<PAGE>   1
                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

[Mark One]                          FORM 10-K

   [X]          ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                   THE SECURITIES EXCHANGE ACT OF 1934 For the
                        Fiscal Year Ended March 31, 1998

                                       OR

   [ ]        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                 For the Transition Period from ______ to ______

                        Commission File Number: 000-6377

                         DREXLER TECHNOLOGY CORPORATION
--------------------------------------------------------------------------------
             (Exact name of registrant as specified in its charter)

            Delaware                                             77-0176309
-------------------------------                              -------------------
(State or other jurisdiction of                               (I.R.S. Employer
 incorporation or organization)                              Identification No.)

1077 Independence Avenue, Mountain View, CA                        94043-1601
-------------------------------------------                        ----------
  (Address of principal executive offices)                         (Zip Code)

                                 (650) 969-7277
              ----------------------------------------------------
              (Registrant's telephone number, including area code)

           Securities registered pursuant to Section 12(b) of the Act:

        None                                                       None
--------------------                                      ----------------------
(Title of each class                                      (Name of each exchange
   so registered)                                          on which registered)

           Securities registered pursuant to Section 12(g) of the Act:

                          Common Stock, $.01 Par Value
                          ----------------------------
                                (Title of class)

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

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

Based on the last trade price of the Company's Common Stock on The Nasdaq Stock
Market on May 12, 1998 the aggregate market value of the voting stock held by
non-affiliates of the registrant is approximately $142,680,000.

        Number of outstanding shares of Common Stock, $.01 par value, at
                             May 12, 1998: 9,678,597

                      DOCUMENTS INCORPORATED BY REFERENCE:
          Portions of the Proxy Statement related to Registrant's 1998
                 Annual Stockholders Meeting are incorporated by
                     reference into Part III of this report.


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                                TABLE OF CONTENTS



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                                     PART I

Item 1.  Business
             General Development of Business........................................................    3
             Financial Information about Industry Segments..........................................    4
             Narrative Description of Business......................................................    4
               LaserCard(R) Optical Memory Cards
                 Optical Data Storage...............................................................    4
                 The Drexon(R) Medium...............................................................    4
                 About the LaserCard................................................................    4
                 Writing and Reading the Cards......................................................    5
                 Card Storage Capacity..............................................................    6
                 Prerecording.......................................................................    6
                 Card Durability....................................................................    7
                 Card Security......................................................................    7
                 International Standards............................................................    8
               LaserCard Products
                 Card Manufacture...................................................................    9
                 Product Evolution..................................................................    9
                 Marketing and Technical Support....................................................    9
                 System Software....................................................................   10
                 The Role of VARs in Application Software...........................................   11
                 Reader/Writers.....................................................................   11
                 Multi-Card Workstations............................................................   11
                 Other Peripherals..................................................................   11
               Licensing
                 Basic Licenses and Upgrades........................................................   12
                 Card Manufacturing Licenses........................................................   12
                 Card Distribution and Other Licenses...............................................   12
               Competition
                 Other Technologies.................................................................   13
                 Other Optical Memory Cards.........................................................   13
               Other Matters
                 Research and Engineering Expenses..................................................   14
                 Patents and Trademarks.............................................................   14
                 Environment........................................................................   15
                 Year 2000 Disclosure...............................................................   16
                 Employees..........................................................................   16
               Risk Factors.........................................................................   16
               Comment Concerning Forward-Looking Statements........................................   19
Item 2.  Properties ................................................................................   19
Item 3.  Legal Proceedings..........................................................................   19
Item 4.  Submission of Matters to a Vote of Security Holders........................................   19

                                     PART II

Item 5.  Market for the Registrant's Common Stock and Related Stockholder Matters...................   20
Item 6.  Selected Financial Data....................................................................   21
Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations......   22
Item 8.  Financial Statements and Supplementary Data
             Report of Independent Public Accountants...............................................   26
             Consolidated Financial Statements......................................................   27
             Notes to Consolidated Financial Statements.............................................   31
             Quarterly Financial Information (Unaudited)............................................   38
Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.......   39

                                    PART III

Item 10. Directors and Executive Officers of the Registrant.........................................   39
Item 11. Executive Compensation.....................................................................   39
Item 12. Security Ownership of Certain Beneficial Owners and Management.............................   39
Item 13. Certain Relationships and Related Transactions.............................................   39

                                     PART IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K...........................   40
</TABLE>


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                                     PART I

ITEM 1. BUSINESS

(a)   General Development of Business

      Drexler Technology Corporation was incorporated under the laws of the
State of California on July 23, 1968, and was reincorporated as a Delaware
corporation on September 17, 1987. Drexler Technology and its wholly owned
subsidiary, LaserCard Systems Corporation, (the "Company") develop, manufacture,
and market optical data storage products used with personal computers for
information recording, storage, and retrieval.

      The Company's product line consists of LaserCard(R) optical memory cards,
optical card data systems, and related system software. The Company's customers
are mainly value-added reseller (VAR) companies throughout the world that
develop commercial applications for LaserCard products. Target markets include
consumer, business, and government applications for portable, recordable,
secure, cumulative record cards. These applications include tamper-resistant ID
cards, healthcare cards, secure access cards, warranty and maintenance records,
and cargo manifests. Revenues also include fees from the occasional sale of
nonexclusive licenses and/or royalties under such licenses, and occasional
customer-funded programs for the development of new products related to optical
memory cards.

      The history of the Company's optical data products business began while
the Company was a supplier of consumable products to the semiconductor industry.
Initially and for many years, the Company sold photomasks, photochemicals, and
emulsion-coated glass photoplates for integrated circuit production. During
experiments with emulsion-coated glass photoplates as a possible data storage
material, Company personnel made discoveries which led to the development of a
laser recording medium (trademarked Drexon(R)) which is comprised of pure silver
metal particles suspended in a matrix.

      Later experiments with Drexon on a flexible substrate led to the invention
and patenting by the Company of a credit-card sized optical memory card
(trademarked LaserCard(R)) containing a reflective stripe of Drexon material.
The optical memory card is a laser-recordable, computer readable, nonvolatile,
data storage card. It offers multiple security features, can be carried in a
wallet, and stores over 4 megabytes of digital data.

      Over time, the Company's focus shifted to optical memory card product
development, manufacturing, marketing, and licensing, and the Company sold the
assets of two of its three semiconductor-related product lines. The Company
began marketing optical memory card products through its subsidiary, LaserCard
Systems Corporation (LSC), which launched a value-added reseller program for
worldwide marketing and distribution of optical cards and card systems. This
program led to small commercial card sales by several VARs by 1993. Also in
1993, the last semiconductor-related product line was discontinued, and optical
memory card products, software, and systems represented the Company's sole
product line. Meanwhile, the Company had established a card manufacturing
facility with a designed production capacity of up to 25 million optical cards
per year, depending upon card type and color-printing specifications. (For a
discussion of card production capacity, please see "Management's Discussion and
Analysis.")

      By the end of calendar year 1996, orders were at levels of 5,000 to
100,000 cards per order, and VAR companies were marketing the LaserCard
internationally. However, the Company had not yet entered into long-term supply
agreements with any of its customers and did not have a consistent, large
backlog of orders for optical memory cards. In February of 1997, the Company
received a $7.1 million order for 2 million optical memory cards to be used as
"Green Cards" by the U.S. Immigration and Naturalization Service (INS). Largely
due to this order, the Company achieved profitability on LaserCard operations
for the first time in fiscal 1998. An additional $6.4 million order was received
from the INS in December of 1997 for "Green Cards" and "Laser Visa" cards.

      Commercial applications for the LaserCard include:

<TABLE>
<S>                                                       <C>
     -  U.S. immigration "Green Cards"                    -  Laser eye surgery setup/key cards
     -  U.S. border crossing "Laser Visa" cards           -  Shopping logs/secure entry cards
     -  Other tamper-resistant ID cards                   -  Military cargo manifests
     -  Medical records/medical image cards               -  Vehicle repair/warranty cards
</TABLE>


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<PAGE>   4
(b)   Financial Information about Industry Segments

      Item 8, Consolidated Financial Statements and Supplementary Data, contains
industry segment information.

(c)   Narrative Description of Business

LASERCARD(R) OPTICAL MEMORY CARDS

Optical Data Storage

      Optical data storage systems use light to write and read information. This
information generally is stored digitally in a binary code of "1" or "0" bits
that are represented by either the presence or absence of a physical "spot" on
the recording surface. The difference in reflectivity between the background
surface and the individual spot is measured by a light-sensing device and,
thereby, is converted into an electrical signal. These signals are then
translated by a microprocessor into text, graphics, voice, or pictures. A major
feature of optical data storage systems is that large amounts of data can be
stored on a relatively small media surface area since the data spots are
microscopic in size and tightly compacted.

