    adverse market conditions in the data storage industry, for the year ended
    December 31, 1998, Phase Metrics recorded $9.0 million of tax expense
    relating to the recording of a valuation allowance against its entire
    deferred tax asset balance.

                                      28
<PAGE>

(5) EBITDA represents income (loss) from operations before depreciation and
    amortization and write downs of intangibles. EBITDA is presented because
    management believes it is a commonly accepted financial indicator used by
    certain investors and analysts to analyze and compare companies on the
    basis of operating performance. EBITDA is not intended to represent cash
    flows for the period, nor has it been presented as an alternative to
    operating income (loss) as an indicator of operating performance and
    should not be considered in isolation or as a substitute for measures of
    performance prepared in accordance with generally accepted accounting
    principles. Phase Metrics understands that, while EBITDA is frequently
    used by securities analysts in the evaluation of companies, EBITDA as used
    herein is not necessarily comparable to other similarly titled captions of
    other companies due to potential inconsistencies in the method of
    calculation.

(6) For purposes of determining this ratio, earnings consist of income (loss)
    before income taxes (benefit) and extraordinary items. Fixed charges
    consist of interest expense, a portion of operating lease rental expense
    that is representative of the interest factor (deemed to be one-third of
    operating lease rental expense) and dividends and related accretion for
    redemption value and dividends on preferred stock. For the years ended
    December 31, 1996, 1997, 1998 and 1999, earnings were inadequate to cover
    fixed charges by $24.8 million, $14.7 million, $69.8 million and $50.9
    million, respectively.

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

  The following discussion of the financial condition and results of
operations of Phase Metrics should be read in conjunction with the
consolidated financial statements and the related notes to such financial
statements included elsewhere in this document. This discussion contains
forward-looking statements that involve risks and uncertainties. Phase
Metrics' actual results may differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including, but not
limited to, those set forth under "Risk Factors" and elsewhere in this
document.

General

  As a result of the matters discussed in greater detail herein, the Company
is facing severe liquidity problems. The Company was unable to make the
interest payment on the Notes due on February 1, 2000 and is not in compliance
with certain covenants of the Notes and the Indenture governing the Notes.

  On April 26, 2000, the Company announced that it had entered into an
agreement in principle with an informal committee representing approximately
81% of Noteholders to restructure the Notes. Under the restructuring, the
$110.0 million principal amount of Notes, plus accrued interest, would be
exchanged for New Common Stock representing 97.5% of the Company's outstanding
common stock after the restructuring. Holders of the existing Senior
Subordinated Convertible Notes, existing Series A, B and C Preferred Stock and
existing Common Stock would receive the remaining 2.5% of New Common Stock, as
well as warrants to purchase additional shares representing up to 10% of the
Company's then outstanding New Common Stock upon certain circumstances. The
restructuring will not in any way affect the Company's obligation to pay its
trade creditors or other vendors. The agreement in principle is subject to a
number of customary conditions.

  In addition, holders of all or some of the Notes will provide the Company
with a $10.0 million New Credit Facility in conjunction with the
restructuring. The New Credit Facility will be secured by a pledge of
substantially all of the Company's assets other than certain secured assets
and customer deposits. The commitment to provide the New Credit Facility is
subject to a number of customary conditions. There is no assurance that the
proposed restructuring will be completed as described above or at all.

  The Company anticipates that the restructuring will take three to five
months to complete. During that time, the Company will face a number of risks
over which it may have limited or no control, including the risk that trade
creditors or vendors may discontinue providing the Company with trade credit,
the risk that customers may decrease the amount of business that they do with
the Company and the risk that, in spite of not paying interest

                                      29
<PAGE>

on the Notes, the Company will not be able to generate the liquidity necessary
to maintain operations. In addition, the Company faces the risk that holders
of Notes or other interests in the Company will refuse to accept the Company's
restructuring proposal when made to them. For these and other reasons, the
Company may be forced to file for protection under Chapter 11 without the
benefit of its agreement in principle with the Noteholders, the Company's
creditors may file an involuntary Chapter 11 case against the Company or it
may be forced to liquidate its business without the benefit of a
reorganization.

  The accompanying financial statements do not purport to reflect or provide
for the consequences of the proposed restructuring.

  The Company was incorporated in 1989 as a specialized merchant supplier of
production-test equipment for the data storage industry. From its inception to
November 1994, the Company was primarily engaged in developing and selling its
flying height tester systems to read/write head manufacturers. In order to
expand its operations and capitalize on the growing demand for process and
production-test equipment for the data storage industry, in November 1994 the
Company completed the Recapitalization and commenced a series of acquisitions
of other specialized suppliers of process and production-test equipment. In
November 1994, the Company acquired ProQuip and Cambrian, suppliers of process
and production-test equipment for disks and read/write heads. In June 1995,
the Company acquired Helios, a supplier of servowriter and other related
equipment used in the production of disk drives. In July 1995, the Company
acquired both ART, a supplier of integrated automation systems for process and
production-test equipment, and Tahoe, a developer of quasi-static MR head
testers used for testing MR read/write heads. In January 1996, the Company
acquired ABI, a supplier of air bearing spindles and other related components
used in the Company's products and by others. In December 1996, the Company
acquired SBM, a developer of spinstands and micropositioner equipment and
technology used by data storage manufacturers, and in December 1996, the
Company acquired a portion of the business of Kirell, a supplier of laser
texturizers used in the production of disks.

  The Company accounted for each of its acquisitions as a purchase, and, as a
result, the Company's consolidated statements of operations include the
operating results of the acquired businesses from their respective dates of
acquisition. In connection with certain of the acquisitions, the Company
agreed to make earnout payments based on future sales of certain products
acquired in the acquisitions. At December 31, 1999, future potential combined
maximum earn-out payments in connection with such acquisitions are not
expectedto be material. Also, in connection with the acquisitions, the Company
recorded capitalized intangibleassets totaling $61.2 million. The net book
value of such capitalized intangible assets was $0.1 million as ofDecember 31,
1999.

  There are a relatively small number of data storage manufacturers throughout
the world and the Company derives a significant portion of its net sales from
a relatively small number of customers. The Company expects that its
dependence on relatively few key customers will continue in the future.
Approximately 51.0%, 50.0% and 53.5% of the Company's net sales in 1997, 1998
and 1999, respectively, were derived from sales to its three largest customers
in each of those periods. Even though the Company's customer mix will likely
change from period to period in the future, Seagate Technology, Inc.
("Seagate"), Komag, Incorporated ("Komag"), HMT Technology Corporation ("HMT")
and Nissho Iwai High Technology Incorporated ("Nissho Iwai") have historically
accounted for a significant portion of its net sales. For 1997, 1998 and 1999,
Seagate accounted for 18.0%, 17.1%, and 36.7% respectively, of net sales;
Komag accounted for 15.9%, 4.8% and 5.3%, respectively, of net sales; HMT
accounted for 17.1%, 16.3%, and 1.0% respectively, of net sales; and Nissho
Iwai accounted for 4.8%, 4.9% and 6.2%, respectively, of net sales. For 1999,
Read-Rite Corporation accounted for 10.6% of net sales. If net sales to these
or any of its other significant customers were to decrease in any material
amount in the future, the Company's business, operating results and financial
condition would be materially adversely affected.

  The Company has no long-term contracts with its customers, and, in general,
the Company's customers may cancel, change or reschedule their orders with
limited or no penalty. The Company's customers often submit master purchase
orders against which they release specific product orders from time to time,
often with little

                                      30
<PAGE>

lead time. Any cancellation, reduction, rescheduling or significant delay of
anticipated or actual orders from significant customers could have a material
adverse effect on the Company's business, operating results and financial
condition. Each of the Company's customers has unique product specification
requirements which requires the Company to provide semi-customized products.
As a result, per unit sales prices for the Company's products will generally
vary by customer and sales order. If production costs with respect to the
customization work are underestimated, there could be an adverse impact on the
Company's gross profits. In addition, the Company's products often require
post-installation, on-site customization and integration in order to tailor
products to customer specifications. Revenue and corresponding expenses for
significant post-installation services are recognized in the period such
services are provided. Inaccurate estimation of such on-site service costs
could have a material adverse effect on the Company's business, operating
results and financial condition.

  The Company derives its revenues primarily from sales of its process and
production-test systems and upgrades and parts for such systems. The Company's
products can generally be categorized into four principal areas: (1) disk
(media) testing and processing, (2) read/write head testing, (3) disk drive
processing and (4) automation. The Company derives a significant portion of
its net sales from a relatively small number of products. In 1997, 1998 and
1999, the Company derived approximately 58.9%, 54.1% and 20.6% of its net
sales, respectively, from sales of its media certifier products (excluding
parts and service). Additionally, in 1999, the Company derived approximately
12.2% and 8.1% of its net sales from its Quasistatic and Flying Height
products, respectively. Moreover, the Company expects that net sales from its
media certifier products, including its MG series and its MC series, will
continue to account for a substantial portion of the Company's total net sales
in the foreseeable future. Any significant reduction in demand for its media
certifier products would have a material adverse effect on the Company's
business, operating results and financial condition.

  The Company's operating results have fluctuated in the past and the Company
expects that its operating results will continue to fluctuate in the future
from quarter to quarter and year to year. These fluctuations have resulted
from a number of factors including:

  . The size and timing of orders from, and shipments to, major customers;

  . The timing of introductions of new products and product enhancements by
    the Company or its competitors;

  . the Company's ability to develop, introduce and market new,
    technologically advanced products;

  . the cyclicality of the data storage industry;

  . the rescheduling of capital expenditures by the Company's customers;

  . variations in the Company's customer base and product mix;

  . the level of any significant volume pricing discounts provided by the
    Company;

  . the availability and cost of key production materials and components;

  . the Company's ability to effectively manage its inventory and to control
    costs;

  . the Company's dependence on a limited number of products and customers;

  . the Company's success in expanding its operations overseas;

  . personnel changes;

  . expenses associated with acquisitions;

  . fluctuations in amortization and write-downs of intangible assets; and

  . exchange rate fluctuations and general economic factors.

  The data storage industry has experienced prolonged and intense competition,
pricing erosion and overcapacity. Such adverse market conditions have
resulted, and may in the future result, in the delay, reschedule or
cancellation of orders and fluctuation in demand for our products. These
adverse market conditions have had a material adverse effect on our results of
operations and financial condition over the last several quarters and are
expected to continue through

                                      31
<PAGE>

2000. Under current or future market conditions, there can be no assurance
that the Company's business will generate adequate cash flow or that any
growth can be achieved. Because the Company must incur expenses and purchase
inventory based on anticipated and actual customer orders, any significant
delay, rescheduling or cancellation of such orders will have a material
adverse effect on the Company's operating results.

  As indicated above, the Company's business, operating results and financial
condition have been affected by adverse market conditions in the data storage
industry. In June 1998, the Company implemented a work force reduction of
approximately 155 employees, relocated and consolidated much of its Concord,
California operations to its Fremont, California facility and consolidated its
San Diego facility. In November 1998, the Company reduced its work force by
approximately 60 employees and consolidated its Fremont, California
facilities. In the second quarter of 1999, the Company consolidated a
significant portion of its Fremont facilities, and in July 1999, implemented a
workforce reduction of approximately 25 employees. Due to the continued
effects of the weakness in demand for data storage products, in the fourth
quarter of 1999, the Company further consolidated its Fremont facilities and
implemented a workforce reduction of approximately 24 employees.

  While the Company believes its cost-cutting measures are appropriate given
the Company's current and anticipated levels of net sales, there can be no
assurance that such measures will be sufficient and that additional
cost-cutting measures will not be necessary, or that the 1998 and 1999
restructuring activities or future cost-cutting measures will not have a
material adverse effect on the Company's ability to increase its net sales.

  In connection with the negative impact on the Company's operations of the
adverse market conditions in the data storage industry, in 1998, the Company
recorded $19.8 million in charges to cost of sales to write-off excess and
obsolete inventory, $4.2 million in restructuring charges related to
restructuring activities, as well as $9.0 million of tax expense related to
the recording of a valuation allowance against its entire net deferred tax
asset balance. In 1999 the Company recorded $5.0 million in charges to cost of
sales to write-off excess and obsolete inventory and $3.1 million related to
restructuring activities.

  In August and September 1998 the Company sold 7,610,000 shares of Series C
Preferred Stock for $4 per share. The proceeds of approximately $30.4 million
were used to repay in full the Company's then existing credit facility and
accrued interest totaling $7.1 million, with the remaining proceeds used for
general operating purposes. The credit facility was then terminated. As of the
date of this filing, the Company's New Credit Facility for working capital was
pending.

  We had net sales of $184.7 million in 1997 compared to $105.0 million in
1998 and $38.1 million in 1999. We had EBITDA (as described in Footnote 5 in
"Selected Consolidated Financial Data") of $24.1 million in 1997 compared to
$(40.3) million in 1998 and $(24.4) million in 1999. Cash used for operating
activities was $12.0 million for 1998 and $13.1 million for 1999. Period to
period fluctuations in operations impacting these amounts were the net losses
for 1998 and 1999, a decrease in amortization and write downs of intangible
assets, a decrease in deferred income tax assets in 1998, decreases in
accounts receivable and inventories, an increase in 1998 income taxes
receivable compared to a decrease in 1999 and decreases in accrued expenses.
Cash used for operating activities increased from $6.4 million for 1997 to
$12.0 million for 1998. Period to period fluctuations in operations impacting
these amounts were the net losses for 1997 and 1998, a decrease in
amortization and write downs of intangible assets, a decrease in deferred
income tax assets, a smaller increase period to period in accounts receivable,
a decrease in 1998 inventories compared to an increase in 1997 and increases
in 1998 income taxes receivable and accrued expenses compared to decreases in
1997. The net loss of $76.9 million for 1998 decreased to a net loss of $47.2
million for 1999. This decrease was primarily due to decreases in research and
development expenses, selling, general and administrative expenses,
amortization and write-downs of intangible assets, the settlement charge, the
restructuring charges, interest expense and the extraordinary loss, partially
offset by a decrease in net sales and related gross margin. The net loss of
$5.5 million for 1997 increased to a net loss of $76.9 million for 1998. This
increase was primarily due to decreased net sales, lower gross profit margins,
the restructuring charges, the settlement charge, increased interest expense
and the extraordinary loss partially offset by decreases in research and
development and selling, general and administrative expenses. See Selected
Consolidated Financial Data.

  The Company believes that period-to-period comparisons of its results of
operations are not necessarily meaningful and should not be relied upon as
indicators of future performance. Quarterly results in the future may
fluctuate due to the factors discussed above or other factors.

                                      32
<PAGE>

Results of Operations

  The following tables set forth for the periods indicated certain
consolidated statement of operations data in dollars, as well as such data
expressed as a percentage of net sales:
<TABLE>
<CAPTION>
                                               Year Ended December 31,
                                              ------------------------------
                                                1997       1998       1999
                                                    (in thousands)
<S>                                           <C>        <C>        <C>
Consolidated Statement of Operations Data:
Net sales.................................... $184,660   $104,994   $ 38,068
Cost of sales................................  101,294     93,168     33,631
                                              --------   --------   --------
 Gross profit................................   83,366     11,826      4,437
Operating expenses:
 Research and development....................   43,572     33,329     23,366
 Selling, general and administrative.........   22,968     17,370     11,047
 Amortization and write-downs of
  intangibles................................   14,591      3,460      1,400
 Settlement charge...........................       --      5,872         --
 Restructuring charge........................       --      4,184      3,091
                                              --------   --------   --------
Income (loss) from operations................    2,235    (52,389)   (34,467)
Interest expense.............................   11,573     14,456     13,809
Other (income) expense -- net................      474       (339)    (1,074)
                                              --------   --------   --------
Loss before income taxes and extraordinary
 items.......................................   (9,812)   (66,506)   (47,202)
Income tax (benefit) expense.................   (4,268)     9,000         --
                                              --------   --------   --------
Loss before extraordinary items..............   (5,544)   (75,506)   (47,202)
Extraordinary loss, net of income taxes......       --     (1,345)        --
                                              --------   --------   --------
Net loss..................................... $ (5,544)  $(76,851)  $(47,202)
                                              ========   ========   ========
Other Data:
Cash used for operating activities........... $ (6,392)  $(11,962)  $(13,063)
Cash provided by (used for) investing
 activities..................................  (17,169)    10,156     (1,453)
Cash provided by (used for) financing
 activities..................................   23,883     23,478     (1,302)
EBITDA(1)....................................   24,107    (40,333)   (24,369)
<CAPTION>
                                               Year Ended December 31,
                                              ------------------------------
                                                1997       1998       1999
<S>                                           <C>        <C>        <C>
Consolidated Statement of Operations Data:
Net sales....................................    100.0 %    100.0 %    100.0 %
Cost of sales................................     54.9       88.7       88.3
                                              --------   --------   --------
 Gross profit................................     45.1       11.3       11.7
Operating expenses:
 Research and development....................     23.6       31.7       61.4
 Selling, general and administrative.........     12.4       16.5       29.0
 Amortization and write-downs of
  intangibles................................      7.9        3.3        3.7
 Settlement charge...........................       --        5.6         --
 Restructuring charge........................       --        4.0        8.1
                                              --------   --------   --------
Income (loss) from operations................      1.2      (49.8)     (90.5)
Interest expense.............................      6.3       13.8       36.3
Other (income) expense -- net................      0.3       (0.3)      (2.8)
                                              --------   --------   --------
Loss before income taxes and extraordinary
 items.......................................     (5.4)     (63.3)    (124.0)
Income tax (benefit) expense.................     (2.3)       8.6         --
                                              --------   --------   --------
Loss before extraordinary items..............     (3.1)     (71.9)    (124.0)
Extraordinary loss, net of income taxes......       --       (1.3)        --
                                              --------   --------   --------
Net loss.....................................     (3.1)     (73.2)    (124.0)
                                              ========   ========   ========
Other Data:
Cash used for operating activities...........     (3.5)%    (11.4)%    (34.3)%
Cash provided by (used for) investing
 activities..................................     (9.3)       9.7       (3.8)
Cash provided by (used for) financing
 activities..................................     12.9       22.4       (3.4)
EBITDA(1)....................................     13.1      (38.4)     (64.0)
</TABLE>
---------
  (1) See "Selected Consolidated Financial Data" for definition of and caveats
regarding EBITDA.