      A read/write optical data storage system is comprised of a medium onto
which digital information is recorded using a laser, equipment which writes and
reads the digital information (a "reader/writer"), system software, and
application software. The Company produces and sells its data storage medium in
the form of laser-recordable, optical memory cards. The Company does not
manufacture reader/writers but purchases them from a licensed supplier and
resells them to customers. The Company develops system software, and customers
develop application-specific software.

      The general advantages of the Company's optical memory cards typically
include high storage capacity relative to size, durability/portability,
nonvolatility, low card cost, prerecordability, and security.

The Drexon Medium

      The Drexon(R) laser-recording medium was invented and patented by the
Company for optical data storage. It consists of a thin, organic film or
colloidal matrix which contains a thin layer of silver particles. Using
proprietary and patented processes, the Drexon medium is produced by chemical
conversion of photographic emulsions. This creates a gold-colored, mirror-like,
reflective recording surface. As described under "Prerecording," Drexon allows
data to be laser recorded, prerecorded using photolithography, or both.

      The Drexon medium is DRAW (direct-read-after write). DRAW media permit
data to be read immediately after laser recording--for instantaneous checking of
information. The Drexon medium also is classified as WORM (write-once,
read-many times). This means that data can be laser written and read at any
time, but once an area is recorded, that same area may not be over-written with
new data. Thus, the Company's optical memory cards are not erasable but are
recordable, correctable, and updatable.

      Data can be added to the Drexon medium over a period of days, weeks, or
years. Previously recorded data is corrected or updated using software--the
obsolete data is ignored by the system but remains permanently stored on the
Drexon material as an audit trail of all data. (See "Card Security.") This audit
feature is particularly desirable for applications such as secure
identification/access cards and medical records cards. Additionally, because the
Drexon medium is a nonvolatile/nonerasable data storage medium, it is not
vulnerable to data loss or damage when exposed to electronic signals or magnetic
fields.

About the LaserCard

      The Drexon laser-recording material is encapsulated within layers of
electron-beam laminated polycarbonate plastic and then die cut. The resulting
LaserCard is the size, shape, and thickness of a standard credit card, with
ample flexibility to be carried in a wallet. The typical wholesale price to VARs
is $4 to $5 per card when cards are ordered in the thousands.


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      The LaserCard is designed primarily for carrying useful, time-saving,
cost-saving, or life-saving data in the wallet and for sequentially recording
information in a secure, permanent mode. It is targeted toward the following
types of information systems:

-     Data recording and transaction systems--for unitary records such as
      medical records and health cards, warranty/service records, cargo
      manifests, other databases, and transaction security

-     Identification systems--for secure access cards and entry passes,
      immigration cards (e.g., INS "Green Cards" and border crossing "Laser
      Visa" cards), and other tamper-resistant ID cards

-     Image storage systems--for medical images such as MRI (magnetic resonance
      imaging) studies, CT (computed tomography) scans, X-rays; and for document
      images, photographs, and graphics

Features of the LaserCard include:

-     Permanent/nonvolatile, recordable, updatable

-     Low cost per card

-     Compact and durable card construction--highly flexible plastic, for wallet
      environment

-     High data storage capacity for its credit-card size

-     Off-line or on-line capability

-     High difficulty of forging, counterfeiting, tampering

-     Audit trail of all data and updates

-     Computer-readable (digital) security options--such as biometric
      identifiers, user codes, photos, data encryption, digital data interleaved
      with images

-     Visible security options added during card
      initialization/issuance--thermally printed text, photograph, images, OCR
      code; and laser-recorded "embedded holograms" of cardholder's name,
      photograph, etc.,

-     Optional customer add-ons--integrated circuit (IC) chip, conventional
      hologram

-     Factory-printed/prerecorded visual security options--logos, emblems,
      micro-images, watermarks

-     Optional factory add-ons--magnetic stripe, signature panel, serial number,
      bar code

Writing and Reading the Cards

      A low-power, semiconductor-diode laser is used to write information onto
the LaserCard. The laser is about the size of a thumbtack and is housed inside
an optical card reader/writer that is connected to a personal computer. The
LaserCard is inserted into a slot in the reader/writer. Information is recorded
when the reader/writer focuses a laser beam through the upper clear layer of the
card, forming microscopically small spots onto the Drexon optical stripe
embedded within the structure of the card. The recorded spots represent digital
data, the language of computers.

      Since the reader/writer is connected to a personal computer, data can be
entered onto the card from the computer's memory or by using the computer's
keyboard. Equipment such as fax machines, medical imaging devices, document
scanners, or even other data storage media also can transfer data, through a
personal computer, onto the card. Information stored on the optical card is read
back using the same reader/writer or a compatible unit. Data read from


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the card can be printed, displayed on a computer monitor, or used to operate a
system. LaserCard systems can be used with data communication networks and also
with stand-alone computers.

      Optical data storage systems use light to write and read information. This
information generally is stored digitally in a binary code of "1" or "0" bits
that are represented by either the presence or absence of a physical "spot" on
the recording surface. The difference in reflectivity between the background
surface and the individual spot is measured by a light-sensing device and,
thereby, is converted into an electrical signal. These signals are then
translated by a microprocessor into text, graphics, voice, or pictures. A major
feature of optical data storage systems is that large amounts of data can be
stored on a relatively small media surface area since the data spots are
microscopic in size and tightly compacted.

      A read/write optical data storage system is comprised of a medium onto
which digital information is recorded using a laser, equipment which writes and
reads the digital information (a "reader/writer"), system software, and
application software. The Company does not manufacture reader/writers but
purchases them from a licensed supplier and resells them to customers. The
Company develops system software, and customers develop the application-specific
software. The Company produces and sells its data storage medium in the form of
laser-recordable, optical memory cards.

      The general advantages of optical card storage systems over magnetic or
semiconductor memories typically include high storage capacity, durability, low
cost per bit stored, and resistance to accidental erasure or data degradation by
magnetic fields. Magnetic and most semiconductor media are updatable and
erasable. The Company's optical cards are not erasable but are updatable and
correctable. Permanent data storage is desired for a number of uses--such as ID,
medical, access, and cargo manifest cards. The Company believes that updatable,
permanent-record, optical memory cards will constitute an important segment of
the market for portable data storage.

      As mentioned previously, system software enables the LaserCard user to
write, read, delete, correct, and update data as if the LaserCard were a floppy
disk. However, unlike a floppy disk, which allows rerecording directly over
erased data, the LaserCard maintains old and new data--providing a permanent,
verifiable, audit trail.

Card Storage Capacity

      The amount of information that can be stored on the LaserCard is dependent
upon such factors as data density and compression, reader/writer design, and
spot size. Spot size is measured in microns. (A micron is 1/1,000 of a
millimeter, or about 1/75 the width of a human hair. The smallest size spot the
human eye can see is about 20 microns.) The size of spot used is determined by
the card format and the configuration of the reader/writer. A spot size of 2.25
microns is used for the Conlux LC-305 reader/writer currently sold by the
Company.

      A portion of the LaserCard's storage capacity is used for the error
detection and correction code (EDAC), a method routinely used throughout the
computer industry to compensate for errors from physical damage to data files.
Data-storage capacity also is determined by data compression and the type of
data encoding technique used. Thus, the storage capacity of the optical card
varies based on the type of data stored, EDAC, spot size, data compression,
encoding technique, reader/writer configuration, and format.

      A byte is a unit of computer storage--the amount of memory needed to store
a single number or letter. A megabyte is one million bytes; a kilobyte is one
thousand bytes. The standard LaserCard has a total data capacity of 4.1
megabytes and, after EDAC, a user data capacity of 2.86 megabytes. This
represents about 350 times the storage capacity of an 8 kilobyte IC chip card
and over 2,800 times the capacity of the standard 1 kilobyte IC chip card.
Magnetic-stripe cards (for example, bank cards) are capable of holding 0.2 to
0.9 kilobytes--which is less than .03% of a standard LaserCard. A special 6.6
megabyte capacity LaserCard (4.2 megabytes of user data capacity) has been used
by a customer for storing medical MRI images. Regardless of its storage
capacity, the LaserCard is identical in size to a credit card.

Prerecording

      Another feature of the LaserCard is its recordability both during the card
manufacturing process and afterward. Since photographic film is the base
material from which Drexon is made, photolithography is used during the


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manufacturing process to prerecord optical digital data and formatting (tracks
and other indicia) while the film is still photosensitive. Later, after the film
is processed to become Drexon and made into cards, data can be laser recorded at
any time--over a period of years (for example, a health history) or over a
period of minutes (for example, a set of medical MRI studies).