                                      33
<PAGE>

 Net Sales

  Net sales consist primarily of revenue from sales of the Company's process
and production-test equipment and related upgrades, and to a lesser extent,
parts and services. Net sales decreased 63.7% from $105.0 million for 1998 to
$38.1 million for 1999 and 43.2% from $184.7 million for 1997 to $105.0
million for 1998. These decreases were primarily due to decreased unit sales
of the Company's products due to the adverse market conditions previously
mentioned.

 Gross Profit

  Cost of sales includes material costs, direct labor and overhead costs
related to the production and delivery of the Company's products, including
warranty and other service costs. Gross profit decreased from $11.8 million
for 1998 to $4.4 million for 1999. Gross profit as a percentage of net sales
("gross margin") increased from 11.3% for 1998 to 11.7% for 1999. This
percentage increase was primarily due to decreases in personnel costs as a
result of workforce reductions in June, July and October 1999 and an inventory
write-down of $5.0 million in 1999 as compared to $19.8 million in 1998,
partially offset by higher costs resulting from lower production volumes and
underutilization of manufacturing capacity.

  Gross profit decreased from $83.4 million for 1997 to $11.8 million for
1998. Gross margin decreased from 45.1% for 1997 to 11.3% for 1998. The
decrease was primarily due to (1) lower gross profit on products shipped in
connection with the Settlement Agreement discussed below, (2) two other
customer contracts involving lower than average sales prices which also
negatively impacted the Company's gross profit, (3) underutilization of
manufacturing capacity, (4) higher costs resulting from lower production
volumes, and (5) $19.8 million of inventory write-offs recorded in 1998 as a
result of adverse market conditions in the data storage industry and its
impact on the Company's operations, partially offset by decreases in personnel
costs as a result of workforce reductions in August 1997, and January, June
and November 1998. See "Restructuring Charge" below.

  In April 1998, the Company entered into an agreement (the "Settlement
Agreement") to reimburse a major customer for costs incurred in connection
with the customer's cancellation of a contract with a third party to purchase
upgrades to certain production test equipment originally purchased from the
Company. The Company took this action to protect its intellectual property and
preserve a valued customer relationship. The Company concluded that such
actions were necessary in order to discourage further unauthorized use of its
intellectual property in the future by this or other third parties. The
Company recorded a $5.9 million charge to earnings in the second quarter of
1998 in connection with the Settlement Agreement. The Company made the
reimbursement provided for under the Settlement Agreement by providing a
credit to the customer for products purchased by the customer. Products
purchased under the Settlement Agreement were at favorable pricing which
negatively impacted the Company's gross profit margin in 1998 and the first
quarter of 1999.

  The Company is unable to control with any degree of certainty its product
sales volume, linearity or mix from period to period and therefore the
Company's gross margin in future periods may fluctuate from those achieved in
past periods. In any period when the Company experiences an unfavorable
product sales volume, linearity or mix and/or provides significant volume
pricing discounts, the Company's gross margin may decrease.

 Research and Development Expense

  Research and development expense consists primarily of salaries and related
costs of personnel and contract labor, project materials and other costs
associated with the Company's ongoing research and product development.
Research and development expense decreased from $33.3 million for 1998 to
$23.4 million for 1999 and from $43.6 million for 1997 to $33.3 million for
1998. Research and development expense as a percentage of net sales increased
from 31.7% for 1998 to 61.4% for 1999 and from 23.6% for 1997 to 31.7% for
1998. These percentage increases were primarily due to the decreases in net
sales, partially offset by a decrease in personnel costs as a result of
workforce reductions in 1998 and 1999. The Company anticipates that it will
continue to devote a significant amount of financial resources to research and
development for the foreseeable future.

                                      34
<PAGE>

 Selling, General and Administrative Expense

  Selling, general and administrative expense primarily consists of salaries
and related personnel costs, including certain acquisition related earnout
costs incurred in connection with certain of the Company's acquisitions. See
Note 10 of Notes to Consolidated Financial Statements. Selling, general and
administrative expense decreased from $17.4 million in 1998 to $11.0 million
in 1999 and from $23.0 million for 1997 to $17.4 million for 1998. Selling,
general and administrative expense as a percentage of net sales increased from
16.5% for 1998 to 29.0% for 1999 and from 12.4% for 1997 to 16.5% for 1998.
The percentage increases were primarily due to a decrease in net sales,
partially offset by a decrease in personnel costs as a result of workforce
reductions in 1998 and 1999.

 Amortization and Write-Downs of Intangibles

  Amortization and write-downs of intangibles primarily consist of the
amortization of intangible assets, including intangible assets acquired in
connection with the acquisitions of ProQuip, Cambrian, Helios, ART and ABI
(principally purchased technology and covenants not to compete) and write-
downs related to the impairment of such assets. See Notes 1 and 2 of Notes to
Consolidated Financial Statements.

  Amortization and write-downs of intangible assets decreased from $3.5
million for 1998 to $1.4 million for 1999. This decrease was due to more
intangible assets becoming fully amortized prior to or during 1999 offset by
an impairment charge recorded for a non-compete agreement in connection with
one of the Company's acquisitions. The write down in 1999 was due to the
discontinued sale of products acquired in connection with SBM.

  Amortization and write downs of intangible assets decreased from $14.6
million for 1997 to $3.5 million for 1998. This decrease was due to more
intangible assets becoming fully amortized prior to or during 1998 offset by a
write down to fair value of $2.0 million in 1997 related to impairment of
certain intangible assets recorded in connection with ABI.

 Settlement Charge

  In connection with the Settlement Agreement, discussed under "Results of
Operations -- Gross Profit," the Company recorded a $5.9 million charge to
earnings in the second quarter of 1998.

 Restructuring Charge

  The data storage industry has experienced intense competition, pricing
erosion and overcapacity. Such adverse market conditions have resulted, and
may in the future result, in the delay, reschedule or cancellation of orders
and fluctuation in demand for the Company's products. These adverse market
conditions have had a material adverse effect on the Company's results of
operations and financial condition over the last several quarters and are
expected to continue through 2000. In June 1998, the Company implemented a
workforce reduction of approximately 155 employees, relocated and consolidated
much of its Concord, California operations to its Fremont, California facility
and consolidated its San Diego facility. In November 1998, the Company reduced
its workforce by approximately 60 employees and consolidated further its
Fremont, California facilities. In the second quarter of 1999, the Company
consolidated a significant portion of its Fremont facilities, and in July
1999, implemented a workforce reduction of approximately 25 employees. Due to
the continued effects of the adverse market conditions in the data storage
industry, in the fourth quarter of 1999, the Company further consolidated its
Fremont facilities and implemented a workforce reduction of approximately
24 employees.

  In the second quarter of 1998, the Company recorded $3.0 million of
restructuring charges. The significant components included $0.9 million for
employee severance costs, $2.0 million in asset impairment costs related to
property, plant and equipment obsoleted due to restructuring activities, and
$0.1 million of other costs. In the fourth quarter of 1998, the Company
recorded $1.1 million of restructuring charges. The significant components
were $0.3 million for employee severance costs, $0.6 million in impairment
costs related to property, plant and

                                      35
<PAGE>

equipment obsoleted due to restructuring activities and $0.2 million of other
costs. In the second quarter of 1999, the Company recorded $2.0 million of
restructuring charges. The significant components included $0.7 million for
future lease costs of consolidated facilities and $1.3 million in asset
impairment costs related to facilities consolidation. In the fourth quarter of
1999, the Company recorded a restructuring charge of $1.1 million. The
significant components included $0.6 million for employee severance costs,
$0.4 million for future lease costs of consolidated facilities and $0.1
million in asset impairment costs related to facilities consolidation. As of
December 31, 1999, $1.3 million was recorded as an accrued liability related
to the restructuring activities.

 Interest Expense

  Interest expense decreased from $14.5 million for 1998 to $13.8 million for
1999. This decrease is primarily related to outstanding debt under a credit
facility which was paid in full during 1998.

  Interest expense increased from $11.6 million for 1997 to $14.5 million for
1998. This increase primarily reflects the increased debt levels outstanding
and higher interest rates during 1998.

 Income Taxes

  Income tax expense (benefit) was $(4.3) million for 1997, $9.0 million for
1998 and none in 1999.

  For 1997, the effective income tax rates differed from the applicable
statutory rates due primarily to state income taxes and utilization of income
tax credits available for research and development expenses. For 1998, the
effective income tax rate differed from the applicable statutory rate due
primarily to the valuation allowance against the Company's entire deferred tax
asset balance. Such charge was taken due to uncertainty regarding realization
of the deferred tax asset, due to the significant loss incurred in 1998 and
uncertainty regarding future taxable income.

 Extraordinary Items

  Extraordinary loss, net of income taxes, was $1.3 million for 1998, and
consisted of the write-off of unamortized debt issuance costs in connection
with the January and August 1998 repayments of debt outstanding under the
Company's then-existing credit agreements.

 Cash Flow from Operating Activities

  Cash flow from operating activities is computed based on net income (loss)
plus depreciation, amortization and write-downs of intangible assets, certain
other non-cash charges, purchased in-process research and development costs
and changes in certain assets and liabilities.

  Cash used for operating activities was $12.0 million for 1998 and $13.1
million for 1999. Period to period fluctuations in operations impacting these
amounts were the net losses for 1998 and 1999 a decrease in amortization and
write-downs of intangible assets, a decrease in deferred income tax assets in
1998, decreases in accounts receivable and inventories, an increase in 1998
income taxes receivable compared to a decrease in 1999 and decreases in
accrued expenses.

  Cash used for operating activities was $6.4 million for 1997 and
$12.0 million for 1998. Period to period fluctuations in operations impacting
these amounts were the net losses for 1997 and 1998, a decrease in
amortization and write downs of intangible assets, a decrease in deferred
income tax assets, a smaller increase period to period in accounts receivable,
a decrease in 1998 inventories compared to an increase in 1997 and increases
in 1998 income taxes receivable and accrued expenses compared to decreases in
1997.

 EBITDA

  EBITDA represents income (loss) from operations before depreciation and
amortization and write-downs of intangible assets. EBITDA is presented because
management believes EBITDA is a commonly accepted financial indicator used by
certain investors and analysts to analyze and compare companies on the basis
of operating

                                      36
<PAGE>

performance. EBITDA is not intended to represent cash flows for the period,
nor has it been presented as an alternative to operating income (loss) as an
indicator of operating performance and should not be considered in isolation
or as a substitute for measures of performance prepared in accordance with
generally accepted accounting principles.

  The Company had EBITDA of $(40.3) million for 1998 compared to $(24.4)
million in 1999. This increase was primarily due to decreases in research and
development expenses, selling, general and administrative expenses,
amortization and write-downs of intangible assets, the settlement charge and
the restructuring charges, partially offset by a decrease in net sales and
cost of sales.

  The Company had EBITDA of $24.1 million for 1997 compared to $(40.3) million
for 1998. This decrease was primarily due to decreased net sales, lower gross
margins, the settlement charge and the restructuring charges, partially offset
by decreases in research and development and selling, general and
administrative expenses.

Liquidity and Capital Resources

  The Company has financed its capital requirements through sales of Common
and Preferred Stock, and borrowings under the Notes and subordinated, term and
revolving credit facilities. The Company's principal requirements for cash are
debt service requirements, capital expenditures and working capital.

  As of December 31, 1999, the Company's outstanding indebtedness included
$106.2 million under the Notes, $8.0 million under its Convertible
Subordinated Notes and $1.5 million of capital lease obligations. At December
31, 1999, the Company had $8.1 million of accrued interest on indebtedness
outstanding on the Convertible Subordinated Notes. The Convertible
Subordinated Notes (including all accrued interest thereon) are convertible
into 5,142,720 shares of Common Stock at the option of the holders thereof and
will automatically convert upon the consummation of an initial public offering
of the Company's Common Stock. As of the date of this filing, the Company does
not have a working capital credit facility in place.

  The Company was unable to make the interest payment on the Notes due on
February 1, 2000 and is not in compliance with certain covenants of the Notes
and the Indenture governing the Notes. On April 26, 2000, the Company
announced that it had entered into an agreement in principle with an informal
committee representing approximately 81% of Noteholders to restructure the
Notes. Under the restructuring, the $110.0 million principal amount of Notes,
plus accrued interest, would be exchanged for New Common Stock representing
97.5% of the Company's outstanding common stock after the restructuring.
Holders of the existing Senior Subordinated Convertible Notes, existing Series
A, B and C Preferred Stock and existing Common Stock would receive the
remaining 2.5% of New Common Stock, as well as warrants to purchase additional
shares representing up to 10% of the Company's then outstanding New Common
Stock upon certain circumstances. The restructuring will not in any way affect
the Company's obligation to pay its trade creditors or other vendors. The
agreement in principle is subject to a number of customary conditions. In
addition, holders of all or some of the Notes will provide the Company with a
$10.0 million New Credit Facility in conjunction with the restructuring. The
New Credit Facility will be secured by a pledge of substantially all of the
Company's assets other than certain secured assets and customer deposits. The
commitment to provide the New Credit Facility is subject to a number of
customary conditions. There is no assurance that the proposed restructuring
will be completed as described above or at all.

  The accompanying financial statements do not purport to reflect or provide
for the consequences of the proposed restructuring.

  Cash provided by (used for) investing activities was $10.2 million for 1998
and $(1.5) million for 1999. In 1998, the amount consisted primarily of
proceeds from the sale of property, plant and equipment partially offset by
cash used in connection with purchases of property, plant and equipment. In
1999, the amount consisted of cash used in connection with purchases of
property, plant and equipment. Cash provided by (used for) financing
activities was $23.5 million for 1998 and $(1.3) million for 1999. In 1998,
the amount consisted primarily of the net proceeds from issuance of the Notes,
net of repayment of borrowings under the Company's previous term notes and
revolving loans, as well as the issuance of the Series C Preferred Stock. In
1999, the amount related primarily to payments on capital lease obligations.

                                      37
<PAGE>

  The Company plans approximately $0.4 million in capital expenditures during
the next 12 months. The Company has no material outstanding commitments with
respect to such planned expenditures as of the date of this filing.

  The Company's non-United States subsidiaries (the "Non-Guarantor
Subsidiaries"), have not guaranteed the Company's obligations under the Notes.
As of and for the year ended December 31, 1999, the operating results and
assets of the Non-Guarantor Subsidiaries were material to our results of
operations and assets on a consolidated basis, net of intercompany
eliminations. See Note 14 of Notes to Consolidated Financial Statements. The
total assets, total liabilities, net sales and net income (loss) of the Non-
Guarantor Subsidiaries as a percentage of the Company's consolidated total
assets, total liabilities, net sales and net income (loss) as of and for the
year ended December 31, 1998, were 6.7%, 0.5%, 11.1% and 0.0%, respectively
and as of and for the year ended December 31, 1999 were 14.8%, 0.2%, 18.9% and
4.2%, respectively. The financial statements of the Company's foreign
subsidiaries are measured using the local currency as the functional currency.
The Company has not historically experienced material gains or losses
resulting from currency exchange rate fluctuations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate and Investment Risk

  The Company's exposure to fluctuations in interest rates and market values
of its investments relates primarily to the Company's short-term investment
portfolio, which is included in cash and cash equivalents. The Company has not
used derivative financial instruments in its investment portfolio. The Company
invests its excess cash in debt instruments of the U.S. Government and its
agencies, and in high-quality corporate issuers and, by policy, limits the
amount of credit exposure to any one issuer. The Company protects and
preserves its invested funds by limiting default, market and reinvestment
risk. However, due to the short-term nature of the Company's investments, the
impact of interest rate changes would not have a material impact on the value
of such investments. The effect of interest rate and investment risk on the
Company has not been material.

  Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. Fixed rate securities may
have their fair market value adversely impacted due to a rise in interest
rates, while floating rate securities may produce less income than expected if
interest rates fall. Due in part to these factors, the Company's future
investment income may fall short of expectations due to changes in interest
rates or the Company may suffer losses in principal if forced to sell
securities which have declined in market value due to changes in interest
rates.

  The Company is also exposed to interest rate risk on its fixed rate debt
obligations. At December 31, 1999, fixed rate debt obligations totaled $114.2
million. The fixed rate debt obligations bear interest at a weighted average
annual rate of 10.7%, and maturities are $1.5 million, $0.4 million, $0.1
million and $110 million in 2000, 2001, 2002 and 2005, respectively. While
generally an increase in market interest rates will decrease the value of this
debt, and decreases in rates will have the opposite effect, the Company is
unable to estimate the impact that interest rate changes will have on the
value of the substantial majority of this debt as there is no active public
market for the debt and the Company is unable to determine the market interest
rate at which alternate financing would have been available at December 31,
1999.

Foreign Currency Risk

  International sales are made primarily by the Company's domestic operations
and are typically denominated in the U.S. dollar, although pricing is
influenced by competitors operating in related foreign currencies. The
currency denominations of international sales made by the Company's foreign
sales and service subsidiaries vary by country and customer, but are generally
the U.S. dollar. These foreign subsidiaries purchase most service and resale
parts, denominated in U.S. dollars, from the Company's U.S. operations. These
foreign subsidiaries incur

                                      38
<PAGE>

most of their operating expenses in the local currencies. All foreign
subsidiaries use the local currency as their functional currency. The effect
of foreign currency exchange rate fluctuations on the Company has not been
material. Net assets and revenues denominated in currencies other than the
U.S. dollar have been greater than 10% of total Company net assets and
revenues. A 10% change in the foreign currency exchange rates may have have a
material impact on the Company's results of operations.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

  Phase Metrics' financial statements, schedules and supplementary data, as
listed under Item 14, appear in a separate section of this Report beginning on
page F-2.