      To perform card prerecording or preformatting, the data pattern is printed
repeatedly, end to end, onto a strip of photographic film. This film is spliced
into a master loop, then inserted into a photolithographic machine. There, a
light source accomplishes "printing with light" by exposing the loop's images
onto long lengths of film at the rate of about 300 feet per minute. These
lengths of film, after chemical conversion and physical development into Drexon,
are laminated between polycarbonate sheets and cut into cards. On the finished
cards, the data pattern has low reflectivity and the background is more
reflective.

      The Drexon material's ability to be prerecorded is utilized not only for
formatting the LaserCard but also to add security features such as special
codes, micro-line printing of text, watermarks, graphics, emblems, etc.

Card Durability

      Unlike other types of storage media, the LaserCard can be manufactured to
withstand temperatures of 100 (degrees) C (212 (degrees) F) for extended
periods. In addition, the LaserCard's ability to withstand flexure exceeds that
of conventional credit cards. And, since the LaserCard is a nonvolatile data
storage medium, it is unaffected by static electricity, application of voltage,
or other electromagnetic interference. Testing has indicated that, when
protected by an appropriate envelope, the LaserCard is not normally damaged by
the usual dust particles, grime, and scratches common to any type of card in a
wallet environment. The ISO/DELA Standard, discussed below, uses a pit center
data detection scheme for the highest reliability in reading and writing,
coupled with a powerful EDAC code to maximize the life of the LaserCard.

      Commercial LaserCard applications are underway, a number of field
trials/pilot programs have been started, and extensive product evaluations have
been successfully completed. However, the LaserCard has only undergone limited
commercial use. The longest running commercial LaserCard programs have been the
U.S. Department of Defense "Automated Manifest System" (since 1993) and the
VISX, Inc. eye surgery system VisionKey(R) card (since 1992).

Card Security

      The level of data security used with the LaserCard will depend upon the
application. Storing automobile maintenance records requires little or no data
security, whereas very high security features can be employed to protect
confidential information such as medical records and other personal data. The
LaserCard's high storage capacity accommodates multiple, nonerasable, security
safeguards in addition to all of the user data and an audit trail. These
measures include both eye-readable and computer-readable security features to
enhance counterfeit-resistance, data security, and confidentiality.

      Using photolithography, eye-readable micro-images can be factory
prerecorded onto the LaserCard's optical stripe as deterrents against
counterfeiting--for example, complex optical watermarks, emblems, seals, and
logos. Later, using digital identification technology and commercially available
thermal printers, visual data and images such as the cardholder's name and
address, a face photograph (in full color or black and white), signature, or
other information can be thermally printed directly onto the back of the
LaserCard at the time the card is initialized (i.e., during card issuance). In
addition, various other security options that can be added to the LaserCard
include conventional holograms, serial numbers, bar codes, optical character
recognition (OCR), and the like.

      For maximum counterfeit-resistance, the LaserCard also uniquely offers
laser-embedded, personalized "holograms" which are visual micro-images
(typically the face photograph, name, signature, number, etc., relating to the
specific card or cardholder). The cardholder-specific "hologram" is laser
recorded by the card issuer onto the card's interior reflective layer (through
the transparent surface that protects the Drexon optical memory stripe). No
field equipment is needed to view the "hologram." Because its is embedded, the
"hologram" cannot be erased or changed, since the optical memory stripe is
nonerasable and cannot be removed without destruction of the card. The
eye-readable


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"holograms" require no field equipment to be visible. The "hologram" is an
unalterable visual validation of the same cardholder-specific images and data
that are thermally printed elsewhere on the card. They also offer an even more
powerful weapon against counterfeiting--the "hologram" itself can contain a
computer-readable, interleaved digital file that validates the
card-personalization data.

      Various computer-readable security safeguards that can be used with
optical memory cards include digitized color photographs; biometric identifiers
such as digitized signatures, fingerprints, and hand geometries; biographic
data; and one or more personal identification numbers (PINs). Combinations of
these and other security features can be recorded onto the card when it is
initialized by the card issuer, for later authentication of the card when it is
in actual use. Also, the Company can prerecord dedicated card/equipment digital
interface codes onto the cards' embedded storage stripe during the card
production process, so that unauthorized cards will not function in dedicated
equipment, or vice versa.

      If desired, data storage on the LaserCard can be segmented according to
confidentiality level (for example, patient records separated from insurance
information or pharmacy records) so that access to each type of data can be
controlled separately. In addition, the software industry has developed products
to protect computer-based data against unauthorized access; these software
products and other techniques can be used with the LaserCard as well.
Furthermore, for applications that warrant cryptography, all data can be
recorded onto the LaserCard using data encryption algorithms.

      Because the LaserCard contains nonvolatile, WORM memory that cannot be
physically erased, the card can hold a complete audit trail of data, changes,
updates, and deletions. This can be achieved through software--to allow access
to previously recorded files and, if desired, to record all attempts to access
data from the LaserCard.

International Standards

      Standardization of optical memory cards allows interchange of the digital
information encoded on the cards and facilitates compatibility among optical
memory card systems. The Company is actively involved in optical card standards
in the United States and internationally. The standard format under which the
Company's optical memory cards operate is called the DELA Standard.

      Shown below is the current status of optical memory card standards
activities under ISO/IEC (the International Organization for
Standardization/International Electrotechnical Committee) and under ANSI (the
American National Standards Institute):

-     ISO/IEC 11693 describes the general characteristics of optical memory
      cards. This approved international standard was published in 1994.

-     ISO/IEC 11694-1 describes the physical characteristics of the card, such
      as height, width, thickness, etc. This approved international standard was
      published in 1994.

-     ISO/IEC 11694-2 describes the dimensions and location of the accessible
      area--the area on the card where data writing/reading occurs. This
      approved international standard was published in 1995.

-     ISO/IEC 11694-3 describes the optical properties and characteristics of
      the card and provides technical specifications which allow interchange.
      This approved international standard was published in 1996.

-     ISO/IEC 11694-4 describes the logical data structure on the card and
      defines the method of writing and reading card data. This approved
      international standard was published in 1996.

-     In the United States, ANSI has adopted all of the above ISO Standards as
      ANSI/ISO Standards.

      The LaserCard optical memory card system, featuring the DELA Standard
format, complies with all documents listed above. (For additional information,
see "Competition.")


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<PAGE>   9
LASERCARD PRODUCTS

Card Manufacture

      Optical memory cards are manufactured in Mountain View, California. As
explained in "Management's Discussion and Analysis," the Company's optical
memory card manufacturing facility is designed for a production capacity of up
to 25 million optical cards per year, depending upon type of card and
color-printing requirements. The Company manufactured approximately 2.3 million
cards in fiscal 1998 and 456,000 cards in fiscal 1997 for commercial sales. The
Company also produces additional quantities of cards for distribution at trade
shows as marketing samples.

      The ability to produce optical memory cards in high volume in the
Company's card manufacturing facility will be dependent upon maintaining sources
of supply of certain materials meeting the requirements for quality, quantity,
and price. Such materials include special photographic films which are
commercially available solely from the Eastman Kodak Company, of the United
States. The Company believes that Kodak will continue to supply such
photographic films to the Company on a satisfactory basis. Plastic films used in
optical card production are available from one supplier in the U.S. and from
multiple foreign suppliers. Processing chemicals, inks, bonding adhesives, and
packaging materials are obtained from various U.S. and foreign suppliers.

      To ensure adequacy of raw material supplies, the Company attempts to
establish ongoing relationships with principal suppliers and maintains
information about alternate suppliers. The Company stocks reasonable inventory
levels of raw materials that are consistent with current expected demand,
order-to-shipment lead times, and minimum order quantities. To enable the
Company to plan raw material inventory levels, quotations to potential customers
generally are based upon certain advance payments to the Company.

Product Evolution

      The Company continues to upgrade its optical memory card products. It has
been able to adjust card production to meet evolving international standards and
for adding signature panels, sequential serial numbers, bar codes, magnetic
stripes, and laser-recorded "embedded holograms" to optical cards for certain
applications. In addition, "chip ready" optical memory cards can be purchased
from the Company, for insertion of IC chips to create what the Company has
termed Smart/OpticalTM cards. The Company expects its products to continue to
evolve to meet changing market needs or to create new markets for optical memory
cards.

Marketing and Technical Support

      LaserCard Systems Corporation (LSC), a wholly owned subsidiary of Drexler
Technology Corporation, markets the Company's products, primarily through an
international network of value-added resellers (VARs). VARs may add value in the
form of services, application-specific software, personal computers, or other
peripherals, and then resell these products, integrated into systems, to
end-user customers.

      LaserCard marketing offices are located in Mountain View, California;
Paris, France; and Zurich, Switzerland. In addition, general management and
technical personnel work closely with the Company's marketing staff. A key
function of the marketing organization is to attract and qualify new VARs and
provide customer support and products to the VARs, thus generating revenues from
the sale of optical memory card products domestically and internationally.

      During fiscal 1998, the Company sold LaserCard products to approximately
38 customers located in seven states and 20 foreign countries. Outside of the
United States, sales of the Company's LaserCard products and licenses in fiscal
1998, 1997, and 1996 were 10%, 35%, and 42%, respectively, of net sales. The
Company believes that international markets will continue to be an important
source of license revenue and product sales. Substantially all foreign product
sales are made through the VAR network, whereas licensing activity is conducted
directly by the Company.

      Under nonexclusive distribution agreements with LSC, the VARs purchase the
Company's optical cards, LSC's system software, optical card reader/writers made
by a licensee of the Company, and other peripherals. LSC also provides customer
technical support related to optical memory card system integration, software,
sales, and maintenance. This technical support is provided by a staff of
administrative, software, and engineering professionals.


                                       9
<PAGE>   10
System Software

      System software controls or facilitates the basic operations and
read/write functions of optical memory card reader/writers so that they can
interface directly with personal computers (PCs). LSC develops LaserCard-related
system software such as device drivers, file system DLLs (dynamic link
libraries), and custom software tools to enhance reader/writer integration. LSC
also offers contract service support to VARs that require custom programming in
the development and integration of their LaserCard applications. In addition,
LSC provides software for demonstrating archival, medical, and security concepts
involving the LaserCard, and software-development tools for related peripherals.
(Also see "The Role of VARs in Application Software.") The Company continues to
upgrade its system software capabilities.

      Windows(R) 3.x/DOS Device Driver. A device driver is system software that
translates operating system commands so that the reader/writer emulates a floppy
disk drive. LaserCard device drivers save VARs and their customers considerable
custom software development time because existing application software can be
modified easily to work with the LaserCard. LSC's first device driver was a DOS
(disk operating system) device driver for using LaserCard-equipped personal
computers under the DOS platform and with Windows 3.x.

      Windows(R) NT Device Driver. The Windows NT device driver, developed by
LSC's software staff, allows the Company's optical memory card to be used with
computer networks under Windows NT, a widely used network operating system. The
Windows NT device driver offers these features:

-     Provides compatibility between device drivers--files written to the
      LaserCard using the DOS/Windows 3.x driver are compatible with Windows NT
      driver, and vice versa

-     Enables use of LaserCard with network software sold by Microsoft, Novell,
      and others

-     Supports multi-tasking applications and background reader/writer operation

-     Facilitates the first-ever connectivity of optical card reader/writers to
      multiple hardware platforms (such as Intel x86, DEC Alpha, IBM Power PC)

-     Functions with Windows NT application software programs

      SCSI Driver/Adapter. System software available from LSC also includes SCSI
(small computer system interface) host adapters and device drivers for
connecting the LaserCard reader/writer to a personal computer. Consisting of a
software data format (driver) and a hardware add-on (adapter), this product
facilitates the interchange of data among different types of ISO/DELA Standard
optical card reader/writers.

      LaserCard File System (LCFS) Software. The LCFS is a complete software
development package that supports Windows 3.x, Windows(R) 95, and Windows NT.
Optical card applications can be developed using LSC's LaserCard File System DLL
for additional security and to optimize the LaserCard's WORM recording medium
without the constraints of a DOS or Windows file structure. The LCFS is not part
of an operating system (as device drivers are) so access to the card is
available only from the application that created the data on the card or from a
related application. The following are features of the LaserCard File System
DLL:

-     Enables use of the LaserCard with database management systems from
      Microsoft, Oracle, Sybase, and others

-     Permits writing of LaserCard application programs under software languages
      such as Visual Basic, C++, and others

-     Generates up to 16 partitions for highly secure, password-protected,
      multiple-application cards

-     Enables LaserCard file format to be operating-system independent

-     Supports multiple sector size recording to optimize data capacity

      Note: Windows, Windows 95 and Windows NT are trademarks of Microsoft
      Corporation.


                                       10
<PAGE>   11
The Role of VARs in Application Software

      As described above, the Company's software consists of optical memory card
device drivers and interface software, file systems, software development tools,
and application demonstration programs. However, the Company does not develop
commercial application software but instead relies on VARs or their customers to
do so. Application software is an important factor in developing commercial
markets for optical memory cards because it directs computers to do specific
tasks related to the customer's end-user application for the LaserCard (such as
storing a health record). In this role, VARs may integrate optical card products
into existing software, write new application software for specific programs, or
license software from other VARs of the Company. VARs have written optical card
application software programs for certain applications, and other application
software development is underway by VARs and their customers.

Reader/Writers

      Under a royalty-bearing license purchased from the Company, commercial
quantities of ISO/DELA Standard format optical card reader/writers are available
from Nippon Conlux Co., Ltd. ("Conlux"). This supplier (a public company listed
on the First Section of the Tokyo Stock Exchange) sells its reader/writers to
the Company under a nonexclusive distribution agreement. The Company then
incorporates the Conlux reader/writers into systems for sale to customers. The
Company sells reader/writers for a few thousand dollars per unit, and these
units generally include the Company's device driver software. The yen/dollar
exchange rate affects the price of reader/writers, since they are purchased in
Japanese yen. In principle, price reductions due to production economies of
scale, volume price breaks on components, and other volume manufacturing cost
savings can be achieved when production shifts from small-scale to large-scale
volumes.

Multi-Card Workstation

      In fiscal 1998, the Company delivered six multi-card workstations that can
read/write a variety of data cards. The multi-card workstation was developed by
the Company for a U.S. government application under an $820,000 contract
received from an existing customer. The Company has the right to manufacture the
workstation and to market it to other customers.

      The multi-card workstation functions in conjunction with a personal
computer (PC). LaserCard optical memory cards used with the workstation contain
a narrower optical memory stripe that is capable of storing over 1 megabyte of
user data. The card workstation also can read and/or write conventional
magnetic-stripe cards, OCR-B (optical character recognition) symbology,
2-dimensional bar codes, and smart cards having a microcontroller chip that
contains a microprocessor and semiconductor memory.

      The multi-card workstation also is capable of writing and reading data to
and from a single "Smart/Optical(TM) card"--a card containing both a
microcontroller/microprocessor chip and an optical memory stripe. In general,
the Smart/Optical card, like a tiny PC, could be used for a wide variety of
applications by utilizing its microprocessor for transaction processing and its
optical memory for data storage. By combining two or three technologies, a
single card could house multiple applications such as Internet electronic
commerce, medical insurance, financial transactions, medical/health records,
identification, admission tickets, and airline- and travel-benefits programs.

Other Peripherals

      LSC also purchases and resells the following application-specific
peripherals:

-     Thermal card printers for printing eye-readable photo, logos, and text in
      black and white or color (using consumable printing ribbons)

-     Digital biometric identity verification systems (hand geometry,
      fingerprint, and signature verification systems) for comparing a unique
      biometric identifier stored on the LaserCard with that of the card user

-     X-ray scanner

-     Electronic digital camera with video capture board for storing
      computer-readable photos in color


                                       11
<PAGE>   12
LICENSING

      The Company has developed a portfolio of U.S. and foreign patents which
have generated significant revenues in the form of license agreements related to
optical memory cards and equipment for using the cards. The Company's patent
licensing program is directed mainly toward licensing the manufacture of optical
card reader/writers and, in a few special cases, manufacture of the optical
cards themselves.

      The Company presently offers nonexclusive, royalty-bearing licenses for
optical memory card reader/writer manufacture and for card manufacture. Also
offered are nonexclusive licenses for optical memory card distribution. These
create licensed card distributors in regions of the world, that can buy cards
wholesale from the Company at prices lower than are charged to VARs. The
Company's royalty-bearing, reader/writer manufacturing licenses include optical
memory card distribution rights and, in some cases, license upgrades for rights
to additional patents. The Company estimates that approximately eight licensees
are involved in some aspect of the optical memory card industry--such as
reader/writer manufacture, optical memory card manufacture, market development,
standards, software development, or system integration.

      Initial license fees charged by the Company for its licenses vary based on
the rights and benefits of each license. License fees are unconditional and
nonrefundable and no significant obligations remain unfulfilled by the Company
under the licenses. The Company conducts its licensing efforts on a selective
basis; the timing, number, type, and magnitude of future license sales, if any,
cannot be predicted. The Company no longer relies on license fees to finance
operations.

Basic Licenses and Upgrades

      The Company has sold limited-term, nonexclusive, basic licenses to over 25
companies worldwide. Each such license involved a one-time license payment and
no royalties. The basic license included certain technical knowhow, information,
and nonexclusive licenses under certain patents, owned by the Company, involving
equipment for reading and writing optical memory cards. Some of these licenses
include card distribution rights for the purchase of optical memory cards, for
use or resale, at the Company's most favorable pricing. The Company also has
sold five nonexclusive, royalty-bearing license upgrades related to equipment
for reading and writing optical memory cards. The upgrade extends the term of
the basic license and covers equipment patents issued to the Company after the
date limits of the original basic license agreements. No basic licenses or
upgrades have been sold since 1989.