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

  Not applicable.

                                      39
<PAGE>

                                   PART III.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors, Executive Officers and Key Employees

  Set forth below is certain information regarding the directors and executive
officers of the Company as of April 30, 2000.

<TABLE>
<S>                    <C> <C>
        Name           Age                     Position
John F. Schaefer.....  57  Chairman of the Board, President and Chief
                           Executive Officer

Thomas D. Carr.......  42  Vice President, Product Development, Head
                           Products

James E. Furman......  61  Vice President, Operations, Disk Drive
                           and Media Products

W. Dewey Hockemeyer..  36  Vice President, Finance, Chief Financial Officer
                           and Assistant Secretary

Jason Lee............  36  Vice President, Sales and Marketing, Head
                           Products

Ronald Y. Miyahara...  50  Vice President and General Manager, Asia
                           Operations

Michael G. Rogowski..  46  Vice President, Sales and Marketing, Disk
                           Drive and Media Products

Dr. Jun Zhu..........  33  Vice President, Product Development,
                           Disk Drive and Media Products

Dr. Gilbert F.
 Amelio(1)...........  55  Director

William E. Terry(1)..  66  Director

</TABLE>

--------
(1) Member of Compensation Committee and Audit Committee

  John F. Schaefer has been Chairman of the Board and Chief Executive Officer
since November 1994 and President since February 1997. From 1992 to 1994, Mr.
Schaefer was President, Chief Operating Officer and Director of McGaw
Incorporated, a provider of intravenous products and devices. From 1989 to
1991, Mr. Schaefer was President, Chief Executive Officer and Director of
Levolor Corporation ("Levolor"), a manufacturer of window blinds and similar
products. Prior to joining Levolor in 1989, Mr. Schaefer was employed by Baker
Hughes, Inc., where he was President of the Process Equipment Group, Executive
Vice President of the Corporation, and a Director.

  Thomas D. Carr became Vice President, Product Development, Head Products in
June 1999. Mr. Carr was a Director of Head Product Development from June 1998
until June 1999. From October 1996 to June 1998, he was a project manager for
the Company. From 1990 to 1996, Mr. Carr was employed as laboratory head of
Advanced Systems Laboratory. From 1984 to 1990, Mr. Carr served in various
research scientist positions with Eastman Kodak.

                                      40
<PAGE>

  James E. Furman became Vice President, Operations, Disk Drive and Media
Products in October 1999. Prior to that Mr. Furman held the Director of
Materials and Director of Operations and Customer Engineering positions from
September 1997 to October 1999. From 1991 to 1995 Mr. Furman was the President
of ECO Resources, a professional water and wastewater management company with
operations in five southwestern states. From 1970 to 1995 Mr. Furman held
various senior management positions in the Process Equipment Group of Baker
Hughes, Inc.

  W. Dewey Hockemeyer became Vice President, Finance, Chief Financial Officer
and Assistant Secretary in June, 1999. Mr. Hockemeyer previously held the
Corporate Controller position since joining Phase Metrics in April, 1995. From
1986 to 1994, Mr. Hockemeyer held manager and other positions with Ernst &
Young LLP.

  Jason Lee became Vice President, Sales and Marketing, Head Products in
January 2000. Prior to that he was Vice President, Operations, Head Products
from October 1999 to January 2000 and Product Marketing Manager from 1997 to
October 1999. From 1992 to 1997, Mr. Lee served as a Product Marketing
Engineer and Product Manager at Applied Materials Corporation. Mr. Lee also
served as Process Engineer and Product Marketing Engineer with NCR Corporation
from 1986 to 1992.

  Ronald Y. Miyahara has been Vice President and General Manager, Asia
Operations for the Company since November 1995, having previously served as
Vice President, Operations from November 1994 through October 1995. Mr.
Miyahara previously served as President of ProQuip, Inc., a supplier of
advanced process and production-test equipment for disk manufacturers, which
the Company acquired in November 1994. Prior to the acquisition, Mr. Miyahara
served in various positions at ProQuip, Inc., including President and General
Manager from 1991 to 1994, Vice President of Operations from 1989 to 1991, and
Chief Financial Officer from 1984 to 1991.

  Michael G. Rogowski became Vice President, Sales and Marketing, Disk Drive
and Media Products in January 2000. Prior to that Mr. Rogowski was Vice
President, Operations, Disk Drive and Media Products since June 1998, Vice
President of Customer Engineering from April 1996 to June 1998 and held other
senior management positions since November 1994. Prior to joining the Company,
Mr. Rogowski was Vice President of Manufacturing/Test Engineering for Cambrian
Systems, Inc., a supplier of advanced process and production-test equipment
for disk and read/write head manufacturers, which the Company acquired in
November 1994. From 1992 to 1994, Mr. Rogowski was the Director of Test
Engineering at Akashic Memories. Between 1979 and 1992, Mr. Rogowski held
various positions in engineering and management in the Mechanical Integration,
Test Equipment Development, and Manufacturing Test Engineering organizations
within IBM Corporation.

  Dr. Jun Zhu became Vice President, Product Development, Disk Drive and Media
Products in June 1999. Dr. Zhu was Vice President, Product Development, Head
Products from June 1997 to June 1998 and Director, Quasistatic Products from
June 1997 until June 1998. From September 1996 to June 1997, he was a project
manager for the Company. From June 1993 to September 1996, Dr. Zhu was
employed by Read-Rite Corporation in various engineering capacities.

                                      41
<PAGE>

  Dr. Gilbert F. Amelio has been a Director of the Company since June 1995.
From 1994 until July 1997, Dr. Amelio served as a Director of Apple Computer,
Inc. ("Apple") and from February 1996 until July 1997 he served as Chairman of
the Board and Chief Executive Officer of Apple. Prior to joining Apple, Dr.
Amelio was Chairman of the Board, President and Chief Executive Officer of
National Semiconductor Corporation for five years. Dr. Amelio is an IEEE
Fellow, holder of 16 patents and is the co-author of two books, "Profit from
Experience: The National Semiconductor Story of Transformation Management" and
"On the Firing Line: My 500 Days at Apple." Dr. Amelio is currently Partner
and Director of The Parkside Group, LLC and serves on the Board of Directors
of SBC Communications.

  William E. Terry has been a Director of the Company since August 1997. From
1986 until his retirement in November 1993, Mr. Terry served as Executive Vice
President and a Director of Hewlett-Packard. Prior to that, Mr. Terry served
in a number of other senior executive positions with Hewlett-Packard. Mr.
Terry currently serves on the Board of Directors of Keytronic Corporation and
Altera Corporation.

Board Committees

  The Board of Directors has a Compensation Committee which is responsible for
making determinations regarding salaries, bonuses and other compensation
matters for the Company's executive officers. The members of the Compensation
Committee are Messrs. Amelio and Terry. Neither of these individuals were at
any time during 1999 an officer or employee of the Company.

  The Board of Directors also has an Audit Committee which supervises and
makes recommendations and decisions with respect to the periodic audits of the
Company's financial results. The members of the Audit Committee are Messrs.
Amelio and Terry.

Director Compensation

  Except as described below, the directors do not receive cash compensation
for services on the Board of Directors or any committee thereof.

  Dr. Amelio and Mr. Terry are each paid a retainer by the Company of $1,000
per month for their services on the Board of Directors. Dr. Amelio and Mr.
Terry also each receive $1,000 for each meeting of the Board of Directors or
committee thereof that they attend. In addition, the Company granted Dr.
Amelio an option to purchase 100,000 shares of common stock under the 1995
Option Plan at an exercise price of $1.00 per share when he joined the Board
in June 1995 and Mr. Terry was granted an option to purchase 50,000 shares of
common stock under the 1995 Option Plan at an exercise price of $8.75 per
share when he joined the Board in August 1997. In August 1998, Mr. Terry was
granted an option to purchase an additional 50,000 shares of common stock at
an exercise price of $3.75 per share. These options are immediately
exercisable for all the option shares, but any shares purchased under the
option will be subject to repurchase by the Company at the option exercise
price paid per share if Dr. Amelio or Mr. Terry cease serving on the Board
prior to vesting in

                                      42
<PAGE>

their respective shares. As of February 29, 2000, Dr. Amelio had vested in
93,333 option shares and Mr. Terry had vested in 40,833 option shares. Dr.
Amelio and Mr. Terry will vest in their remaining option shares, as long as
they remain members of the Board, in a series of successive equal monthly
installments upon completion of each additional month of Board service. The
vesting period for the options granted to Dr. Amelio and Mr. Terry is five
years.

  Prior to his resignation as Director of the Company in April 2000, Art
Cormier provided consulting services to the Company under an arrangement which
provided for payment of $1,500 per day plus expenses when consulting services
were provided, including attendance at Company meetings and technical
conferences. Under the consulting arrangement, Mr. Cormier also received an
office and clerical assistance at the Company's facilities, and his family
received health care insurance coverage.

  All non-employee Board members are reimbursed for their out-of-pocket
expenses incurred in connection with serving on the Board of Directors.

ITEM 11. EXECUTIVE COMPENSATION

  The following table sets forth certain summary information concerning the
compensation earned in 1998 and 1999 by the Company's Chief Executive Officer
and its four other most highly compensated executive officers (the "Named
Executive Officers") whose total salary and bonus for 1999 exceeded $100,000,
for services rendered to the Company in all capacities during that year. No
executive who would otherwise have been includable in such table on the basis
of salary and bonus earned for 1999 has resigned or otherwise terminated
employment during 1999.

                          Summary Compensation Table
<TABLE>
<CAPTION>
                                                         Long Term
                                                        Compensation
                                                           Awards
                                                        ------------
                                 Annual Compensation     Securities
        Name and              -------------------------  Underlying     All Other
 Principal Position(s)   Year  Salary   Bonus  Other(1)   Options    Compensation(2)

<S>                      <C>  <C>      <C>     <C>      <C>          <C>
John F. Schaefer........ 1998 $314,615      --      --       --          $5,000
 Chairman and Chief
  Executive Officer      1999  305,000      --      --       --           5,000

David L. Bultman(3)..... 1998  250,962 201,708   3,818       --           3,358
 Vice President, General
  Manager, Product       1999  296,154      --   3,970       --           4,471
 Development, Disk Drive
  and Media Products

Wayne G. Erickson(4).... 1998  207,692  11,200   1,921       --           2,762
 Vice President, Sales
  and Marketing,         1999  196,154      --   2,025       --           3,923
 Head Products and Vice
 President, Corporate
 Business Development

Ronald Y. Miyahara...... 1998  179,913 $14,553  $7,279       --           2,857
 Vice President and
  General                1999  173,250      --   7,223       --           2,901
 Manager, Asia
  Operations

Albert H.
 Munnikhuis(4).......... 1998  166,346  39,545   6,900       --           4,003
 Vice President, Sales
  and Marketing,         1999  204,149      --   7,800       --           3,678
 Disk Drive and Media
  Products

Michael G. Rogowski..... 1998  171,346  19,635   7,800       --           1,537
 Vice President, Sales
  and Marketing,         1999  179,438      --   7,800       --           1,854
 Disk Drive and Media
  Products

Dr. Jun Zhu............. 1998  129,770  32,983   3,900       --           3,255
 Vice President, Product
  Development,           1999  157,821      --      --       --           3,110
 Disk Drive and Media
  Products

</TABLE>

--------
(1) Includes the value of personal use of Company automobiles.
(2) Includes the Company's matching contribution under its 401(k) Plan.
(3) The Company reached an agreement for the termination of Mr. Bultman's
    full-time employment with the Company in June 1999.
(4) Mr. Erickson and Mr. Munnikhuis terminated employment with the Company in
    January 2000 and December 1999, respectively.

                                      43
<PAGE>

Stock Options and Stock Appreciate Rights

  The following table contains information concerning the stock options
granted to the Named Executive Officers during 1998 and 1999. All the grants
were made under the Company's 1995 Plan (as defined herein). No stock
appreciation rights were granted to the Named Executive Officers during 1998
or 1999.

<TABLE>
<CAPTION>
                                                          Individual
                                                          Grants(1)
                              ---------------------------------------------------------
                                                                                           Potential
                                                                                          Realization
                                                                                           Value at
                                                                                            Assumed
                                                                    Market              Annual Rates of
                                                                   Price of               Stock Price
                              Number of      Percent              Securities             Appreciation
                              Securities    of Total     Exercise Underlying              For Option
                              Underlying Options Granted  Price   Options on                Term(3)
                               Options   to Employees in   Per     Date of   Expiration ---------------
          Name           Year  Granted    1998 and 1999  Share(2)  Grant(2)     Date      5%      10%
          ----           ---- ---------- --------------- -------- ---------- ---------- ------- -------
<S>                      <C>  <C>        <C>             <C>      <C>        <C>        <C>     <C>
John F. Schaefer........ 1998       --          --           --        --          --        --      --
                         1999       --          --           --        --          --        --      --
David L. Bultman(4)..... 1998  125,000        10.6         3.75      3.75     7/30/08   294,794 747,067
                         1999       --          --           --        --          --        --      --
Wayne G. Erickson(5).... 1998       --          --           --        --          --        --      --
                         1999   18,000          .3         3.75      3.75     2/24/09    42,450 107,578
Ronald Y. Miyahara...... 1998       --          --           --        --          --        --      --
                         1999   18,000          .3%       $3.75     $3.75     2/24/09    42,450 107,578
Albert H.
 Munnikhuis(5).......... 1998   40,000         3.4         3.75      3.75     7/30/08    94,334 239,061
                         1999   18,000          .3         3.75      3.75     2/24/09    42,450 107,578
Michael G. Rogowski..... 1998       --          --           --        --          --        --      --
                         1999   18,000           3         3.75      3.75     2/24/09    42,450 107,578
Dr. Jun Zhu ............ 1998   70,000         5.9         3.75      3.75     7/30/08   165,085 418,357
                         1999       --          --           --        --          --        --      --
</TABLE>
--------
(1) Option grants are immediately exercisable for all the option shares, but
    any shares purchased under such option will be subject to repurchase until
    vested by the Company at the option exercise price paid per share.
(2) The exercise price is equal to the fair market value of the Common Stock
    on the date of grant, as determined by the Board of Directors taking into
    account a number of factors at the time of the grants, including, without
    limitation, the current status of the Company and its future prospects,
    the status of the disk drive industry, values of comparable companies and
    the appraisals of an independent, third-party appraiser engaged by the
    Company.
(3) There can be no assurance provided to any executive officer or other
    holder of the Company's securities that the actual stock price
    appreciation over the ten-year option term will be at the assumed 5% and
    10% levels or at any other defined level. Unless the market price of the
    Common Stock appreciates over the option term, no value will be realized
    from those option grants which were made to the Named Executive Officers
    with an exercise price equal to the fair market value of the option shares
    on the grant date.
(4) The Company reached an agreement for the termination of Mr. Bultman's
    full-time employment with the Company in June 1999.
(5) Mr. Erickson and Mr. Munnikhuis terminated employment with the Company in
    January 2000 and December 1999, respectively.

                                      44
<PAGE>

Aggregate Option Exercises in 1998 and 1999 and Year-End Values

  The following table provides information, with respect to each of the Named
Executive Officers, concerning the exercise of options during 1998 and 1999
and unexercised options held by them at the end of each of those fiscal years.
None of the Named Executive Officers exercised any options during 1998 or
1999.

<TABLE>
<CAPTION>
                                                                            Value of Unexercised
                                Number of Unexercised Options              In-the-Money Options at
                              at December 31, 1998 and 1999(#)        December 31, 1998 and 1999($)(1)
                              --------------------------------------  -----------------------------------
          Name           Year   Exercisable         Unexercisable       Exercisable      Unexercisable
          ----           ---- ---------------     ------------------  ---------------  ------------------
<S>                      <C>  <C>                 <C>                 <C>              <C>
John F. Schaefer........ 1998             --                     --               --                  --
                         1999             --                     --               --                  --
David L. Bultman(5)..... 1998          250,000(4)                --               --                  --
                         1999             --                     --               --                  --
Wayne G. Erickson(6).... 1998             --                     --               --                  --
                         1999           18,000(2)                --               --                  --
Ronald Y. Miyahara...... 1998             --                     --               --                  --
                         1999           18,000(2)                --               --                  --
Albert H.
 Munnikhuis(6).......... 1998           60,000(4)                --            $55,000                --
                         1999           18,000(2)                --               --                  --
Michael G. Rogowski..... 1998           --                      --                --                 --
                         1999           18,000(2)                --               --                  --
Dr. Jun Zhu............. 1998           70,000(3)               --                --                 --
                         1999             --                    --                --                 --
</TABLE>
--------
(1) Based upon the fair market values of $3.75 and $1.00 per share determined
    by the Board of Directors at December 31, 1998 and 1999, respectively,
    less the option exercise price (i.e., the fair market value of the Common
    Stock on the date of grant, as determined by the Board of Directors),
    payable per share. The Board of Directors takes into account a number of
    factors in determining fair market value, including, without limitation,
    the current status of the Company and its future prospects, the status of
    the data storage industry, values of comparable companies and the
    appraisals of an independent, third-party appraiser engaged by the
    Company.

(2) Although the options are fully exercisable, none had vested as of December
    31, 1999. The option shares issuable upon exercise of such options are,
    prior to vesting, subject to a right of repurchase in favor of the
    Company.

(3) Although the options are fully exercisable, only 19,833 options had vested
    as of December 31, 1999. The option shares issuable upon exercise of such
    options are, prior to vesting, subject to a right of repurchase in favor
    of the Company.

(4) These options were cancelled as of December 31, 1999.

(5) The Company reached an agreement for the termination of Mr. Bultman's
    full-time employment with the Company in June 1999.

(6) Mr. Erickson and Mr. Munnikhuis terminated employment with the Company in
    January 2000 and December 1999, respectively.

Compensation Committee Interlocks and Insider Participation

  The members of the Compensation Committee are Messrs. Amelio and Terry, none
of whom has been an officer or employee of the Company at any time since the
Company's inception. No executive officer of the Company serves as a member of
the Board of Directors or Compensation Committee of any entity which has one
or more executive officers serving as a member of the Company's Board of
Directors or Compensation Committee. Prior to the formation of the
Compensation Committee, the Board of Directors as a whole made decisions
relating to compensation of the Company's executive officers.

                                      45
<PAGE>

  Thompson Dean, a former Director of the Company, is a Managing Director of
DLJ Merchant Banking Partners, L.P., and Robert Finzi, a former Director of
the Company, is a General Partner of Sprout Group, both of which are
affiliates of DLJ. DLJ is a principal stockholder of the Company. In each of
1997 and 1998, the Company paid DLJ $200,000 in fees for financial advisory
and certain investment banking services provided to the Company. DLJ acted as
the Initial Purchaser in the Original Note Offering and received an
underwriting discount of $3.575 million in connection therewith. See "Security
Ownership of Certain Beneficial Owners and Management" and "Certain
Relationships and Related Transactions."

Compensation Plans and Arrangements

 Employment Contracts and Change in Control Arrangements

  In November 1994, the Company entered into an employment contract with Mr.
Schaefer providing for his employment as chief executive officer and chairman
of the Board of the Company. The employment contract is terminable at will by
either Mr. Schaefer or the Company upon 30-days notice. The employment
contract provides for an annual minimum base salary of $300,000. In addition,
beginning in 1996, Mr. Schaefer became eligible to receive a bonus under the
Company's bonus plan for officers. If the employment contract is terminated by
the Company for any reason other than for cause or by Mr. Schaefer due to
breach of the agreement or certain other actions by the Company, the Company
must pay Mr. Schaefer, in addition to all accrued and unpaid salary and
benefits, his salary and certain benefits for a period of 12 months from the
date of such termination. If the Company terminates Mr. Schaefer's employment
upon his permanent disability, subject to reduction for any insurance benefits
received, Mr. Schaefer is entitled to receive his salary and benefits for 12
months from the date of such termination.

  In connection with any change of control of the Company, subject to certain
limitations, outstanding options held by certain senior executive officers
will either immediately vest in full, or will subsequently vest in full upon
the involuntary termination of the individual's employment within 12 months
thereafter.

 Bonus Plan for Officers and Certain Key Employees

  The Company has an established bonus plan for officers and certain key
employees, including the Named Executive Officers. Payment of bonuses under
this plan is dependent on the Company achieving financial goals established
annually by the Compensation Committee, as well as the employee achieving
certain priorities as established by Company management. Bonus targets range
from a low of 10% of base salary for certain employees to a high of 50% of
base salary for the Chief Executive Officer. Employees can earn up to 150% of
their bonus targets, depending upon the performance of both the employee and
the Company.

 1995 Stock Option Plan

  The Company's 1995 Stock Option Plan (the "1995 Plan") became effective when
adopted by the Board of Directors (the "Board") and approved by the Company's
shareholders in April 1995. A total of 6,300,000 shares of common stock have
been authorized for issuance over the term of the 1995 Plan, subject to
adjustment in the event of any stock dividends, stock splits or other similar
changes affecting the Company's outstanding common stock.

  Employees (including officers), non-employee Board members and consultants
and other advisors in the service of the Company or any parent or subsidiary
company may, at the discretion of the Plan Administrator, be granted options
to purchase shares of common stock at an exercise price not less than 85% of
the fair market value per share on the grant date.

  The 1995 Plan is currently administered by the Board. However, the Board may
at any time delegate such administration to the Compensation Committee. The
Plan Administrator (whether the Board or such committee) has complete
discretion to determine which eligible persons are to receive option grants,
the time or times when

                                      46
<PAGE>

such grants are to be made, the number of shares subject to each such grant,
the status of an option as either an incentive stock option or a non-statutory
stock option under the federal tax laws, the vesting or exercise schedule in
effect for the option and the maximum term for which any option will remain
outstanding. No option granted under the 1995 Plan may have a term in excess
of 10 years and will be subject to earlier termination following the
optionee's cessation of service with the Company.

  Option grants under the 1995 Plan may either become exercisable for the
option shares in a series of installments over the optionee's period of
service with the Company or may be immediately exercisable for all the option
shares, but any shares purchased under such an immediately exercisable option
will be subject to repurchase by the Company, at the option exercise price
paid per share, should the optionee leave the Company's service prior to
vesting in those shares. The Company will also have a right of first refusal
with respect to any proposed sales or transfers of the shares of common stock
issued under the 1995 Plan. Accordingly, the Company will have the opportunity
to match any third-party offer to acquire those shares. However, all first
refusal rights under the 1995 Plan will terminate in the event the Company's
common stock is publicly held.

  The option exercise price will normally be payable in cash at the time of
exercise. However, the Plan Administrator may allow the optionee to deliver a
promissory note in payment of the exercise price and any withholding taxes
incurred in connection with the exercise. Any such note will bear interest at
the minimum rate required under the federal tax laws and will be secured by
the purchased shares. Following an initial public offering of the common
stock, the exercise price may be paid in shares of common stock valued at fair
market value or through a cashless exercise procedure pursuant to which the
purchased option shares are sold immediately and a portion of the sale
proceeds equal to the option exercise price for those shares are remitted to
the Company.

  Should the Company be acquired by merger or asset sale, all outstanding
options will immediately vest in full, except to the extent those options are
assumed by the successor entity. In the event the price payable per share of
common stock in the acquisition (determined on a fully-diluted basis) is at
least $7.00, the shares subject to the outstanding options under the 1995 Plan
will, whether or not those options are to be assumed by the successor entity,
vest for some option holders immediately upon such acquisition and will vest
for the remaining option holders upon the subsequent termination of their
service with the Company or the successor entity within 18 months following
such acquisition.

  As of December 31, 1999, options to purchase up to 1,754,369 shares of
common stock were outstanding under the 1995 Plan, options for 1,455,839
shares had been exercised, net of repurchases, and 3,089,792 shares of common
stock were available for future option grant. To the extent any outstanding
options terminate or expire unexercised, the shares of common stock subject to
those options will be available for subsequent option grants.

  The Plan Administrator has the authority to effect the cancellation of
outstanding options under the 1995 Plan in return for the grant of new options
for the same or a different number of option shares with an exercise price per
share based upon the fair market value of the common stock on the new grant
date.

  The Board may amend or modify the 1995 Plan at any time. The 1995 Plan will
terminate on April 1, 2005, unless sooner terminated by the Board.

                                      47
<PAGE>

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The following table sets forth certain information regarding beneficial
ownership of Phase Metrics' common stock as of December 31, 1999, by (1) each
person or group of affiliated persons known by Phase Metrics to own
beneficially more than 5% of the outstanding shares of Phase Metrics' common
stock, (2) the Named Executive Officers, (3) each of Phase Metrics' directors,
and (4) all directors and executive officers of Phase Metrics as a group.
Unless otherwise indicated, the address for each of the following stockholders
is 10260 Sorrento Valley Road, San Diego, California 92121.

<TABLE>
<CAPTION>
                               Common           Series A          Series B          Series C
                              Stock(2)        Preferred(3)      Preferred(4)      Preferred(5)         Total(6)
                          ----------------- ----------------- ----------------- ----------------- ------------------
  Beneficial Owner(1)      Number   Percent  Number   Percent  Number   Percent  Number   Percent   Number   Percent
<S>                       <C>       <C>     <C>       <C>     <C>       <C>     <C>       <C>     <C>        <C>
DLJ and the Sprout
 Entities(7)............  5,942,720  51.4%  2,000,000  24.2%  3,857,280  100.0% 2,500,000  32.9%  14,300,000  36.7%
Arthur J. Cormier(8)....         --    --   4,500,000  54.5          --     --         --    --    4,500,000  13.6
John F. Schaefer(9).....  2,750,000  49.0   1,750,000  21.2          --     --         --    --    4,500,000  13.6
ABS Capital Partners II,
 L.P.(10)...............                           --    --          --     --  5,000,000  65.7    5,000,000  15.1
Neil A. Brumberger(11)..    410,000   7.3          --    --          --     --         --    --      410,000   1.2
Wayne G. Erickson(12)...    318,000   5.7          --    --          --     --         --    --      318,000   1.0
Ronald Y. Miyahara(13)..    118,000   2.1          --    --          --     --         --    --      118,000     *
Michael E.
 Rogowski(14)...........    118,000   2.1          --    --          --     --         --    --      118,000     *
Dr. Gilbert F.
 Amelio(15).............    100,000   1.8          --    --          --     --    100,000   1.3      200,000     *
William E. Terry(16)....    100,000   1.8          --    --          --     --     10,000     *      110,000     *
Dr. Jun Zhu(17).........     90,000   1.6          --    --          --     --         --    --       90,000     *
Albert H.
 Munnikhuis(18).........     30,000     *          --    --          --     --         --    --       30,000     *
David L. Bultman(19)....         --    --          --    --          --     --         --    --           --     *
All directors and
 executive officers as a
 group (12 persons)
 (20)...................  3,876,100  61.6   6,250,000  75.8          --     --    110,000   1.4   10,236,100  30.4
</TABLE>
-------
 * Less than one percent.

 (1) Except as indicated by footnote, the Company understands that the persons
     named in the table above have sole voting and investment power with
     respect to all shares shown as beneficially owned by them, subject to
     community property laws where applicable.

 (2) Reflects the beneficial ownership of the Company's common stock, assuming
     the conversion of the Convertible Subordinated Notes and the Bridge Note
     Warrants. Shares of common stock subject to options, warrants or notes
     which are currently exercisable or exercisable within 60 days of December
     31, 1999, are deemed outstanding for computing the percentages of the
     person holding such options, warrants or notes, but are not deemed
     outstanding for computing the percentages of any other person. Percentage
     ownership is based on 5,609,839 shares of common stock outstanding as of
     December 31, 1999.

 (3) The number of shares reflects the number of shares of common stock in the
     aggregate issuable upon the conversion of the Series A Preferred Stock
     held by each person. Each share of Series A Preferred Stock is
     convertible into one share of common stock.

 (4) The number of shares reflects the number of shares of common stock in the
     aggregate issuable upon the conversion of the Series B Preferred Stock
     held by each person. Each share of Series B Preferred Stock is
     convertible into one share of common stock.

 (5) The number of shares reflects the number of shares of common stock in the
     aggregate issuable upon the conversion of the Series C Preferred Stock
     held by each person. Each share of Series C Preferred Stock is
     convertible into one share of common stock.

 (6) Reflects the beneficial ownership of the Company's capital stock,
     assuming the conversion of the Series A Preferred Stock, Series B
     Preferred Stock, Convertible Subordinated Notes and the Bridge Note
     Warrants. Shares of common stock subject to options, warrants or notes
     which are currently exercisable or exercisable within 60 days of
     December 31, 1999, are deemed outstanding for computing the percentage of
     the person holding such options, warrants or notes, but are not deemed
     outstanding for computing the percentage of any other person.

 (7) Consists of shares held directly by DLJ Merchant Banking Partners, L.P.
     ("DLJMBP"), DLJ International Partners, C.V. ("DLJIP"), DLJ Offshore
     Partners, C.V. ("DLJOP"), DLJ Merchant Banking Funding, Inc. ("DLJMBF"),
     DLJ Capital Corporation ("DLJCC"), Sprout Growth II, L.P. ("Sprout II"),
     and Sprout Capital VI, L.P. ("Sprout VI," collectively, "DLJ and

                                      48
<PAGE>

     the Sprout Entities") and PM Funding, Inc. See "Certain Relationships and
     Related Transactions." The address of each of DLJMBP, DLJMBF, DLJCC, DLJ
     First and PM Funding is 277 Park Avenue, New York, New York 10172. The
     address of DLJIP and DLJOP is John B. Gorsiraweg 14, Willemstad, Curacao,
     Netherlands Antilles. The address of Sprout II and Sprout VI (the "Sprout
     Group") is 3000 Sand Hill Road, Building 3, Suite 170, Menlo Park,
     California 94025. Thompson Dean, as a Managing Director of DLJMBP, and
     Robert Finzi, as a General Partner of the Sprout Group, each of whom are
     former Directors of the Company, may be deemed to share voting and
     investment power over such shares. Messrs. Dean and Finzi disclaim
     beneficial interest in such shares, except to the extent of their
     respective interests in DLJ and the Sprout Entities. Includes 800,000
     shares of Common Stock issuable upon the exercise of the Bridge Note
     Warrants at an exercise price of $1.55 per share held by DLJCC and PM
     Funding. Includes an aggregate of 5,142,720 shares of Common Stock issuable
     upon the exercise of the Convertible Subordinated Notes.

 (8) Includes 130,000 shares held by Mr. Cormier's children and other
     relatives for which Mr. Cormier maintains voting control.

 (9) Includes 98,700 shares of common stock which are held by Mr. Schaefer's
     children and other relatives for which Mr. Schaefer maintains voting
     control and 657,500 shares held by Mr. Schaefer's wife as her separate
     property.

(10) Mr. Andrew Sheehan, a former Director of the Company, as a General
     Partner of ABS, may be deemed to share voting and investment power over
     such shares. Mr. Sheehan disclaims beneficial interest in such shares,
     except to the extent of his interests in ABS. The address of ABS is 101
     California Street, 47th Floor, San Francisco, California 94111.

(11) The Company reached an agreement for the termination of Mr. Brumberger's
     full-time employment with the Company, effective July 1998.

(12) Includes 19,736 shares held in trust for Mr. Erickson's children for
     which Mr. Erickson maintains voting control. Mr. Erickson terminated his
     position with the Company in January 2000.

(13) Includes immediately exercisable options to purchase 18,000 shares. The
     option shares issuable upon exercise of such option are, prior to
     vesting, subject to a right of repurchase in favor of the Company that
     lapse in a series of annual and monthly installments ending in February
     2004.

(14) Includes immediately exercisable options to purchase 118,000 shares.
     Because of limitations under the federal tax laws for Incentive Stock
     Options, only options to purchase 107,200 shares are currently
     exercisable or exercisable within 60 days of December 31, 1999. The
     option shares issuable upon exercise of such option are, prior to
     vesting, subject to a right of repurchase in favor of the Company that
     lapse in a series of monthly installments ending in February 2004.

(15) Includes immediately exercisable options to purchase 100,000 shares. The
     option shares issuable upon exercise of such option are, prior to
     vesting, subject to a right of repurchase in favor of the Company that
     lapse in a series of monthly installments ending in June 2000.

(16) Includes immediately exercisable options to purchase 100,000 shares. The
     option shares issuable upon exercise of such option are, prior to
     vesting, subject to a right of repurchase in favor of the Company that
     lapse in a series of annual and monthly installments ending in July 2003.

(17) Includes immediately exercisable options to purchase 90,000 shares. The
     option shares issuable upon exercise of such options are, prior to
     vesting, subject to a right of repurchase in favor of the Company that
     lapse in a series of annual and monthly installments ending in July 2003.

(18) Mr. Munnikhuis terminated his position with the Company in December 1999.

(19) The Company reached and agreement for the termination of Mr. Bultman's
     full-time employment with the Company, in June, 1999.

(20) See Footnotes 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18 and 19 above.
     Includes options exercisable for 800,000 shares of common stock under the
     1995 Plan of which options to purchase 648,558 shares are currently
     exercisable or exercisable within 60 days of December 31, 1999, because
     of limitations under the Federal tax laws for Incentive Stock Options.
     Also includes 430,000 shares of common stock of which 1,000 shares are
     subject to a right of repurchase in favor of the Company that lapses in a
     series of monthly installments ending in April 2000. Excludes shares held
     by DLJ and the Sprout Entities and ABS. See Footnotes 7 and 10 above.

                                      49
<PAGE>

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  Since January 1, 1998, other than as described below or elsewhere in this
Report there has not been any transaction or series of similar transactions to
which Phase Metrics was or is a party in which the amount involved exceeded or
exceeds $60,000 and in which any director, executive officer, holder of more
than 5% of any class of Phase Metrics' voting securities, or any member of the
immediate family of any of the foregoing persons had or will have a direct or
indirect material interest, other than the transactions described below. See
"Executive Compensation -- Compensation Plans and Arrangements -- Employment
Contracts and Change in Control Arrangements" and "-- Limitation of Liability
and Indemnification Matters."

Series C Preferred Stock Financing

  In August and September 1998, the Company issued and sold an aggregate of
7,610,000 shares of its Series C Preferred Stock for $4.00 per share to a
group of investors, which included a number of its current
stockholders and two members of the Company's Board of Directors. The Company
received aggregate proceeds of approximately $30.4 million in connection with
the Series C Financing. Immediately following the consummation of the Series C
Financing, the Company used $7.1 million of the net proceeds therefrom to
repay the indebtedness and accrued interest outstanding under the New Credit
Facility.

Securityholders Agreement

  The Amended and Restated Securityholders Agreement (the "Securityholders
Agreement") provides that each of Messrs. Schaefer and Cormier, DLJMBP, Sprout
II and ABS, shall be entitled to designate one director to the Company's
Board, and Messrs. Schaefer and Cormier, with the consent of DLJ and the
Sprout Entities, shall have the right to designate the sixth director and DLJ
and the Sprout Entities shall have the right to designate the seventh director
to the Company's Board. The Securityholders Agreement also contains certain
restrictions on the ability of the parties thereto to sell their shares of
stock; registration rights; preemptive rights in connection with the issuance
by the Company of additional equity securities other than upon certain defined
events, including an initial public offering by the Company; certain rights of
first refusal between the stockholders who are party to such agreement
providing each such party the right to purchase any equity securities that any
of the other parties to the agreement desire to sell to third parties and
other matters customary for such agreements. The rights of the parties to the
Securityholders Agreement with respect to certain restrictions on transfer and
the preemptive rights under such Agreement terminate in connection with
certain public offerings of common stock by the Company. Under the
Securityholders Agreement, the Company was obligated until November 23, 1998,
to use DLJ as its exclusive financial advisor and investment banker. In
consideration for DLJ's services, the Company has agreed to pay DLJ an annual
retainer of $200,000. In each of 1997 and 1998, the Company paid DLJ $200,000
in fees for financial advisory and certain investment banking services
provided to the Company.