Card Manufacturing Licenses

      Two nonexclusive, royalty-bearing, patent licenses have been sold by the
Company for optical memory card manufacture--one in fiscal 1989 and one in
fiscal 1991. The fee for each card manufacturing license was $10 million plus
long-term, periodic royalty payments to the Company. The 1989 license sale was
to Canon Inc., which previously also had purchased a basic license from the
Company. The 1991 optical memory card manufacturing license was sold to Optical
Memory Card Business Corporation ("OMCBC"), a Japanese company formed by Dai
Nippon Printing Co., Ltd. and three reader/writer equipment licensees of the
Company--Nippon Conlux Co., Ltd., Olympus Optical Co., Ltd., and Omron
Corporation. As described under "Competition," OMCBC is a second source
(alternate) supplier for optical memory cards compatible with the Company's
cards. The Company may consider the sale of additional such licenses, but the
future sale or timing of any licenses cannot be predicted or inferred from past
events.

Card Distribution and Other Licenses

      A card distribution license entitles the licensee to purchase optical
memory cards from the Company at the most favorable pricing, for use or resale.
Card prices to licensed distributors are typically 10% to 15% below VAR pricing
for optical cards having similar data capacity, printing complexity, formatting
complexity, specifications, tolerances, quality, quantity, and delivery times.
No card distribution licenses were sold in fiscal 1998 or 1997; however, a
fiscal 1998 agreement licensed the Company's Canadian patent covering motion
picture digital sound, with certain rights for conversion to other license
rights. In fiscal 1996, a $200,000 fee payment was received toward the purchase
of an optical memory card distribution license in conjunction with a trademark
license.


                                       12
<PAGE>   13
COMPETITION

Other Technologies

      Depending on the application, optical memory cards compete with certain
other portable data storage cards used for the storage and transfer of digital
information. In addition, in countries such as the United States and Japan,
where the telecommunications infrastructure is extensive and low cost, it is
possible that centralized databases and wide-area networks may limit the
penetration of optical memory cards into some potential markets. Also, since the
optical memory card is not widely commercialized, some potential customers may
choose to employ technologies that have been in use longer. The Company believes
that the LaserCard's storage capacity, read/write capability, performance/cost
ratio, rugged card construction, portability, ability to store an audit trail,
and resistance to counterfeiting and tampering make the LaserCard a viable
choice for a number of card applications. Examples include medical
records/medical image cards, high-security ID card systems, and
warranty/maintenance cards.

      IC Cards. The LaserCard competes in some applications, such as the medical
records market, with cards that contain an integrated circuit (IC) memory and/or
a microprocessor. They are known as "smart cards" or "IC cards" or "chip cards."
They are susceptible to damage by electrical discharges and also can be more
vulnerable to unauthorized access and duplication. The IC card can be more
easily damaged in everyday use, whereas the Company's card construction and the
use of polycarbonate plastic make the LaserCard more rugged. Also, an 8-
kilobyte IC card can store only about 1% of the amount of data storable on a
LaserCard. (See "Card Storage Capacity" for memory comparisons.) IC card prices
and performance vary widely. The IC card uses a much lower cost reader/writer
than is used with an optical card, whereas a typical smart card containing an
8-kilobyte IC and a microprocessor is higher priced than the Company's 4.1
megabyte optical memory card.

      Because of their low-priced reader/writer, IC cards containing an
8-kilobyte IC and a microprocessor are very competitive, particularly in
one-card-per-reader/writer systems and in the markets for financial transaction
systems. The IC card has a greater installed base outside the U.S.A. (it was
invented five years before the LaserCard). Low-storage capacity IC cards are
currently used as payphone cards and point-of-sale cards, particularly in
Europe. Low-storage capacity cards for payphones and for debit/cash card systems
(recently introduced into the U.S. banking industry) are not markets for the
Company's cards. However, for multi-application cards, secure electronic
commerce applications, and some patient record applications, the Company offers
"chip ready" optical memory cards to which an IC can be added (called
Smart/Optical(TM) cards).

      Other Card Products. Read/write magnetic-stripe cards, read-only-memory
(ROM) bar code cards, and ROM symbology cards compete with the Company's optical
memory cards for certain markets, such as identification cards. However, the
Company's cards have significantly higher storage capacity and offer unique
security features to deter counterfeiting. Magnetic-stripe cards are relatively
easy to duplicate and, because they are erasable and re-recordable, are highly
susceptible to unauthorized erasure and alteration. ROM bar codes on cards and
other symbology cards store relatively small amounts of data compared to the
LaserCard and cannot be recorded on after they are issued. However, alternative
technologies such as magnetic stripes, IC chips, and bar codes/symbology can be
incorporated into the Company's optical memory cards, thereby adding additional
performance features to the LaserCard.

      There also are high capacity, high cost storage cartridges called PCMCIA
(Personal Computer Memory Card Industry Association) cards, or "PC cards," that
are used in personal computer applications, for example, data-storage devices
for portable computers. Because they are structurally rigid, thick, and
significantly higher in cost, PC cards are not considered competitive with the
LaserCard for wallet-card applications.

Other Optical Memory Cards

      Under royalty-bearing licenses from the Company, two Japanese firms,
Optical Memory Card Business Corporation (OMCBC) and Canon Inc., make and sell
read/write optical memory cards in competition with the Company. The Company's
LaserCard utilizes the ISO/DELA format developed by the Company in conjunction
with a group of its licensees, and the Canon optical memory card uses the
ISO/SIOC format developed by Canon. Although both card formats meet the ISO
Standard, the Company's ISO/DELA format and the Canon ISO/SIOC format are not


                                       13
<PAGE>   14
functionally compatible. The Company believes that its ISO/DELA format offers
some performance advantages over Canon's ISO/SIOC format. The Company also
believes that, through its LaserCard Systems subsidiary, it currently offers
competitive advantages in areas such as system integration, system software, and
customer support services.

      Optical card reader/writers using the ISO/DELA format are manufactured by
Conlux, a licensee from which the Company purchases reader/writers for resale.
(See "Reader/Writers") Canon-produced reader/writers use the ISO/SIOC format.
Another licensee of the Company, Olympus Optical Co., of Japan, is capable of
producing reader/writers compatible with DELA, SIOC, or its own proprietary,
non-standard format but is not known to be selling ISO/DELA format
reader/writers at this time.

      The Company produces ISO/DELA format cards. Dai Nippon Printing Co., Ltd.
(the principal owner of OMCBC) produces optical memory cards using the ISO/SIOC
format, as well as cards using the ISO/DELA format, and is capable of producing
the non-standard Olympus format. The Company's current worldwide market share
for optical memory cards exceeds that of its competitors. At least several times
as many ISO/DELA cards than have been manufactured and sold than ISO/SIOC format
cards. Nevertheless, ISO/SIOC format cards and reader/writers have been sold in
competition with Company products, although in smaller quantities so far. The
Company believes that if Canon and Olympus continue their marketing programs,
they should begin to obtain material orders for cards and equipment. The Company
anticipates that a number of optical memory card programs will be dedicated
applications for defined groups of users and, thus, various types of
optical-card formats will coexist. However, the resources for marketing of
Canon, Olympus, and Dai Nippon Printing are substantially greater than those of
the Company.

      Additional entrants into the read/write optical memory card industry could
expand the overall size of the market and also could result in licensing
opportunities for the Company. In the past, a number of firms have disclosed the
development of alternative optical cards, including Asahi Chemical, Optical
Recording Corporation, Polaroid, Sony, and Toppan Printing. However, the Company
is not aware of any current optical memory card-related commercial activities by
these firms.

      Please see "Patents and Trademarks" for a discussion of Optical
Read-Only-Memory (OROM) cards, which do not compete with read/write optical
memory cards but may involve certain patents owned by the Company.

OTHER MATTERS

Research and Engineering Expenses

      In fiscal years 1998, 1997, and 1996, research and engineering expenses,
excluding customer-funded engineering programs, approximated $435,000, $938,000,
and $1,092,000. The manufacturing facility is used both for engineering and card
manufacturing. Therefore, facility costs (depreciation expense, building lease
payments, and other costs) are allocated between manufacturing and engineering
based on the level of manufacturing activity. (For further information, please
see "Management's Discussion and Analysis.")

Patents and Trademarks

      As of March 31, 1998, the Company owned approximately 50 U.S. patents
relating to optical data storage (including media, optical cards, formats,
equipment, systems, and the utilization of optical storage media). Counterparts
of certain U.S. patents have been issued as patents in a number of foreign
countries, and the Company has applied for additional foreign patents
corresponding to U.S. patent applications. However, the Company owns certain
U.S. patents as to which foreign counterparts have either not been filed or the
prosecution has been terminated without issuance of the foreign patents. Also,
from time to time, the Company elects to allow some of its U.S. or foreign
patents to expire when maintenance fees become due, if the patents are deemed no
longer relevant. In addition to its patents, the Company has chosen to protect
as trade secrets, rather than by patents, some refinements to the Drexon medium
and cards and knowhow related to their manufacture.

      The Company's United States patents have expiration dates ranging from
2002 to 2012, with the majority expiring during the first half of this period.
Counterpart patents in foreign countries also expire during that period. Under
its


                                       14
<PAGE>   15
license agreement with the Company for manufacture of optical memory cards,
OMCBC's obligation to pay royalties to the Company for use of the licensed
patents ceases on December 31, 2003. Canon's royalty obligations in connection
with its licenses to manufacture optical memory cards and reading and writing
equipment expire on December 31, 2008. Other royalty-bearing licenses sold by
the Company related to equipment for reading and writing optical cards provide
for royalty payments to cease on the last expiration date of the licensed
patents.

      The Company is unable to determine whether there would be a material,
adverse effect on royalties in the event of expiration or unenforceability of
its patents, because the Company's royalty revenues are not significant at this
time. The Company also cannot predict whether the expiration or invalidation of
its patents would result in the introduction of competitive products which would
affect its future revenues adversely. The Company is not aware of any optical
card products in commercial use which otherwise would infringe its patents in
countries where the Company might have difficulty enforcing its patents or has
no patent protection.

      The Company presently intends to pursue any infringement of its patents
either by litigation, arbitration, or negotiation. However, there can be no
assurance that any of the Company's patents will be sufficiently broad in scope
to afford protection from products with comparable characteristics that may be
sold by competitors in the future. There also can be no assurance that the
validity of any patents actually granted will not be challenged. In 1992, the
claims of three of the Company's issued U.S. patents successfully passed
re-examination proceedings in the U.S. Patent and Trademark Office (USPTO) after
a two-year review by the USPTO's Board of Patent Appeals and Interferences.

      Motion Picture Digital Sound. The Company believes that two of its optical
data storage U.S. patents apply to the motion picture industry in connection
with using CCD (charge-coupled device) arrays for reading digital sound signals
from optically stored digital data on motion picture film. The Company has
notified some of the probable infringers and has been attempting to license the
two patents and in 1996 offered to submit the patent infringement complaints to
binding arbitration.

      OROM Card Systems. Optical Read-Only-Memory (OROM) cards cannot be
recorded by the end user (consumer) but are compact, high-storage capacity, data
carriers. OROM cards, currently under development by Ioptics, Inc., would be
approximately 2 millimeters thick and relatively rigid compared with the
Company's 0.8-millimeter-thick, flexible cards. According to an April 1998 press
article, Ioptics' current OROM demonstration units use glass media as cards and
CCD-based sensors for reading data from the cards. Because OROM cards are not
read/write cards, they would not compete directly in applications for which the
Company's read/write cards are being used. Instead, if they become commercially
viable, OROM cards would be used for the distribution of software, video games,
databases, etc., for hand-held personal computers. The Ioptics plan is to have
data stamped onto plastic cards for high-volume applications or stored on a
laser-recordable layer of the card using special laser-writing equipment for
smaller volume applications. It has been reported that Microsoft Corporation is
working with Ioptics on an OROM card system, to be used in a future
mini-notebook computer that would run on Windows CE 2.0 software. This is the
first time that Microsoft has been reported as showing support for optical
memory cards. The Company has advised Microsoft that it probably could be
infringing as many as five of the Company's U.S. patents plus foreign
counterparts and has offered Microsoft a worldwide patent license on terms and
conditions normally offered to companies that have not infringed the Company's
patents.

      There is no assurance that any of the Company's patent licensing efforts
will be successful. The Company no longer relies on license fees to finance
operations.

      Trademarks. LaserCard(R) and Drexon(R) are federally registered trademarks
of Drexler Technology Corporation.

Environment

      Compliance with federal, state, and local laws and regulations involving
the protection of the environment did not have and is not expected to have a
material effect on the Company's capital expenditures, earnings, or competitive
position. The Company is a voluntary participant in the U.S. Environmental
Protection Agency's "Green Lights" program, under which most of the Company's
lighting systems have been upgraded for energy efficiency.


                                       15
<PAGE>   16
Year 2000 Disclosure

      To ensure that the Company's computer systems are Year 2000 compliant, the
Company has begun preparing for the Year 2000 issue. The Company has been
reviewing each of its financial and operating systems to identify those that
contain two-digit year codes. The Company is assessing the amount of programming
required to upgrade or replace each of the affected programs, with the goal of
completing all relevant internal software remediation and testing by the end of
calendar year 1998, with continuing Year 2000 compliance efforts through 1999.
Based upon current information, the Company does not anticipate costs associated
with the Year 2000 to have a material financial impact. However, there can be no
assurances that there will not be interruptions or other limitations of
financial and operating systems functionally or that the Company will not incur
significant costs to avoid such interruptions or limitations. Costs incurred
relating to the Year 2000 issue will be expensed by the Company during the
period in which they are incurred. The Company's expectations about future costs
associated with the Year 2000 issue are subject to uncertainties that could
cause actual results to have a greater financial impact than currently
anticipated. Factors that could influence the amount and timing of future costs
include the success of the Company in identifying systems and programs that
contain two-digit year codes, the nature and amount of programming required to
upgrade or replace each of the affected programs, the rate and magnitude of
related labor and consulting costs, and the success of the Company's customers
and suppliers in addressing the Year 2000 issue.

Employees

      As of March 31, 1998, the Company and its subsidiaries employed 85 persons
(including four executive officers). This workforce consisted of approximately
66 persons in administration, marketing/sales, manufacturing, and research and
engineering, plus approximately 19 temporary personnel mainly for quality
assurance inspection of cards. None of the Company's employees is represented by
a labor union.

RISK FACTORS

Early Stage of Product Commercialization

      Commercial Status. The Company has invested considerable resources in the
development of optical memory cards and related equipment and system software.
These products entered the commercial stage through the Company's VAR
(value-added-reseller) network, which was initially launched in 1991; and, in
1993, optical memory card products, software, and systems represented the
Company's sole product line. During fiscal 1998, the Company sold approximately
2.3 million optical memory cards, related equipment, and system software through
its subsidiary, LaserCard Systems Corporation, to approximately 38 customers
located in seven states and 20 foreign countries. The Company currently makes
and sells optical cards in varying quantities, with orders typically ranging
from 5,000 to 150,000 cards per order, with the exception of two 2-million-card
orders. High-volume orders for optical memory cards require the VAR companies to
develop customers and applications, or to obtain significant follow-on orders
from customers whose programs are already underway. The frequency and size of
such orders cannot be predicted. The Company has received orders from the U.S.
Immigration and Naturalization Service ("INS") totalling $13.5 million for 4
million cards, with deliveries scheduled monthly through December of 1998.

      Reliance on a Single Customer. The Company is heavily dependent on INS
orders for "Green Cards" and "Laser Visa" cards. These orders provide the
largest component of the Company's currently anticipated card production. The
Company could encounter equipment, raw material, quality control, or other
production problems under high-volume production of this magnitude. Also, as is
the case in all U.S. government procurement, the government reserves the right
to change specifications, delay deliveries, and cancel all or part of the
orders. The Company believes that follow-on orders should be forthcoming;
however, the Company could experience difficulty in the future if it does not
receive ongoing orders for INS cards or find additional customers.


                                       16
<PAGE>   17
Sources of Supply

      Raw Materials. The Company does not have the technology or resources to
manufacture certain raw materials used in the manufacture of optical memory
cards; accordingly, its ability to produce the cards will be dependent upon
maintaining sources of supply of such raw materials meeting its requirements for
quality and quantity.

      Reader/Writer Availability. Optical card reader/writer availability is
essential for the viability and growth of the optical memory card business.
Nippon Conlux Co., Ltd. ("Conlux"), a Japanese company, is currently the only
supplier of reader/writer equipment for DELA-standard format cards, which are
the type of card manufactured by the Company and a licensed second-source card
manufacturer. DELA Standard format cards comprise the majority of optical memory
cards sold in the world marketplace to date. Two other licensees of the Company
have the technical capability to produce reader/writers compatible with the
Company's optical memory cards, but are not manufacturing them. If Conlux were
to curtail manufacture of reader/writers, the Company would allocate its
incoming shipments of such devices among incoming orders from established
customers. Conlux has not developed its own optical memory card and is not known
to be doing so. Its customers continue to rely on cards manufactured by the
Company or, particularly with respect to Japanese customers, by Optical Memory
Card Business Corporation ("OMCBC"), a Japanese licensee of the Company, of
which Conlux is a minority owner. The Company sells Conlux reader/writers for a
few thousand dollars per unit, and these units generally include the Company's
device-driver software. The Company believes that card-related revenues would
grow more rapidly if card reader/writers are produced and sold in volume at
lower prices than at present. However, the Company can give no assurance that
increased reader/writer production will occur in the near term or that
high-volume sales and correspondingly lower prices will result. Furthermore, the
yen/dollar exchange rate affects the price of reader/writers, since they are
purchase in Japanese yen. In addition, if market demand increases sharply over a
short period of time, an initial shortage of reader/writers could result.