  DLJ acted as the initial purchaser in the Original Note Offering and
received an underwriting discount of $3.575 million in connection therewith.

                                      50
<PAGE>

                                   PART IV.

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

  (a) Documents filed as part of this Report:

  1. Financial Statements. The following financial statements of Phase Metrics
are included in a separate section of this Annual Report on Form 10-K
commencing on the pages referenced below:

<TABLE>
<CAPTION>
                                                                           Page
<S>                                                                        <C>
 Independent Auditors' Report.............................................  F-2
 Consolidated Balance Sheets as of December 31, 1998 and 1999.............  F-3
 Consolidated Statements of Operations for the years ended December 31,
  1997, 1998 and 1999.....................................................  F-4
 Consolidated Statements of Stockholders' Deficit for the years ended
  December 31, 1997, 1998 and 1999........................................  F-5
 Consolidated Statements of Cash Flows for the years ended December 31,
  1997, 1998 and 1999.....................................................  F-6
 Notes to Consolidated Financial Statements...............................  F-7

  2. Financial Statement Schedules. The following financial statement schedule
of Phase Metrics is included in a separate section of this Annual Report on
Form 10-K commencing on the pages referenced below. All other schedules have
been omitted because they are not applicable, not required, or the information
is included in the consolidated financial statements or notes thereto.

Independent Auditors' Report on Schedule II............................... F-27
Schedule II--Valuation and Qualifying Accounts............................ F-28
</TABLE>

  3. Exhibits. The following Exhibits are attached hereto and incorporated
herein by reference:

<TABLE>
   <C>    <S>
   12.1   Statement Regarding Computation of Ratios.
   21.1** List of Subsidiaries.
   24.1** Powers of Attorney (contained on signature page on page 56).
   25.1** Form T-1 Statement of Eligibility and Qualification of State Street
          Bank and Trust Company of California, N.A. as Trustee.
   27.1   Financial Data Schedule.
</TABLE>
--------
**  Incorporated by reference to the Exhibit indicated in the Company's
    Registration Statement on Form S-4 (File No. 333-48817).

(b)  Reports on Form 8-K:

  No reports on Form 8-K were filed during the last quarter of the year ended
December 31, 1999.

                                      51
<PAGE>

                                  SIGNATURES

  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Annual Report on
Form 10-K to be signed on its behalf by the undersigned, thereunto duly
authorized, in the City of San Diego, State of California, on the 11th day of
May, 2000.

                                          PHASE METRICS

                                                  /s/ John F. Schaefer
                                          By: _________________________________
                                                      John F. Schaefer
                                                   Chairman of the Board,
                                           Chief Executive Officer and President

                               POWER OF ATTORNEY

  KNOW ALL MEN BY THESE PRESENTS, the undersigned hereby constitute and
appoint John F. Schaefer and W. Dewey Hockemeyer, and each of them, his true
and lawful attorneys-in-fact and agents, each with full power of substitution
and resubstitution, for him and in his name, place and stead, in any and all
capacities, to sign any and all amendments to this Report, and to file the
same, with exhibits thereto, and other documents in connection therewith, with
the Securities and Exchange Commission, granting unto said attorneys-in-fact
and agents, full power and authority to do and perform each and every act and
thing requisite or necessary to be done in connection therewith, as fully to
all intents and purposes as he might or could do in person, hereby ratifying
and confirming all that each of said attorneys-in-fact and agents, or his
substitute or substitutes, may lawfully do or cause to be done by virtue
hereof.

  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed by the following persons in the capacities and on the
dates indicated:

<TABLE>
<CAPTION>
             Signature                             Title                     Date
             ---------                             -----                     ----

<S>                                  <C>                                <C>
      /s/ John F. Schaefer           Chairman of the Board, Chief        May 11, 2000
____________________________________  Executive Officer and President
          John F. Schaefer            (Principal Executive Officer)

     /s/ W. Dewey Hockmeyer          Vice President, Chief Financial     May 11, 2000
____________________________________  Officer and Assistant Secretary
         W. Dewey Hockmeyer           (Principal Accounting and
                                      Financial Officer)
   /s/ Dr. Gilbert F. Amelio         Director                            May 11, 2000
____________________________________
       Dr. Gilbert F. Amelio

      /s/ William E. Terry           Director                            May 11, 2000
____________________________________
          William E. Terry
</TABLE>



                                      52
<PAGE>

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                           Page
<S>                                                                        <C>
Phase Metrics, Inc.:

 Independent Auditors' Report............................................. F-2

 Consolidated Balance Sheets as of December 31, 1998 and 1999............. F-3

 Consolidated Statements of Operations for the years ended December 31,
  1997, 1998 and 1999..................................................... F-4

 Consolidated Statements of Stockholders' Deficit for the years ended
  December 31, 1997, 1998 and 1999........................................ F-5

 Consolidated Statements of Cash Flows for the years ended December 31,
  1997, 1998 and 1999..................................................... F-6

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

                                      F-1
<PAGE>

                         INDEPENDENT AUDITORS' REPORT

Phase Metrics, Inc.:

  We have audited the accompanying consolidated balance sheets of Phase
Metrics, Inc. and its subsidiaries as of December 31, 1998 and 1999, and the
related consolidated statements of operations, stockholders' deficit and cash
flows for each of the three years in the period ended December 31, 1999. 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 audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

  In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Phase Metrics, Inc. and its
subsidiaries as of December 31, 1998 and 1999, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1999 in conformity with generally accepted accounting
principles.

  The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company's operating loss and its cash requirements
in excess of current resources and the breach of the terms of its major debt
agreement, raise substantial doubt about its ability to continue as a going
concern. Management's plans concerning these matters are also described in
Note 1. The financial statements do not include any adjustments that might
result from the outcome of these uncertainties.

/s/ DELOITTE & TOUCHE LLP

San Jose, California
February 4, 2000
(March 1, 2000 as to the
 third paragraph of Note 1)

                                      F-2
<PAGE>

                              PHASE METRICS, INC.

                          CONSOLIDATED BALANCE SHEETS
                (In thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                             December 31,
                                                          --------------------
                                                            1998       1999
                                                          ---------  ---------

                         ASSETS
<S>                                                       <C>        <C>
Current assets:
  Cash and cash equivalents.............................. $  24,714  $   8,942
  Accounts receivable, net...............................    13,577      7,044
  Inventories............................................    25,222     14,500
  Prepaid expenses and other.............................     2,189      1,225
  Income taxes receivable................................     6,062         --
                                                          ---------  ---------
    Total current assets                                     71,764     31,711

Property, plant and equipment, net.......................    17,793     10,494
Intangible assets, net...................................     1,782        408
Other                                                         4,776      4,038
                                                          ---------  ---------
Total assets                                              $  96,115  $  46,651
                                                          =========  =========

<CAPTION>
      LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' DEFICIT

<S>                                                       <C>        <C>
Current liabilities:
  Accounts payable....................................... $   6,682  $   2,397
  Accrued expenses and other liabilities.................    16,966     13,440
  Customer deposits and advances.........................       859      6,455
  Current portion of debt................................     1,374      1,205
                                                          ---------  ---------
    Total current liabilities............................    25,881     23,497
Long-term liabilities:
  Long-term debt (Notes 1 and 3).........................   107,257    106,531
  Convertible subordinated notes.........................     8,000      8,000
  Accrued expenses and interest..........................     9,591     10,236
Series B redeemable preferred stock, $.0001 par value,
 3,857,280 shares authorized, issued and outstanding
 (liquidation preference of $11,328 and $12,079 at
 December 31, 1998 and 1999, respectively)...............    11,331     12,081
Series C redeemable preferred stock, $.0001 par value,
 7,610,000 shares authorized, issued and outstanding
 (liquidation preference of $38,050).....................    31,212     34,184

Commitments and contingencies (Notes 5 and 10)

Stockholders' deficit:
  Series A preferred stock, $.0001 par value, 8,250,000
   shares authorized, issued and outstanding (liquidation
   preference of $9,000).................................         3          3
  Common stock, $.0001 par value, 70,000,000 shares
   authorized; 5,622,309 and 5,609,839 shares issued and
   outstanding at December 31, 1998 and 1999,
   respectively..........................................     6,498      6,892
  Retained deficit.......................................  (103,298)  (154,222)
  Accumulated other comprehensive loss...................      (360)      (551)
                                                          ---------  ---------
    Total stockholders' deficit..........................   (97,157)  (147,878)
                                                          ---------  ---------
Total liabilities, redeemable preferred stock and
 stockholders' deficit................................... $  96,115  $  46,651
                                                          =========  =========
</TABLE>

See notes to consolidated financial statements.


                                      F-3
<PAGE>

                              PHASE METRICS, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                  Year Ended December 31,
                                                 ----------------------------
                                                   1997      1998      1999
                                                 --------  --------  --------
<S>                                              <C>       <C>       <C>
Net sales....................................... $184,660  $104,994  $ 38,068
Cost of sales...................................  101,294    93,168    33,631
                                                 --------  --------  --------
    Gross profit................................   83,366    11,826     4,437
Operating expenses:
  Research and development......................   43,572    33,329    23,366
  Selling, general and administrative...........   22,968    17,370    11,047
  Amortization and write-downs of intangibles...   14,591     3,460     1,400
  Settlement charge.............................      --      5,872       --
  Restructuring charges.........................      --      4,184     3,091
                                                 --------  --------  --------
    Total operating expenses....................   81,131    64,215    38,904
                                                 --------  --------  --------
Income (loss) from operations...................    2,235   (52,389)  (34,467)
Interest expense................................   11,573    14,456    13,809
Other (income) expense, net.....................      474      (339)   (1,074)
                                                 --------  --------  --------
Loss before income taxes and extraordinary
 items..........................................   (9,812)  (66,506)  (47,202)
Income tax expense (benefit)....................   (4,268)    9,000       --
                                                 --------  --------  --------
Loss before extraordinary items.................   (5,544)  (75,506)  (47,202)
Extraordinary loss, net of income taxes.........      --     (1,345)      --
                                                 --------  --------  --------
Net loss........................................ $ (5,544) $(76,851) $(47,202)
                                                 ========  ========  ========
Accretion for redemption value and dividends on
 Series B and C redeemable preferred stock...... $ (2,923) $ (3,281) $ (3,722)
                                                 ========  ========  ========
Net loss attributable to common stockholders.... $ (8,467) $(80,132) $(50,924)
                                                 ========  ========  ========
Comprehensive loss:
  Net loss...................................... $ (5,544) $(76,851) $(47,202)
Other comprehensive income (loss):
  Foreign currency translation adjustments......     (800)      440      (191)
                                                 --------  --------  --------
Comprehensive loss.............................. $ (6,344) $(76,411) $(47,393)
                                                 ========  ========  ========
</TABLE>

See notes to consolidated financial statements.

                                      F-4
<PAGE>

                              PHASE METRICS, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
                             (Dollars in thousands)

<TABLE>
<CAPTION>
                                                                          Accumulated
                              Series A                        Retained       Other
                          Preferred Stock    Common Stock     Earnings   Comprehensive
                           Shares   Amount  Shares    Amount  (Deficit)      Loss        Total
                          --------- ------ ---------  ------  ---------  ------------- ---------
<S>                       <C>       <C>    <C>        <C>     <C>        <C>           <C>
Balance, January 1,
 1997...................  8,250,000  $ 3   5,632,500  $5,665  $ (14,699)       --      $  (9,031)
Exercise of options, net
 of repurchases.........        --   --       (5,069)     25        --         --             25
Accrued dividends on
 Series B redeemable
 Preferred stock........        --   --          --      --      (1,423)       --         (1,423)
Accretion for redemption
 value on Series B
 redeemable preferred
 stock..................        --   --          --      --      (1,500)       --         (1,500)
Compensation expense on
 option grants..........        --   --          --      400        --         --            400
Net loss................        --   --          --      --      (5,544)       --         (5,544)
Accumulated translation
 adjustments............        --   --          --      --         --       $(800)         (800)
                          ---------  ---   ---------  ------  ---------      -----     ---------
Balance, December 31,
 1997...................  8,250,000    3   5,627,431   6,090    (23,166)      (800)      (17,873)
Exercise of options, net
 of repurchases.........        --   --       (5,122)      8        --         --              8
Accrued dividends on
 Series B redeemable
 preferred stock........        --   --          --      --        (750)       --           (750)
Accretion for redemption
 value on Series B
 redeemable preferred
 stock..................        --   --          --      --      (1,337)       --         (1,337)
Accretion for dividends
 and redemption value on
 Series C redeemable
 preferred stock........        --   --          --      --      (1,194)       --         (1,194)
Compensation expense on
 option grants..........        --   --          --      400        --         --            400
Net loss................        --   --          --      --     (76,851)       --        (76,851)
Accumulated translation
 adjustments............        --   --          --      --         --         440           440
                          ---------  ---   ---------  ------  ---------      -----     ---------
Balance, December 31,
 1998...................  8,250,000    3   5,622,309   6,498   (103,298)      (360)      (97,157)
Exercise of options, net
 of repurchases.........        --   --      (12,470)     (6)       --         --             (6)
Accrued dividends on
 Series B redeemable
 preferred stock........        --   --          --      --        (750)       --           (750)
Accretion for dividends
 and redemption value on
 Series C redeemable
 preferred stock........        --   --          --      --      (2,972)       --         (2,972)
Compensation expense on
 option grants..........        --   --          --      400        --         --            400
Accumulated translation
 adjustments............        --   --          --      --         --        (191)         (191)
Net loss................        --   --          --      --     (47,202)       --        (47,202)
                          ---------  ---   ---------  ------  ---------      -----     ---------
Balance, December 31,
 1999...................  8,250,000  $ 3   5,609,839  $6,892  $(154,222)     $(551)    $(147,878)
                          =========  ===   =========  ======  =========      =====     =========
</TABLE>

See notes to consolidated financial statements.

                                      F-5
<PAGE>

                              PHASE METRICS, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                             (Dollars in thousands)

<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                   ----------------------------
                                                     1997      1998      1999
                                                   --------  --------  --------
<S>                                                <C>       <C>       <C>
Operating activities:
  Net loss.......................................  $ (5,544) $(76,851) $(47,202)
  Adjustments to reconcile net loss to net cash
   used for operating activities:
    Depreciation and amortization and write-downs
     of intangibles..............................    21,872    12,056     9,024
    Amortization of deferred financing costs.....       540       776       789
    Loss on disposal of property, plant and
     equipment...................................       714       163       121
    Compensation expense on option grants........       400       400       400
    Deferred income taxes........................    (1,353)   14,221       --
    Interest on convertible subordinated notes...     1,894     1,000     1,000
    Impairment of property, plant and equipment..       --      2,519     1,406
    Extraordinary loss net of income taxes.......       --      1,345       --
    Changes in assets and liabilities:
      Accounts receivable........................    (3,688)   15,153     6,533
      Inventories................................    (4,508)   29,897     9,967
      Prepaid expenses and other assets..........     3,732    (3,681)    1,645
      Income taxes receivable....................      (156)     (168)    6,062
      Accounts payable...........................    (7,769)   (3,737)   (4,285)
      Customer deposits, accrued expenses and
       other liabilities.........................   (12,526)   (5,055)    1,477
                                                   --------  --------  --------
        Net cash used for operating activities...    (6,392)  (11,962)  (13,063)
                                                   --------  --------  --------

Investing activities:
  Acquisition of property, plant and equipment...   (17,091)   (1,492)   (2,029)
  Proceeds from sale of property, plant and
   equipment.....................................       --     11,926       601
  Other..........................................       (78)     (278)      (25)
                                                   --------  --------  --------
        Net cash provided by (used for) investing
         activities..............................   (17,169)   10,156    (1,453)
                                                   --------  --------  --------

Financing activities:
  Proceeds from senior notes.....................       --    110,000       --
  Repayment of term and subordinated notes.......    (1,800)  (79,200)      --
  Revolving loans--net...........................    26,900   (30,700)      --
  Payment of debt issuance costs.................      (330)   (5,560)      --
  Payments on capital lease obligations..........      (912)   (1,090)   (1,296)
  Issuance (repurchase) of common stock, net.....        25         8        (6)
  Proceeds from issuance of preferred stock......       --     30,020       --
                                                   --------  --------  --------
        Net cash provided by (used for) financing
         activities..............................    23,883    23,478    (1,302)
                                                   --------  --------  --------
Effect of exchange rate changes on cash and cash
 equivalents.....................................       (82)       65        46
                                                   --------  --------  --------
Net increase (decrease) in cash and cash
 equivalents.....................................       240    21,737   (15,772)
Cash and cash equivalents, beginning of period...     2,737     2,977    24,714
                                                   --------  --------  --------
Cash and cash equivalents, end of period.........  $  2,977  $ 24,714  $  8,942
                                                   ========  ========  ========
Supplemental disclosure of cash flow information:
  Interest paid..................................  $  9,393  $  7,760  $ 12,036
                                                   ========  ========  ========
  Income tax refunds.............................  $ (5,357) $ (5,103) $ (6,476)
                                                   ========  ========  ========
</TABLE>


See notes to consolidated financial statements.

                                      F-6
<PAGE>

                              PHASE METRICS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                 YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

1. The Company and Summary of Significant Accounting Policies

  Nature of Operations--Phase Metrics, Inc. and its wholly-owned subsidiaries
(the "Company") design, manufacture and sell process and production test
equipment for the data storage industry. The consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries. All
significant intercompany balances and transactions have been eliminated in
consolidation.

  Going Concern Basis of Presentation--The accompanying financial statements
have been prepared on a going concern basis, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. As shown in the financial statements, during the years ended
December 31, 1997, 1998 and 1999, the Company incurred net losses of
approximately $5.5 million $76.9 million and $47.2 million, respectively and
as of December 31, 1999 had negative stockholders' equity of $147.8 million.
The Company is highly dependant on its ability to reduce its current amount of
debt and obtain sufficient financing in order to fund its current and planned
operating levels. The Company's ability to continue as a going concern is
dependent upon its ability to reduce debt and obtain financing, as well as the
recovery of the data storage industry.

  The Company did not make the interest payment of $5.9 million which was due
in February 2000, and therefore was in default of the terms of the debt
agreement effective March 1, 2000. As a result of this default, the entire
face amount of the debt of $110.0 million plus accrued and unpaid interest is
due and payable as of March 1, 2000. The Company is currently seeking to
restructure this debt, including the February 2000 interest payment. (see Note
13)

  These financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts and
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern (See Note 3).

  Use of Estimates in the Preparation of the Consolidated Financial
Statements--The preparation of consolidated financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions. Assets, liabilities, revenues and expenses and
disclosures of contingent assets and liabilities are affected by such
estimates and assumptions. Actual results could differ from those estimates.

  Cash and Cash Equivalents--The Company invests its excess cash in money
market accounts, commercial paper and highly liquid government securities. The
Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.

  Fair Value of Financial Instruments--As of December 31, 1998 and 1999, the
carrying amounts of cash and cash equivalents approximated their respective
fair values. Estimation of the fair value of the Senior notes and convertible
subordinated notes is not deemed practicable as there is no public market for
these notes and the Company is unable to determine the market interest rate at
which financing would have been available at December 31, 1999.

  Concentrations of Credit Risk--Financial instruments that potentially
subject the Company to concentrations of credit risk consists of cash
equivalents and accounts receivable.

  The Company sells its products without collateral primarily to companies
located in the western United States and Asia. Historically, a significant
portion of the Company's sales in any particular period have been attributable
to sales to a limited number of customers. Credit is extended based on an
evaluation of the customer's financial condition. The Company estimates its
potential losses on trade receivables on an ongoing basis and provides for
anticipated losses in the period in which the sales are recognized.

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

                                      F-7
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Property, Plant and Equipment--Property, plant and equipment are recorded at
cost. Depreciation and amortization are provided using the straight-line
method over the estimated useful lives of the assets. Buildings and
improvements were depreciated over 39 years and equipment and furniture are
generally depreciated over three to five years. Amortization of leasehold
improvements is provided using the straight-line method over the lesser of the
remaining lease term or the life of the assets. Depreciation and amortization
expense related to property, plant and equipment totaled $7.3 million, $8.6
million, and $7.6 million for the years ended December 31, 1997, 1998 and
1999, respectively.

  Intangible Assets--Intangible assets consist primarily of patents and
convenants not to compete and are being amortized using the straight-line
method over their expected useful lives, generally 17 years and 5 to 7 years,
respectively.

  Impairment of Long-Lived Assets--The recoverability of long-lived assets is
evaluated by an analysis of operating results and consideration of other
significant events or changes in the underlying assets and business
environment. If the Company identifies events or circumstances which indicate
that an impairment might exist, the Company determines whether the sum of the
estimated undiscounted future cash flows attributable to the assets in
question is less than their carrying amounts. If impairment exists, the
Company recognizes an impairment loss based on the excess of the carrying
amount of the assets over their fair values determined by the estimated
discounted future cash flows.

  In 1997, the Company recorded a write-down totaling $2.0 million related to
an impairment loss for Air Bearings, Inc. ("ABI") purchased technology. In
1998 and 1999, the Company recorded write-downs totaling $2.5 million and $1.4
million, respectively, related to impairment losses for property, plant and
equipment obsoleted due to restructuring activities. In 1999, the Company
recorded an impairment loss of $1.0 million related to a non-compete agreement
in connection with the discontinued sale of products acquired in connection
with SBM.

  Stock-Based Compensation--As permitted by SFAS 123, "Accounting for Stock-
Based Compensation," the Company has elected to account for stock-based awards
to employees using the intrinsic value method, in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" in
accounting for its stock-based awards to employees.

  Foreign Currency Translation--The financial statements of the Company's
subsidiaries outside the United States are measured using the local currency
as the functional currency. Assets and liabilities of these subsidiaries are
translated at the rates of exchange at the balance sheet date. The resulting
translation adjustments are presented as a separate component of stockholders'
deficit.

  Revenue and Related Cost Recognition--Sales are generally recognized upon
shipment. A provision for estimated warranty and installation costs is
recorded upon product shipment.

  Research and Development--Research and development costs are expensed as
incurred. The Company's products include certain software applications that
are integral to the operation of the product. 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 technological feasibility of the software.

  Comprehensive Income--As of January 1, 1998, the Company adopted 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 non-owner sources. Accumulated translation adjustments are the
only other comprehensive income component for the Company and have been
reported as other comprehensive income in the accompanying consolidated
statements of operations.

                                      F-8
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Segment Reporting--As of January 1, 1998, the Company adopted SFAS No. 131,
"Disclosures About Segments of an Enterprise and Related Information." The
Company operates in one reportable segment. The adoption of SFAS No. 131 had
no impact on earnings or the statement of financial position of the Company.

  Recent Accounting Pronouncements--In June 1998, the FASB issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No.
133 requires that all derivative instruments be recorded on the balance sheet
at their fair value. Changes in the fair value of derivatives are recorded
each period in current earnings or other comprehensive income, depending on
whether a derivative is designated as part of a hedge transaction and, if it
is, the type of hedge transaction. SFAS No. 133 is effective for the year
ending December 31, 2001. The Company has not determined what impact the
adoption of SFAS No. 133 may have on its earnings or statement of financial
position.

  Reclassifications--Certain prior year amounts have been reclassified to
conform with the current year presentation.

2. Balance Sheet Details

 Accounts Receivable

  Accounts receivable consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                           December 31,
                                                         ------------------
                                                           1998      1999
                                                         --------  --------
     <S>                                                 <C>       <C>       <C>
     Trade receivables.................................. $ 15,938  $  7,476
     Allowance for doubtful accounts....................   (2,361)    ( 432)
                                                         --------  --------
                                                          $13,577  $  7,044
                                                         ========  ========

 Inventories

  Inventories consist of the following (in thousands):

<CAPTION>
                                                           December 31,
                                                         ------------------
                                                           1998      1999
                                                         --------  --------
     <S>                                                 <C>       <C>       <C>
     Raw materials and components....................... $ 10,611  $  9,983
     Work-in-process....................................    4,903     1,806
     Finished goods.....................................    9,708     2,711
                                                         --------  --------
                                                          $25,222  $ 14,500
                                                         ========  ========

 Property, Plant and Equipment

  Property, plant and equipment consist of the following (in thousands):

<CAPTION>
                                                           December 31,
                                                         ------------------
                                                           1998      1999
                                                         --------  --------
     <S>                                                 <C>       <C>       <C>
     Equipment and furniture............................ $ 32,753  $ 30,742
     Leasehold improvements.............................    5,500     5,462
     Construction in progress...........................      171       --
                                                         --------  --------
                                                           38,424    36,204
     Accumulated depreciation and amortization..........  (20,631)  (25,710)
                                                         --------  --------  ---
                                                          $17,793  $ 10,494
                                                         ========  ========
</TABLE>


                                      F-9
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Intangible Assets

  Intangible assets consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1999
                                                               -------  -------
     <S>                                                       <C>      <C>
     Covenants not to compete................................. $ 2,175  $   375
     Patents..................................................     409      434
                                                               -------  -------
                                                                 2,584      809
     Accumulated amortization.................................    (802)    (401)
                                                               -------  -------
                                                                $1,782  $   408
                                                               =======  =======

 Accrued Expenses and Other Liabilities

  Accrued expenses and other liabilities consist of the following (in
thousands):

<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1999
                                                               -------  -------
     <S>                                                       <C>      <C>
     Accrued warranty......................................... $ 3,625  $ 1,922
     Accrued compensation.....................................   2,173    1,957
     Accrued interest on senior notes.........................   5,012    4,957
     Other....................................................   6,156    4,604
                                                               -------  -------
                                                               $16,966  $13,440
                                                               =======  =======

 Accrued Expenses and Interest

  Accrued expenses and interest consist of the following (in thousands):

<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1999
                                                               -------  -------
     <S>                                                       <C>      <C>
     Accrued interest on convertible subordinated notes....... $ 7,102  $ 8,103
     Other accrued expenses...................................   2,489    2,133
                                                               -------  -------
                                                               $ 9,591  $10,236
                                                               =======  =======
</TABLE>

  Customer Advance--As of December 31, 1999, the Company entered into an
advance payment agreement with one of its customers. The agreement provided
for an initial advance of $8.0 million, to be offset by future purchases of
the Company's equipment and services through June 30, 2000, and is secured by
certain inventory. In the event the advance is not fully offset by June 30,
2000, the full amount will become due with interest accruing at 7% per annum
thereafter. As of December 31, 1999, the customer advance balance was $5.4
million.


                                     F-10
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

3. Debt

  Debt Summary--Debt is summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                             December 31,
                                                           ------------------
                                                             1998      1999
                                                           --------  --------
     <S>                                                   <C>       <C>
     Senior notes......................................... $105,487  $106,219
     Convertible subordinated notes.......................    8,000     8,000
     Capital lease obligations with weighted average
      annual interest rates of 9%.........................    3,144     1,517
                                                           --------  --------
     Total................................................  116,631   115,736
     Less current portion.................................   (1,374)   (1,205)
                                                           --------  --------
     Long-term debt....................................... $115,257  $114,531
                                                           ========  ========
</TABLE>

  Senior Notes--In January 1998, the Company sold $110.0 million of its 10.75%
Senior Notes due January 2005 (the "Notes"), in a private offering. The Notes
bear interest at 10.75% per annum, payable semiannually in arrears in February
and August. The Notes are senior unsecured obligations of the Company, and are
redeemable at the option of the Company, in whole or in part, at any time on
or after February 1, 2002, in cash at redemption prices as defined. In
addition, at any time prior to February 1, 2001, the Company may redeem up to
33% of the Notes at a redemption price as defined, with the net proceeds of a
public equity offering, as defined. Issuance costs of the Notes offering
totaled $5.1 million, including $3.6 million of underwriting discount paid to
an affiliate of a number of major stockholders of the Company.

  The Notes contain customary affirmative and negative covenants, including
limitations on other indebtedness, liens, investments and guarantees,
restricted payments, mergers and acquisitions, sales of assets, capital
expenditures, leases and affiliate transactions. The Company did not make the
interest payment of $5.9 million which was due in February 2000, and therefore
was in default of the terms of the debt agreement effective March 1, 2000. As
a result of this default, the entire face amount of the debt of $110.0 million
plus accrued and unpaid interest is due and payable as of March 1, 2000. The
Company is currently seeking to restructure this debt, including the February
2000 interest payment. (see Note 13)

  Effective in October 1998, the Company completed offers to exchange all of
the Notes with new notes with substantially identical terms that are
registered under the Securities Act of 1933, as amended.

  The Company is accreting the carrying value of the senior notes payable to
their redemption value.

  Credit Agreements--Through January 1998, the Company had a $120.0 million
credit agreement (the "Credit Agreement") with a group of financial
institutions (the "Lenders") which provided for five-year term loans (the
"Term Loans") in the principal amount of $80.0 million and a three-year
revolving credit facility (the "Revolver") of up to $40.0 million. In
connection with the Credit Agreement, in 1998 the Company paid fees of $1.2
million, for debt issuance costs to the syndication agent, who was an
affiliate of a number of the major stockholders of the Company.

  The Company used the net proceeds of the Notes to repay in full its then
existing credit agreements and accrued interest. In connection with the
January 1998 repayment of its then existing credit agreements and accrued
interest, the related unamortized debt issuance costs were written off. This
write-off, net of related tax benefit of $0.7 million, has been reported as an
extraordinary loss in the accompanying consolidated statements of operations.

                                     F-11
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Concurrently with closing the sale of the Notes, the Company entered into a
$25 million revolving credit facility with a group of banks (the "New Credit
Facility"). In August 1998, with the proceeds from the sale of its Series C
Preferred Stock (see Note 8), the Company repaid in full the New Credit
Facility and accrued interest, totaling $7.1 million, and terminated the New
Credit Facility. In connection with this repayment, in the third quarter of
1998 the Company recorded a $0.4 million write-off of the related unamortized
debt issuance costs as an extraordinary loss in the accompanying consolidated
statements of operations.

  Convertible Subordinated Notes--In November 1994, the Company issued and
sold $8.0 million principal amount of its convertible subordinated notes (the
"Convertible Subordinated Notes") to certain stockholders.

  The Convertible Subordinated Notes mature in July 2005. Interest accrued at
$2 million per year from issuance through November 23, 1997, and thereafter at
a minimum of $1 million per year. The Convertible Subordinated Notes bore
interest at 12.5% as of December 31, 1999. Interest is payable at maturity.
The convertible subordinated notes, including accrued interest are: (i)
convertible into 5,142,720 shares of Common Stock at the option of the holder,
(ii) automatically converted into Common Stock upon effectiveness of a public
equity offering as defined, and (iii) entitled to anti-dilution rights.

4. Income Taxes

  The components of income tax expense (benefit) are summarized as follows (in
thousands):

<TABLE>
<CAPTION>
                                                        Years Ended December
                                                                 31,
                                                        -----------------------
                                                         1997     1998    1999
                                                        -------  -------  -----
   <S>                                                  <C>      <C>      <C>
   Current income taxes:
     Federal..........................................  $(2,915) $(5,960) $ --
                                                        -------  -------  -----
       Total..........................................   (2,915)  (5,960)   --
   Deferred income taxes:
     Federal..........................................      386   17,782    --
     State............................................   (1,739)  (3,561)   --
                                                        -------  -------  -----
       Total..........................................   (1,353)  14,221    --
   Income tax (benefit) expense before extraordinary
    items.............................................   (4,268)   8,261    --
   Extraordinary items................................      --       739    --
                                                        -------  -------  -----
   Income tax expense (benefit).......................  $(4,268) $ 9,000  $ --
                                                        =======  =======  =====
</TABLE>

  The reconciliations between the statutory federal income tax rate and the
effective income tax rate for the years ended December 31, 1997, 1998 and 1999
are as follows:

<TABLE>
<CAPTION>
                                 Years Ended
                                December 31,
                              ---------------------
                              1997    1998    1999
                              -----   -----   -----
     <S>                      <C>     <C>     <C>
     Statutory tax rate--
      expense (benefit)...... (34.0)% (34.0)% (34.0)%
     Federal research and
      development credits....  (8.2)   (1.7)    --
     State income taxes, net
      of federal benefit.....  (4.2)   (3.3)   (2.0)
     Compensation on option
      grants.................   1.4     0.2     0.3
     Valuation allowance.....   --     50.7    35.0
     Other...................   1.5     0.6     0.7
                              -----   -----   -----
     Effective tax rate--
      expense (benefit)...... (43.5)%  12.5%    --
                              =====   =====   =====
</TABLE>

                                     F-12
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities used for financial
reporting and the amounts used for income tax purposes. The items comprising
the Company's deferred tax assets are as follows (in thousands):

<TABLE>
<CAPTION>
                                                              Years Ended
                                                             December 31,
                                                           ------------------
                                                             1998      1999
                                                           --------  --------
     <S>                                                   <C>       <C>
     Reserves not currently deductible.................... $  7,252  $  4,869
     Customer deposits....................................      539       129
     Uniform capitalization adjustment....................      282       407
     State taxes..........................................   (2,635)   (3,128)
     Purchased technology.................................    6,228     5,433
     Property and equipment...............................    2,218     3,446
     Tax loss and credit carryforwards (expiring through
      2018)...............................................   18,261    37,078
     Other................................................    1,419     2,626
     Valuation allowance..................................  (33,564)  (50,860)
                                                           --------  --------
     Total................................................ $    --   $    --
                                                           ========  ========
</TABLE>

  At December 31, 1999, the Company had available federal and California state
net operating loss carryforwards of approximately $19.7 million in the
aggregate, to offset future taxable income through 2013 and 2003,
respectively. Current tax laws impose substantial restrictions on the
utilization of net operating loss and credit carryforwards in the event of an
"ownership change," as defined by the Internal Revenue Code. If there should
be an ownership change, the Company's ability to utilize its carryforwards
could be limited.

  In 1998 and 1999, the Company recorded a valuation allowance against its
entire net deferred tax asset balance due to uncertainty regarding realization
of the deferred tax asset, due to the significant losses incurred and
uncertainty regarding future taxable income.

5. Leases

  Sale/Leaseback--In December 1998, the Company disposed of the real property,
improvements, fixtures and office buildings (collectively, the "Property")
located at its San Diego facility for net proceeds of $11.9 million. The
purchaser of the Property included an entity which is affiliated with a number
of the Company's major stockholders. The property was listed and sold through
a national real estate broker and the Company believes the purchase price
represented fair value for the property. In connection with the sale of the
Property, the Company entered into a lease with the purchaser to lease back a
portion of the Property. The resulting gain of $0.9 million from the sale of
the Property has been deferred in the accompanying financial statements, and
is being amortized to income over the three year term of the lease.

  Capital Leases--The Company entered into capital lease obligations of $1.1
million in connection with lease agreements for equipment and furniture during
the year ended December 31, 1998. At December 31, 1998 and 1999, assets under
capital leases included in property, plant and equipment totaled $3.2 million
and $3.1 million, respectively, with accumulated amortization of $1.3 million
and $2.0 million in 1998 and 1999, respectively.

  Operating Leases--The Company leases certain of its facilities and certain
equipment under operating leases that expire at various dates through 2004.
Certain facility leases include provisions for inflation escalation
adjustments, as well as one to five year renewal options. Rent expense under
operating leases totaled $5.1 million, $4.8 million and $3.4 million for the
years ended December 31, 1997, 1998 and 1999, respectively.