Limited Capital Resources

      Prior to fiscal 1998, the Company did not generate net cash from
operations after expenses. For fiscal 1998, the level of revenues was sufficient
to generate cash from operations after expenses, excluding fluctuations in
operating assets and liabilities, primarily due to card sales for U.S.
government use. No assurance can be made that this level of sales will continue
beyond the term of the existing INS card orders. The Company believes that it
should receive additional orders from the INS, but no assurance can be given
that such orders will be forthcoming. The Company generally obtains advance
payments, in whole or in part, from customers prior to the time of manufacturing
items made to customer specifications. The Company believes that, although
working capital requirements should grow in proportion to increased product
order and shipment levels, the advance payments will reduce the need for working
capital financing. However, the Company may require financing for capital
expenditures to increase production capacity and for other reasons. In addition,
the Company has not established a line of credit, and no assurance can be made
that the Company will be successful in obtaining a line of credit should it
become necessary to do so. During fiscal 1998, the Company generated cash of
$1,850,000 on the sale of 283,600 shares of common stock to Company employees
through the exercise of stock options under the Company's 1991 Stock Option
Plan. Also during fiscal 1998, the Company received approximately $1,900,000
from the sale of 200,000 shares of common stock divided among three investors;
there is no assurance that such financing could be repeated on similar terms.

Historical Losses

      As of March 31, 1998, the Company had an accumulated deficit of
$25,717,000. The Company operated profitably for fiscal 1998, primarily as a
result of card sales for a U.S. government application. The Company operated at
a loss during the previous four fiscal years. The Company is relying upon its
optical card technology to generate future product revenues, earnings, and cash
flow. Losses could recur if U.S. government orders decrease and there are delays
in other customers' development of optical-card-based programs and corresponding
commercialization of the Company's optical cards and related products.


                                       17
<PAGE>   18
Stock Price Volatility

      The price of the Company's common stock is subject to significant
volatility due to fluctuations in revenues, earnings, capitalization, liquidity,
press coverage, and financial market interest. Some of these factors may be
exacerbated because the Company operates solely in the optical memory card
products industry, which is in the early stages of commercialization.

Competition

      Read/Write Optical Memory Cards. Under royalty-bearing licenses from the
Company, two Japanese firms, Optical Memory Card Business Corporation (OMCBC)
and Canon Inc., make and sell read/write optical memory cards in competition
with the Company. The Company's LaserCard utilizes the ISO/DELA format developed
by the Company in conjunction with a group of its licensees, and the Canon
optical memory card uses the ISO/SIOC format developed by Canon. Although both
card formats meet the ISO Standard, the Company's ISO/DELA format and the Canon
ISO/SIOC format are not functionally compatible. The Company believes that its
ISO/DELA format offers some performance advantages over Canon's ISO/SIOC format.
The Company also believes that, through its LaserCard Systems subsidiary, it
currently offers competitive advantages in areas such as system integration,
system software, and customer support services. Optical card reader/writers
using the ISO/DELA format are manufactured by Conlux, a licensee from which the
Company purchases reader/writers for resale. (See "Reader/Writer Availability")
Canon-produced reader/writers use the ISO/SIOC format. Another licensee of the
Company, Olympus Optical Co., of Japan, is capable of producing reader/writers
compatible with DELA, SIOC, or its own proprietary, non-standard format but is
not known to be selling ISO/DELA format reader/writers at this time. The Company
produces ISO/DELA format cards. Dai Nippon Printing Co., Ltd. (the principal
owner of OMCBC) produces optical memory cards using the ISO/SIOC format, as well
as cards using the ISO/DELA format, and is capable of producing the non-standard
Olympus format. The Company's current worldwide market share for optical memory
cards exceeds that of its competitors. At least several times as many ISO/DELA
cards than have been manufactured and sold than ISO/SIOC format cards.
Nevertheless, ISO/SIOC format cards and reader/writers have been sold in
competition with Company products, although in smaller quantities so far. The
Company believes that if Canon and Olympus continue their marketing programs,
they should begin to obtain material orders for cards and equipment. The Company
anticipates that a number of optical memory card programs will be dedicated
applications for defined groups of users and, thus, various types of
optical-card formats will coexist. However, the resources for marketing of
Canon, Olympus, and Dai Nippon Printing are substantially greater than those of
the Company.

      Other Technologies. The Company also competes in certain applications with
other portable data storage cards, particularly chip (integrated
circuit/microprocessor or "IC") cards. IC cards which store three or four pages
of text compete directly with optical memory cards in applications where the
limited storage capacity of IC cards and higher cost per card, but lower cost
per reader/writer, will suffice. The advantages of the optical memory card in
storage capacity, durability, and unique security or privacy features, make it
better suited for certain customers (for example, for patient record cards for
healthcare and high-security identification cards for immigration). The IC card
has a greater installed base worldwide at present, mainly as prepaid telephone
cards, which is not a market for the Company's cards. For applications with
relatively low storage capacity, such as pay-per-view television or electronic
banking/credit/debit cards, the Company expects IC cards to be used instead of
optical memory cards. (Also, see "IC Cards" elsewhere in this report.)

      Read/write magnetic-stripe cards, read-only-memory (ROM) bar code cards,
and ROM symbology cards compete with the Company's optical memory cards for
certain markets, such as identification cards. However, the Company's cards have
significantly higher storage capacity and offer unique security features to
deter counterfeiting. Magnetic-stripe cards are relatively easy to duplicate
and, because they are erasable and re-recordable, are highly susceptible to
unauthorized erasure and alteration. ROM bar codes on cards and other symbology
cards store relatively small amounts of data compared to the LaserCard and
cannot be recorded on after they are issued. However, alternative technologies
such as magnetic stripes, IC chips, and bar codes/symbology can be incorporated
into the Company's optical memory cards, thereby adding additional performance
features to the LaserCard.

      There also are high capacity, high cost storage cartridges called PCMCIA
(Personal Computer Memory Card Industry Association) cards, or "PC cards," that
are used in personal computer applications, for example, data-storage


                                       18
<PAGE>   19
devices for portable computers. Because they are structurally rigid, thick, and
significantly higher in cost, PC cards are not considered competitive with the
LaserCard for wallet-card applications.

      In addition, in countries such as the United States and Japan, where the
telecommunications infrastructure is extensive and low cost, it is possible that
centralized data bases and wide-area networks may limit the penetration of
optical memory cards into some potential markets.

Patent Protection

      The Company's U.S. patents have expiration dates ranging from 2002 to
2012, with the majority expiring during the first half of this period.
Counterpart patents in foreign countries also expire during that period. Under
its license agreement with the Company for manufacture of optical memory cards,
OMCBC's obligation to pay royalties to the Company for use of the licensed
patents ceases on December 31, 2003. Canon's royalty obligations in connection
with its licenses to manufacture optical memory cards and reading and writing
equipment expire on December 31, 2008. Other royalty-bearing licenses sold by
the Company related to equipment for reading and writing optical cards provide
for royalty payments to cease on the last expiration date of the licensed
patents. The Company is unable to determine whether there would be a material,
adverse effect on royalties in the event of expiration or unenforceability of
its patents, because the Company's royalty revenues are not significant at this
time. The Company also cannot predict whether the expiration or invalidation of
its patents would result in the introduction of competitive products which would
affect its future revenues adversely. The Company is not aware of any optical
memory card products in commercial use which otherwise would infringe its
patents in countries where the Company might have difficulty enforcing its
patents or has no patent protection.

FORWARD-LOOKING STATEMENTS

      Certain statements made above relating to plans, objectives, and economic
performance go beyond historical information and may provide an indication of
future results. To that extent, they are forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and
each is subject to factors that could cause actual results to differ from those
in the forward-looking statement. In particular, the ability of the Company to
maintain a profitable level of optical memory card sales is subject to risks and
uncertainties with respect to customer diversification, customer expansion, the
economic availability of reader/writers, the implementation of ongoing
commercial applications by customers, and the economic configuration and
operation of the Company's card manufacturing facility for increased output
levels. Such factors are described above, in the "Management's Discussion
Analysis" section of this Form 10-K, and in other documents filed by the Company
from time to time with the Securities and Exchange Commission.