                                     F-13
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Future minimum lease payments under capital and operating leases as of
December 31, 1999 are summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                              Capital  Operating
     Year Ending December 31:                                 Leases    Leases
     ------------------------                                 -------  ---------
     <S>                                                      <C>      <C>
     2000.................................................... $ 1,290   $1,973
     2001....................................................     279    1,527
     2002....................................................      45      963
     2003....................................................     --       655
     2004....................................................     --        23
                                                              -------   ------
     Total...................................................   1,614   $5,141
                                                                        ======
     Amount representing interest............................     (97)
                                                              -------
     Present value of minimum lease payments.................   1,517
     Current portion.........................................  (1,205)
                                                              -------
     Long-term portion....................................... $   312
                                                              =======
</TABLE>

6. Settlement Charge

  In April 1998, the Company entered into an agreement (the "Settlement
Agreement") to reimburse a major customer for costs incurred in connection
with the customer's cancellation of a contract with a third party to purchase
upgrades to certain production test equipment originally purchased from the
Company. The Company took this action to protect its intellectual property and
preserve a valued customer relationship. The Company concluded that this
action was necessary in order to discourage further unauthorized use of its
intellectual property in the future by this or other third parties. The
Company recorded a $5.9 million charge to earnings in the second quarter of
1998 in connection with the Settlement Agreement. The Company made the
reimbursement provided for under the Settlement Agreement by providing a
credit to the customer for products purchased by the customer. Products
purchased under the Settlement Agreement were at favorable pricing which
negatively impacted the Company's gross profit margin through the first
quarter of 1999.

7. Restructuring and Valuation Charges

  The data storage industry has experienced prolonged and intense competition,
pricing erosion and overcapacity. Such adverse market conditions have
resulted, and may in the future result, in the delay, reschedule or
cancellation of orders and fluctuation in demand for the Company's products.
These adverse market conditions have had a material adverse effect on the
Company's results of operations and financial condition over the last several
quarters and are expected to continue through 2000. In the second quarter of
1999, the Company consolidated a significant portion of its Fremont
facilities, and in July 1999, implemented a workforce reduction of
approximately 25 employees.

  Due to the continued effects of the weakness in demand for data storage
products, in the fourth quarter of 1999, the Company further consolidated its
Fremont facilities and reduced its workforce by 24 employees.

  In the second quarter of 1998, the Company recorded $3.0 million of
restructuring charges. The significant components included $0.9 million for
employee severance costs, $2.0 million in asset impairment costs related to
property, plant and equipment obsoleted due to restructuring activities, and
$0.1 million of other costs. In the second quarter of 1999, the Company
recorded $2.0 million of restructuring charges. The significant components
included $0.7 million for future lease costs of consolidated facilities and
$1.3 million in asset impairment costs related to facilities consolidation. In
the fourth quarter of 1999, the Company recorded a restructuring charge of

                                     F-14
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

$1.1 million. The significant components included $0.6 million for employee
severance costs, $0.4 million for future lease costs of consolidated
facilities and $0.1 million in asset impairment costs related to facilities
consolidation. As of December 31, 1999, $1.3 million was recorded as an
accrued liability related to the restructuring activities.

8. Redeemable Preferred Stock

  The Series B redeemable preferred stock ("Series B Preferred Stock") is: (i)
voting, (ii) convertible at the option of the holder into Common Stock on a
one-for-one basis, (iii) entitled to $1.56 per share preference to Common
Stockholders in the event of liquidation, after payment of dividends, (iv)
entitled to cumulative dividends at a minimum rate of $1.5 million per year
through November, 1997 and thereafter at a minimum rate of $0.8 million per
year, (v) automatically converted into Common Stock on a one-for-one basis
upon the effectiveness of a public equity offering as defined, (vi) entitled
to antidilution rights, (vii) to have approval rights on new issuances of
Preferred Stock and (viii) redeemable at $1.56 per share beginning July 2005,
subject to funds legally available, after payment of dividends.

  The $6.0 million redemption value was accreted to retained earnings over the
original redemption period which ended November 23, 1998.

  In August and September 1998, the Company sold 7,610,000 shares of Series C
redeemable preferred stock (the "Series C Preferred Stock") for $4 per share.
The proceeds of approximately $30.4 million were used to repay in full the
Company's then existing revolving line of credit and accrued interest totaling
$7.1 million, with the remainder for general operating purposes.

  The Series C Preferred Stock is: (i) voting, (ii) convertible at the option
of the holder into Common Stock on a one-for-one basis, (iii) entitled to $5
per share preference to the holders of Common Stock, Series A Preferred Stock,
Series B Preferred Stock and the Convertible Subordinated Notes in the event
of liquidation, after payment of dividends, (iv) entitled to cumulative
dividends at a minimum rate of $3.8 million per year beginning August 2000,
(v) automatically converted into Common Stock on a one-for-one basis upon the
effectiveness of a public equity offering as defined, (vi) entitled to
antidilution rights, (vii) to have approval rights on new issuances of
Preferred Stock and (viii) redeemable at $5 per share beginning July 2005,
after payment of dividends.

  The dividends and the excess of redemption price over sales price are being
accreted to retained earnings using the effective interest method over the
redemption period ending July 2005.

9. Stockholders' Deficit

  Series A Preferred Stock--Series A Preferred Stock is: (i) voting, (ii)
convertible at the option of the holder into Common Stock on a one-for-one
basis, (iii) entitled to $1.09 per share preference to Common Stockholders in
the event of liquidation, after payment to Series B and C Preferred
Stockholders, (iv) entitled to dividends to the same extent as Common
Stockholders, (v) automatically converted into Common Stock on a one-for-one
basis upon the effectiveness of a public equity offering as defined and (vi)
entitled to anti-dilution rights.

                                     F-15
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Common Shares Reserved--As of December 31, 1999 the Company reserved the
following number of shares of Common Stock for future issuance:

<TABLE>
     <S>                                                              <C>
     Conversion of Series A, B and C Preferred Stock................. 19,717,280
     Conversion of subordinated notes................................  5,142,720
     Exercise and issuance of stock options..........................  4,944,161
     Exercise of warrants............................................    800,000
                                                                      ----------
     Total........................................................... 30,604,161
                                                                      ==========
</TABLE>

  Registration Rights--Series A, B and C Preferred Stockholders, Convertible
Subordinated Noteholders and the holders of the Common Stock warrants
(collectively "Securityholders") have been granted certain registration
rights. Such rights may be invoked by request of the holders of at least 25%
of such securities then outstanding or to be issued upon conversion of the
Series A, B or C Preferred Stock. The Securityholders have been granted a
right of first refusal to purchase any capital stock offered for sale as
defined.

  Warrants--In connection with the issuance and repayment of certain debt, the
Company has outstanding warrants to acquire 800,000 shares of Common Stock at
$1.55 per share. The warrants expire on November 23, 2004.

  Stock Option Plan--Under the 1995 Stock Option Plan (the "Plan"), 6,400,000
shares of Common Stock are reserved for issuance upon exercise of options
granted by the Company. Under the Plan, incentive and non-qualified stock
options may be granted to employees, officers, directors and consultants to
purchase shares of the Company's Common Stock. The exercise price for an
incentive stock option and a nonqualified stock option cannot be less than
100% and 85%, respectively, of the fair market value of the Company's Common
Stock on the grant date as determined by the Board of Directors. Options vest
over three or five years. Options are immediately exercisable and underlying
shares are subject to the Company's repurchase rights, which lapse over the
original vesting period of the options exercised. Options expire as determined
by the Board of Directors, but not more than 10 years after the grant date. At
December 31, 1999, 3,189,792 shares were available for future option grants.

                                     F-16
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  A summary of stock option transactions is as follows:

<TABLE>
<CAPTION>
                                                                        Weighted
                                                                        Average
                                                                        Exercise
                                                                         Price
                                                            Number of     Per
                                                              Shares     Share
                                                            ----------  --------
     <S>                                                    <C>         <C>
     Balance at January 1, 1997............................  1,716,801   $5.22
     Granted...............................................  1,093,500    8.36
     Exercised.............................................    (52,498)   1.69
     Canceled..............................................   (469,619)   6.72
                                                            ----------   -----
     Balance at December 31, 1997..........................  2,288,184    6.49
     Granted...............................................  1,181,200    4.22
     Exercised.............................................    (32,365)   1.01
     Canceled.............................................. (1,033,010)   7.07
                                                            ----------   -----
     Balance at December 31, 1998..........................  2,404,009    5.20
     Granted...............................................    496,400    2.10
     Exercised.............................................       (100)   3.75
     Canceled.............................................. (1,145,940)   5.13
                                                            ----------   -----
     Balance at December 31, 1999..........................  1,754,369   $4.23
                                                            ==========
     Vested at December 31, 1997...........................    495,833   $4.32
                                                            ==========
     Vested at December 31, 1998...........................    656,319   $5.02
                                                            ==========
     Vested at December 31, 1999...........................    620,914   $4.02
                                                            ==========
     Subject to repurchase at December 31, 1997............    493,063   $0.55
                                                            ==========
     Subject to repurchase at December 31, 1998............    221,752   $0.56
                                                            ==========
     Subject to repurchase at December 31, 1999............     19,618   $1.38
                                                            ==========
</TABLE>

  The Company recognized compensation expense of $0.4 million during each of
the years ended December 31, 1997, 1998 and 1999 for the amortization of the
excess of the fair market value of the Company's Common Stock on the grant
date over the exercise price of certain stock options granted in 1995. The
remaining unamortized compensation expense related to such options is $0.3
million at December 31, 1999, which will be recognized ratably over the
remaining vesting period.

  The pro forma information required by SFAS 123 and presented below has been
determined as if the Company had accounted for its employee stock awards under
the Plan using the minimum value method of that statement. The fair value for
these awards was estimated at the date of grant using the minimum value
pricing model with the following weighted-average assumptions for December 31,
1997, 1998 and 1999, respectively: weighted average risk-free interest rates
of 6.04%, 5.26%; and 5.59%; no dividend yield; and a weighted average expected
life of 3.5, 3.2 and 3.2 years. In management's opinion, the existing models
do not necessarily provide a reliable single measure of the fair value of its
employee stock awards.

                                     F-17
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  For purposes of pro forma disclosures, the estimated fair value of the
awards is amortized to expense over the options' vesting period. The Company's
pro forma information follows (in thousands):

<TABLE>
<CAPTION>
                                                           Years Ended December
                                                                   31,
                                                          ----------------------
                                                           1997   1998    1999
                                                          ------ ------- -------
     <S>                                                  <C>    <C>     <C>
     Pro forma net loss.................................. $5,976 $76,742 $47,272
                                                          ====== ======= =======
</TABLE>

  The following table summarizes information as of December 31, 1999
concerning options outstanding:

<TABLE>
<CAPTION>
                                     Weighted Average                       Shares
     Exercise        Options            Remaining                         Subject to
      Prices       Outstanding       Contractual Life       Vested        Repurchase
     --------      -----------       ----------------       -------       ----------
                                   (years)
     <S>           <C>               <C>                    <C>           <C>
     $0.37             75,450              5.32              70,567         11,485
      1.00            442,933              7.76             177,792          5,883
      3.75            675,209              8.80             148,187            --
      5.00             34,633              5.88              23,767            --
      5.50             17,633              8.31               5,000            --
      7.50            243,801              6.69              94,686          2,250
      8.75            264,710              7.58             100,915            --
                    ---------                               -------         ------
                   1,754,369                                620,914         19,618
                    =========                               =======         ======
</TABLE>

  The weighted average fair value of options granted during the years ended
December 31, 1997, 1998 and 1999 was $1.53, $0.64 and $0.33, respectively.

10. Commitments and Contingencies

  Acquisition-Related Agreements--Concurrent with certain of its acquisitions,
the Company entered into earn-out agreements based on units produced or sold.
At December 31, 1999, future potential combined maximum earn-out payments in
connection with such acquisitions are not expected to be material. During the
years ended December 31, 1997, 1998 and 1999, $2.0 million, $1.1 million, and
$0.2 million, respectively, of earn-outs have been paid and charged to
operations.

  Letter of Credit--As of December 31, 1999, the Company had a letter of
credit outstanding to a third party beneficiary in the amount of $1.9 million.
The letter of credit is secured by a $1.9 million certificate of deposit which
is included in non-current assets on the accompanying balance sheet.

  Legal Matters--The Company is also subject to various other legal matters in
the normal course of its business. While the results of litigation and claims
cannot be predicted with certainty, the Company believes that the final
outcome of these other matters will not have a material adverse effect on its
business, operating results or financial condition.

11. Employee Savings Plan

  Under the Company's 401(k) plan (the "Plan"), eligible employees may defer
up to 15% of their pretax earnings, subject to the Internal Revenue Service
annual contribution limit. Company matching contributions to the Plan were
$0.6 million for each of 1997 and 1998 and $0.3 million for 1999.

                                     F-18
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


12. Industry and Geographic Information

  The Company operates in one reportable segment. Sales to customers outside
the United States (primarily Asia) totaled 49%, 49%, and 48% of net sales for
the years ended December 31, 1997, 1998 and 1999, respectively. As of December
31, 1998 and 1999, balances due from foreign customers (primarily located in
Asia) were $4.0 million and $3.8 million, respectively.

  The Company had sales to individual customers in excess of 10% of net sales,
as follows:

<TABLE>
<CAPTION>
                                                                 1997  1998  1999
     Customer:                                                   ----  ----  ----
     <S>                                                         <C>   <C>   <C>
       A........................................................  18%   17%   37%
       B........................................................ --     17%  --
       C........................................................  17%   16%  --
       D........................................................  16%  --    --
       E........................................................ --    --     11%
</TABLE>

  As of December 31, 1998 and 1999, accounts receivable from individual
customers with balances due in excess of 10% of total accounts receivable
totaled $12.3 million and $3.4 million, respectively.

  For the year ended December 31, 1999, the Company recorded revenue from
customers throughout the United States and Japan, Korea and Singapore
(collectively referred to as "Asia"). The following presents net sales for the
years ended December 31, 1997, 1998 and 1999 and long-lived assets as of
December 31, 1998 and 1999 by geographic territory:

<TABLE>
<CAPTION>
                                  1997          1998                1999
                                -------- ------------------- ------------------
                                  Net      Net    Long-Lived   Net   Long-Lived
                                 Sales    Sales     Assets    Sales    Assets
                                -------- -------- ---------- ------- ----------
   <S>                          <C>      <C>      <C>        <C>     <C>
   United States operations:
     Domestic.................. $ 94,177 $ 53,547  $23,589   $19,671  $13,324
     Foreign...................   87,594   39,758      --     11,297      --
   Asia operations.............    2,889   11,689      762     7,100    1,616
                                -------- --------  -------   -------  -------
   Total....................... $184,660 $104,994  $24,351   $38,068  $14,940
                                ======== ========  =======   =======  =======
</TABLE>

13. Subsequent Event (Unaudited)


                                     F-19
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The Company was unable to make the interest payment on the Notes due on
February 1, 2000 and is not in compliance with certain covenants of the Notes
and the Indenture governing the Notes. On April 26, 2000, the Company
announced that it had entered into an agreement in principle with an informal
committee representing approximately 81% of holders to restructure the Notes.
Under the restructuring, the $110.0 million principal amount of Notes, plus
accrued interest, would be exchanged for New Common Stock representing 97.5%
of the Company's outstanding common stock after the restructuring. Holders of
the existing Senior Subordinated Convertible Notes, existing Series A, B and C
Preferred Stock and existing Common Stock would receive the remaining 2.5% of
New Common Stock, as well as warrants to purchase additional shares
representing up to 10% of the Company's then outstanding New Common Stock upon
certain circumstances. The restructuring will not in any way affect the
Company's obligation to pay its trade creditors or other vendors. The
agreement in principle is subject to a number of customary conditions. In
addition, holders of all or some of the Notes will provide the Company with a
$10.0 million New Credit Facility in conjunction with the restructuring. The
New Credit Facility will be secured by a pledge of substantially all of the
Company's assets other than certain secured assets and customer deposits. The
commitment to provide the New Credit Facility is subject to a number of
customary conditions. There is no assurance that the proposed restructuring
will be completed as described above or at all.

  The accompanying financial statements do not purport to reflect or provide
for the consequences of the proposed restructuring.

14. Financial Information for Guarantor Subsidiaries and Non-Guarantor
Subsidiaries.

  The Company conducts substantially all of its business through the parent
company and its domestic and foreign subsidiaries. In January 1998, the
Company issued the Notes (see Note 3). The Notes are fully and unconditionally
guaranteed, on a joint and several basis, by all of the Company's wholly-owned
domestic subsidiaries (the "Guarantor Subsidiaries").

  Presented below is condensed consolidating financial information for Phase
Metrics, Inc. (the "Parent Company"), the Guarantor Subsidiaries and the
wholly-owned foreign subsidiaries (the "Non-Guarantor Subsidiaries") for the
years ended December 31, 1997, 1998 and 1999. The condensed consolidating
financial information has been presented to show the nature of assets held,
results of operations and cash flows of the Parent Company, Guarantor
Subsidiaries and Non-Guarantor Subsidiaries assuming the expected guarantee
structure of the Senior Notes was in effect at the beginning of the periods
presented. Separate financial statements for the Guarantor Subsidiaries are
not presented based on management's determination that they would not provide
additional information that is material to investors.

  The supplemental condensed consolidating financial information reflects the
investments of the Parent Company in the Guarantor and Non-Guarantor
Subsidiaries using the equity method of accounting.


                                     F-20
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

          SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
                          Year Ended December 31, 1997

<TABLE>
<CAPTION>
                                                    Foreign
                           Parent    Guarantor   Non-Guarantor Eliminating
                          Company   Subsidiaries Subsidiaries    Entries   Consolidated
                          --------  ------------ ------------- ----------- ------------
                                                 (in thousands)
<S>                       <C>       <C>          <C>           <C>         <C>
Net sales...............  $165,724    $38,995       $12,631     $(32,690)    $184,660
Cost of sales...........   102,461     16,098        11,069      (28,334)     101,294
                          --------    -------       -------     --------     --------
  Gross profit..........    63,263     22,897         1,562       (4,356)      83,366
Research and development
 expense................    40,412      3,004           156          --        43,572
Selling, general and
 administrative
 expense................    18,559      3,556         2,140       (1,287)      22,968
Amortization and write-
 downs of intangibles...    14,591        --            --           --        14,591
                          --------    -------       -------     --------     --------
  Income (loss) from
   operations...........   (10,299)    16,337          (734)      (3,069)       2,235
Interest expense........    11,566        --              7          --        11,573
Other (income) expense--
 net....................       278        (53)          249          --           474
                          --------    -------       -------     --------     --------
  Income (loss) before
   equity in
   subsidiaries and
   Taxes................   (22,143)    16,390          (990)      (3,069)      (9,812)
Equity in net income of
 subsidiaries...........     5,631        --            --        (5,631)         --
Income tax expense
 (benefit)..............   (10,968)     7,130          (430)         --        (4,268)
                          --------    -------       -------     --------     --------
Net income (loss).......  $ (5,544)   $ 9,260       $  (560)    $ (8,700)    $ (5,544)
                          ========    =======       =======     ========     ========
</TABLE>

                                      F-21
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

          SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
                          Year ended December 31, 1997

<TABLE>
<CAPTION>
                                                   Foreign
                          Parent    Guarantor   Non-Guarantor Eliminating
                         Company   Subsidiaries Subsidiaries    Entries   Consolidated
                         --------  ------------ ------------- ----------- ------------
<S>                      <C>       <C>          <C>           <C>         <C>
Net income (loss)....... $ (5,544)   $ 9,260       $  (560)     $(8,700)    $ (5,544)
 Depreciation and
  amortization and
  write-downs of
  intangibles...........   21,119        487           266                    21,872
 Equity in net income of
  subsidiaries..........   (5,631)       --            --         5,631          --
 Other non-cash
  adjustments...........    3,548        --            --           --         3,548
 Changes in working
  capital...............  (21,090)    (4,154)       (4,093)       3,069      (26,268)
                         --------    -------       -------      -------     --------
   Net cash provided by
    (used for) operating
    Activities..........   (7,598)     5,593        (4,387)           0       (6,392)
                         --------    -------       -------      -------     --------
Investing activities:
 Acquisition of
  property, plant and
  equipment.............  (15,442)    (1,404)         (245)         --       (17,091)
 Other..................      (78)       --            --           --           (78)
                         --------    -------       -------      -------     --------
   Net cash used for
    investing
    activities..........  (15,520)    (1,404)         (245)         --       (17,169)
                         --------    -------       -------      -------     --------
Financing activities:
 Revolving loans--net...   26,900        --            --           --        26,900
 Repayment of term and
  subordinated notes....   (1,776)       --            (24)         --        (1,800)
 Other..................   (1,364)    (4,531)        4,678          --        (1,217)
                         --------    -------       -------      -------     --------
   Net cash provided by
    (used for) financing
    Activities..........   23,760     (4,531)        4,654          --        23,883
                         --------    -------       -------      -------     --------
Effect of exchange rate
 changes on cash and
 cash Equivalents.......      --         --            (82)         --           (82)
Net increase (decrease)
 in cash and cash
 equivalents............      642       (342)          (60)         --           240
Cash and cash
 equivalents, beginning
 of period..............    1,115      1,122           500          --         2,737
                         --------    -------       -------      -------     --------
Cash and cash
 equivalents, end of
 period................. $  1,757    $   780       $   440      $   --      $  2,977
                         ========    =======       =======      =======     ========
</TABLE>


                                      F-22
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


               SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET
                               December 31, 1998

<TABLE>
<CAPTION>
                                       ASSETS
                                                   Foreign
                          Parent    Guarantor   Non-Guarantor Eliminating
                         Company   Subsidiaries Subsidiaries    Entries   Consolidated
                         --------  ------------ ------------- ----------- ------------
                                                (in thousands)
<S>                      <C>       <C>          <C>           <C>         <C>
Cash and cash
 equivalents............ $ 23,631    $    13       $1,070      $    --      $ 24,714
Accounts receivable,
 net....................   11,001        315        2,261           --        13,577
Inventories.............   23,346        614        5,110        (3,848)      25,222
Other current assets....    8,084          5          162           --         8,251
Property, plant and
 equipment, net.........   16,814        701          278           --        17,793
Intercompany balances...     (809)     9,375       (8,566)          --           --
Investment in
 subsidiaries...........    6,655        --           --         (6,655)         --
Other...................    6,073          1          484           --         6,558
                         --------    -------       ------      --------     --------
  Total assets.......... $ 94,795    $11,024       $  799      $(10,503)    $ 96,115
                         ========    =======       ======      ========     ========

<CAPTION>
     LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)

<S>                      <C>       <C>          <C>           <C>         <C>
Other current
 liabilities............ $ 23,768    $   264       $  475      $    --      $ 24,507
Current portion of
 debt...................    1,374        --           --            --         1,374
Long-term debt..........  115,257        --           --            --       115,257
Redeemable preferred
 stock..................   42,543        --           --            --        42,543
Other...................    9,010        --           581           --         9,591
Stockholders' equity
 (deficit)..............  (97,157)    10,760         (257)      (10,503)     (97,157)
                         --------    -------       ------      --------     --------
  Total liabilities,
   redeemable preferred
   stock and
   Stockholders' equity
   (deficit)............ $ 94,795    $11,024       $  799      $(10,503)    $ 96,115
                         ========    =======       ======      ========     ========
</TABLE>

                                      F-23
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

          SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
                          Year ended December 31, 1998

<TABLE>
<CAPTION>
                                                    Foreign
                           Parent    Guarantor   Non-Guarantor Eliminating
                          Company   Subsidiaries Subsidiaries    Entries   Consolidated
                          --------  ------------ ------------- ----------- ------------
                                                 (in thousands)
<S>                       <C>       <C>          <C>           <C>         <C>
Net sales...............  $ 97,969     $9,769       $15,086     $(17,830)    $104,994
Cost of sales...........    95,224      2,494        13,532      (18,082)      93,168
                          --------     ------       -------     --------     --------
  Gross profit..........     2,745      7,275         1,554          252       11,826
Research and development
 expense................    33,318         11           --           --        33,329
Selling, general and
 administrative
 expense................    14,106      1,528         1,774          (38)      17,370
Amortization and write-
 downs of intangibles...     3,460        --            --           --         3,460
Settlement charge.......     5,872        --            --           --         5,872
Restructuring charges...     4,184        --            --           --         4,184
                          --------     ------       -------     --------     --------
Income (loss) from
 operations.............   (58,195)     5,736          (220)         290      (52,389)
Interest expense........    14,438         (4)           22          --        14,456
Other (income) expense--
 net....................      (109)       --           (230)         --          (339)
                          --------     ------       -------     --------     --------
Income (loss) before
 equity in subsidiaries
 and Taxes..............   (72,524)     5,740           (12)         290      (66,506)
Equity in net income of
 subsidiaries...........     5,245        --            --        (5,245)         --
Income tax expense
 (benefit)..............     8,227        775            (2)         --         9,000
                          --------     ------       -------     --------     --------
Net income (loss) before
 extraordinary items....   (75,506)     4,965           (10)      (4,955)     (75,506)
Extraordinary items, net
 of income taxes........    (1,345)       --            --           --        (1,345)
                          --------     ------       -------     --------     --------
Net income (loss).......  $(76,851)    $4,965       $   (10)    $ (4,955)    $(76,851)
                          ========     ======       =======     ========     ========
</TABLE>

                                      F-24
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


          SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
                          Year ended December 31, 1998

<TABLE>
<CAPTION>
                                                   Foreign
                          Parent    Guarantor   Non-Guarantor Eliminating
                         Company   Subsidiaries Subsidiaries    Entries   Consolidated
                         --------  ------------ ------------- ----------- ------------
                                                (in thousands)
<S>                      <C>       <C>          <C>           <C>         <C>
OPERATING ACTIVITIES:
Net income (loss)....... $(76,851)   $ 4,965       $  (10)      $(4,955)    $(76,851)
 Depreciation and
  amortization and
  write-downs of
  Intangibles              11,741        215          100                     12,056
 Equity in net income of
  subsidiaries..........   (5,245)       --           --          5,245          --
 Other non-cash
  adjustments...........    4,858        --           --            --         4,858
 Extraordinary Item.....    1,345        --           --            --         1,345
 Changes in working
  capital...............   55,786     (8,157)        (709)         (290)      46,630
                         --------    -------       ------       -------     --------
   Net cash used for
    operating
    activities..........   (8,366)    (2,977)        (619)          --       (11,962)
                         --------    -------       ------       -------     --------
Investing activities:
 Acquisition of
  property, plant and
  equipment.............   (1,387)        (4)        (101)          --        (1,492)
 Proceeds from sale of
  property, plant and
  equipment.............   11,926        --           --            --        11,926
 Other..................     (278)       --           --            --          (278)
                         --------    -------       ------       -------     --------
   Net cash provided by
    (used for) investing
    activities..........   10,261         (4)        (101)          --        10,156
                         --------    -------       ------       -------     --------

Financing activities:
 Proceeds from senior
  notes.................  110,000        --           --            --       110,000
 Repayment of term and
  subordinated notes....  (79,200)       --           --            --       (79,200)
 Revolving loans--net...  (30,700)       --           --            --       (30,700)
 Payment of debt
  issuance costs........   (5,560)       --           --            --        (5,560)
 Proceeds from issuance
  of preferred stock....   30,020        --           --            --        30,020
 Other..................   (4,581)     2,214        1,285           --        (1,082)
                         --------    -------       ------       -------     --------
   Net cash provided by
    financing
    activities..........   19,979      2,214        1,285           --        23,478
                         --------    -------       ------       -------     --------
Effect of exchange rate
 on cash and cash
 equivalents............      --         --            65           --            65
Net increase (decrease)
 in cash and cash
 equivalents............   21,874       (767)         630           --        21,737
Cash and cash
 equivalents at
 beginning of year......    1,757        780          440           --         2,977
                         --------    -------       ------       -------     --------
Cash and cash
 equivalents at end of
 year................... $ 23,631    $    13       $1,070       $   --      $ 24,714
                         ========    =======       ======       =======     ========
</TABLE>


                                      F-25
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


               SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET
                               December 31, 1999

<TABLE>
<CAPTION>
                                                    Foreign
                          Parent     Guarantor   Non-Guarantor Eliminating
                          Company   Subsidiaries Subsidiaries    Entries   Consolidated
                         ---------  ------------ ------------- ----------- ------------
                                                (in thousands)
<S>                      <C>        <C>          <C>           <C>         <C>
                                        ASSETS

Cash and cash
 equivalents............ $   8,158    $   167      $    617      $   --     $   8,942
Accounts receivable,
 net....................     3,532        165         3,347          --         7,044
Inventories.............    12,042        646         5,342       (3,530)      14,500
Other current assets....       920          8           297          --         1,225
Property, plant and
 equipment, net.........     8,767        492         1,235          --        10,494
Intercompany balances...     2,887     10,193       (13,080)         --           --
Investment in
 subsidiaries...........     5,703        --            --        (5,703)         --
Other...................     4,063          2           381          --         4,446
                         ---------    -------      --------      -------    ---------
  Total assets.......... $  46,072    $11,673      $ (1,861)     $(9,233)   $  46,651
                         =========    =======      ========      =======    =========

      LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)

Other current
 liabilities............ $  21,913    $   196      $    183      $   --     $  22,292
Current portion of
 debt...................     1,205        --            --           --         1,205
Long-term debt..........   114,531        --            --           --       114,531
Redeemable preferred
 stock..................    46,265        --            --           --        46,265
Other...................    10,036        --            200          --        10,236
Stockholders' equity
 (deficit)..............  (147,878)    11,477        (2,244)      (9,233)    (147,878)
                         ---------    -------      --------      -------    ---------
  Total liabilities,
   redeemable preferred
   stock and
   stockholders' equity
   (deficit)............ $  46,072    $11,673      $ (1,861)     $(9,233)   $  46,651
                         =========    =======      ========      =======    =========
</TABLE>

                                      F-26
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

          SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
                          Year ended December 31, 1999

<TABLE>
<CAPTION>
                                                    Foreign
                           Parent    Guarantor   Non-Guarantor Eliminating
                          Company   Subsidiaries Subsidiaries    Entries   Consolidated
                          --------  ------------ ------------- ----------- ------------
                                                 (in thousands)
<S>                       <C>       <C>          <C>           <C>         <C>
Net sales...............  $ 37,043     $2,665       $ 9,476     $(11,116)    $ 38,068
Cost of sales...........    34,315      1,295         9,455      (11,434)      33,631
                          --------     ------       -------     --------     --------
Gross profit............     2,728      1,370            21          318        4,437
Research and development
 expense................    23,211        155           --           --        23,366
Selling, general and
 administrative
 expense................     8,340        498         2,209          --        11,047
Amortization and write-
 downs of intangibles...     1,400        --            --           --         1,400
Restructuring charges...     3,091        --            --           --         3,091
                          --------     ------       -------     --------     --------
Income (loss) from
 operations.............   (33,314)       717        (2,188)         318      (34,467)
Interest expense........    13,804        --              5          --        13,809
Other (income) expense--
 net....................      (868)       --           (206)         --        (1,074)
                          --------     ------       -------     --------     --------
Income (loss) before
 equity in subsidiaries
 and taxes..............   (46,250)       717        (1,987)         318      (47,202)
Equity in net income of
 subisidiaries..........      (952)       --            --           952          --
                          --------     ------       -------     --------     --------
Net income (loss) before
 extraordinary items....   (47,202)       717        (1,987)       1,270      (47,202)
Extraordinary items, net
 of income taxes........       --         --            --           --           --
                          --------     ------       -------     --------     --------
Net income (loss).......  $(47,202)    $  717       $(1,987)    $  1,270     $(47,202)
                          ========     ======       =======     ========     ========
</TABLE>


                                      F-27
<PAGE>

                              PHASE METRICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

          SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
                          Year ended December 31, 1999

<TABLE>
<CAPTION>
                                                Foreign Non-
                          Parent    Guarantor    Guarantor   Eliminating
                         Company   Subsidiaries Subsidiaries   Entries   Consolidated
                         --------  ------------ ------------ ----------- ------------
                                               (in thousands)
<S>                      <C>       <C>          <C>          <C>         <C>
OPERATING ACTIVITIES:
Net income (loss).......  (47,202)    $ 717       $(1,987)     $1,270      $(47,202)
  Depreciation and
   amortization and
   write-downs of
   intangibles..........    8,701       209           114         --          9,024
  Equity in net loss of
   subsidiaries.........      952       --            --         (952)          --
  Other non-cash
   adjustments..........    3,716       --            --          --          3,716
  Changes in working
   capital..............   24,051      (721)       (1,613)       (318)       21,399
                         --------     -----       -------      ------      --------
Net cash provided by
 (used for) operating
 activities.............   (9,782)      205        (3,486)        --        (13,063)
                         --------     -----       -------      ------      --------

Investing activities:
  Acquisition of
   property, plant and
   equipment............   (1,132)      --           (897)        --         (2,029)
  Proceeds from sale of
   property, plant and
   equipment............      601       --            --          --            601
  Increase in patent
   costs................      (25)      --            --          --            (25)
                         --------     -----       -------      ------      --------
Net cash used for
 investing activities...     (556)      --           (897)        --         (1,453)
                         --------     -----       -------      ------      --------
Financing activities:
  Other.................   (4,998)     (818)        4,514         --         (1,302)
                         --------     -----       -------      ------      --------
Net cash provided by
 (used for) financing
 activities.............   (4,998)     (818)        4,514         --         (1,302)
                         --------     -----       -------      ------      --------

Net increase (decrease)
 in cash and cash
 equivalents............  (15,336)     (613)          177         --        (15,772)
Cash and cash
 equivalents at
 beginning of year......   23,494       780           440         --         24,714
                         --------     -----       -------      ------      --------
Cash and cash
 equivalents at end of
 year................... $  8,158     $ 167       $   617      $  --       $  8,942
                         ========     =====       =======      ======      ========
Effect of exchange rate
 on cash................      --        --             46         --             46
</TABLE>

                                      F-28
<PAGE>

                             INDEPENDENT AUDITORS'
                              REPORT ON SCHEDULE

Phase Metrics, Inc.:

  We have audited the consolidated financial statements of Phase Metrics, Inc.
and its subsidiaries as of December 31, 1998 and 1999, and for each of the
three years in the period ended December 31, 1999, and have issued our report
thereon dated February 4, 2000 (March 1, 2000 as to the third paragraph of
Note 1) (which report is unqualified and includes an explanatory paragraph
referring to the substantial doubt regarding the ability of the Company to
continue as a going concern); such financial statements and report have been
included in this Annual Report on Form 10-K. Our audits also included the
consolidated financial statement schedule of Phase Metrics, Inc. and its
subsidiaries, listed in Item 14(a)2. This 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 statement
schedule, when considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

s/ DELOITTE & TOUCHE LLP

San Jose, California
February 4, 2000

                                     F-29
<PAGE>

                                  SCHEDULE II

                              PHASE METRICS, INC.
                 CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                Additions
                           ---------------------------------------------------
                           Balance at Charges to Charges              Balance
                           beginning  costs and  to other             at end
       Description         of period   expenses  accounts Deductions of period
       -----------         ---------- ---------- -------- ---------- ---------
<S>                        <C>        <C>        <C>      <C>        <C>
Year ended December 31,
 1997
 Allowance for doubtful
 accounts.................   $  746     $1,405     $--       $488     $1,663
Year ended December 31,
 1998
 Allowance for doubtful
 accounts.................    1,663        787      --         89      2,361
Year ended December 31,
 1999
 Allowance for doubtful
 accounts.................    2,361         57      --       1986        432
</TABLE>

                                      F-30