ITEM 2. PROPERTIES

      As of March 31, 1998, approximately 32,000 square feet of floor space are
leased by the Company for production, administration, sales, and research and
engineering, in two buildings located in Mountain View, California. These
facilities have a current total annualized rental of approximately $367,000. The
Company also leases small marketing offices in France and Switzerland.
Management believes these leased facilities to be satisfactory for its present
operations. Upon expiration of the leases, management believes that these or
other suitable facilities will be able to be leased on a reasonable basis.

ITEM 3. LEGAL PROCEEDINGS

      There are no legal proceedings to which the Company is a party or to which
any of its property is subject. However, the Company has advised certain parties
of probable infringement of the Company's patents, which could lead to legal
proceedings.

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

      There were no matters submitted to a vote of security holders during the
fourth quarter of fiscal 1998.


                                       19
<PAGE>   20
                                     PART II


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

      The Company's only class of common stock, $.01 par value, is traded on The
Nasdaq Stock Market(SM) under the symbol DRXR and is quoted in The Wall Street
Journal and other newspapers. The table below sets forth the high and low trade
prices (rounded to the nearest one-eighth) for the Company's common stock as
reported by Nasdaq during the fiscal periods indicated.


                       QUARTERLY STOCK PRICES (Unaudited)

<TABLE>
<CAPTION>
                                                                      Fiscal Quarters
                                                   -----------------------------------------------------
                                                     1st            2nd             3rd            4th
                                                   -------        -------         -------        -------
                                                                (High and Low Trade Prices)
<S>                                                <C>            <C>             <C>            <C>
Fiscal 1997
   High.......................................     18  1/2         16 3/8          14 1/4         14 1/4
   Low........................................     12               9 7/8          10              9 1/4

Fiscal 1998
   High.......................................     11  3/4         13 1/4          12 7/8         16 7/8
   Low........................................      8  11/16        9 1/8           9 3/8         10
</TABLE>

      On March 31, 1998, there were approximately 1,215 holders of record of the
Company's common stock. The Company has never paid cash dividends on its common
stock. The Company anticipates that for the foreseeable future, it would retain
any earnings for use and reinvestment in its business.


                                       20
<PAGE>   21
ITEM 6. SELECTED FINANCIAL DATA

      The following selected consolidated financial information for, and as of
the end of, each of the years in the five-year period ended March 31, 1998, is
derived from the consolidated financial statements of the Company. This
financial data should be read in conjunction with the consolidated financial
statements and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" appearing elsewhere herein.


                   FIVE-YEAR SUMMARY OF FINANCIAL INFORMATION
                    Fiscal Years Ended March 31, 1994 - 1998
                    (In thousands, except per share amounts)


<TABLE>
<CAPTION>
OPERATIONS DATA:                                               1994          1995          1996          1997          1998
                                                             -------       -------       -------       -------       -------
<S>                                                          <C>           <C>           <C>           <C>           <C>    

   Revenues ...........................................      $ 1,838       $ 3,166       $ 5,295       $ 3,529       $11,081
   Cost of product sales ..............................        1,180         1,511         3,659         2,388         5,923
   Selling, general, and administrative expenses.......        1,925         2,023         2,400         2,602         2,978
   Research and engineering expenses ..................        2,202         1,860         1,092           938           435
   Other income .......................................          713             4           202            22            16
   Interest income ....................................           24            35            78            50           148
   Interest expense ...................................            4             7             8             8            10
                                                             -------       -------       -------       -------       -------
   Income (loss) from continuing operations
      before income taxes .............................       (2,736)       (2,196)       (1,584)       (2,335)        1,899
   Provision for income taxes .........................           --            --            --            --            68
   Income (loss) from discontinued operations .........          (90)           22            --            --            --
                                                             -------       -------       -------       -------       -------
   Net income (loss) ..................................      $(2,826)      $(2,174)      $(1,584)      $(2,335)      $ 1,831
                                                             =======       =======       =======       =======       =======
   Income (loss) per share (basic and diluted):
      Continuing operations ...........................      $  (.36)      $  (.27)      $  (.18)      $  (.26)      $   .19
      Discontinued operations .........................         (.01)           --            --            --            --
                                                             -------       -------       -------       -------       -------
   Net income (loss) per share ........................      $  (.37)      $  (.27)      $  (.18)      $  (.26)      $   .19
                                                             =======       =======       =======       =======       =======
   Weighted average number of common
      and common equivalent shares:
      Basic ...........................................        7,581         8,161         8,692         9,006         9,391
      Diluted .........................................        7,581         8,161         8,692         9,006         9,677



BALANCE SHEET DATA:                                            1994          1995          1996          1997          1998
                                                             -------       -------       -------       -------       -------


   Current assets .....................................      $ 2,733       $ 1,873       $ 3,782       $ 4,588       $ 7,561
   Current liabilities ................................        1,154           995         2,044         3,030         1,539
   Total assets .......................................        5,856         4,531         6,371         7,089        11,248
   Long-term obligations ..............................           --            --            --            --            --
   Stockholders' equity ...............................        4,702         3,536         4,327         4,059         9,709
</TABLE>


                                       21
<PAGE>   22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

RESULTS OF OPERATIONS--FISCAL 1998 COMPARED WITH FISCAL 1997 AND 1996

Revenues

      The Company's total revenues for fiscal 1998 were $11,081,000 compared
with $3,529,000 for fiscal 1997 and $5,295,000 for fiscal 1996.

      Product Sales. Sales of LaserCard(R) optical memory cards and related
products to value-added resellers (VARs), licensees, and end-user customers were
$9,844,000 for fiscal 1998 versus $3,510,000 for fiscal 1997 and $5,059,000 for
fiscal 1996. The increase in sales between fiscal 1998 and fiscal 1997 resulted
primarily from United States government orders totalling 4 million optical
memory cards. Of these, approximately 1.8 million cards were delivered during
fiscal 1998. Deliveries under these U.S. government orders are expected to
continue at an average of more than 200,000 cards per month through December of
1998. The difference between fiscal 1997 and fiscal 1996 revenues was due mainly
to an order from the U.S. Department of Defense (DoD) for 537 reader/writer
units in fiscal 1996 versus 83 units for that customer in fiscal 1997, for an
ongoing DoD program. Optical memory card sales in fiscal 1998, 1997, and 1996
were 2.3 million cards, 456,000 cards, and 420,000 cards, respectively.

      Applications for the Company's LaserCard products include: medical data
applications in the United States; various programs in Europe and Asia; several
programs in the Philippines--including an admission pass/retail purchase log at
a duty-free shopping zone and a vehicle warranty and maintenance records card;
and U.S. government-related programs, including the U.S. Department of Defense
"Automated Manifest" card, the U.S. Immigration and Naturalization Service
"Green Card," and the U.S. Department of State "Laser Visa" border crossing
card.

      The Company sold LaserCard products in fiscal 1998 to approximately 38
customers in seven states and 20 foreign countries. The Company utilizes VAR
companies for the development of commercial markets and applications for
LaserCard products. Product sales to VARs include the Company's optical memory
cards, the Company's system software, and optical card reader/writers made by a
licensee of the Company, and may include add-on peripherals made by other
companies (such as equipment for adding a digitized photo, fingerprint, hand
template, or signature to the cards). The VARs may add application software,
personal computers, and other peripherals, and then resell these products,
integrated into data systems, for end-user customers.

      There can be no assurances that any new or existing VAR company in any
country will be successful in its markets or field trials or that it will place
follow-on orders with the Company for additional quantities of cards and
systems. In order to upgrade its VAR customer base to increase the probability
of success, the Company will continue its efforts to recruit new VARs and
eliminate nonproductive ones. The Company provides marketing leads, customer
technical support, and system software to assist VARs.

      Software is an important factor in developing the commercial markets for
optical memory cards. The Company's system software consists of optical card
interface software/device drivers, file systems, software development tools, and
demonstration software. The Company does not provide software for specific
applications, but instead depends on its VARs to integrate optical card products
into existing software products, write new application software for specific
optical card programs, or license software from other VARs. Several VARs have
written optical card software programs for applications such as automobile
warranty and maintenance records, cargo manifesting, digital optical key
systems, admissions/ID, data logging systems, and various medical-related
applications such as medical image storage and health history cards. Other
application software development is underway by VARs and their customers.

      Optical memory cards are used in conjunction with card reader/writer
equipment connected to personal computers and accessed in the same manner as
floppy disk drives. Such reader/writers are sold to VARs and other customers of
the Company. The price, performance, and availability of such reader/writers are
factors in the commercialization of optical cards. The Company sells
reader/writers for a few thousand dollars per unit, and these units generally
include the Company's interface software/device drivers.


                                       22
<PAGE>   23
      The Company does not manufacture card reader/writers but instead continues
to purchase such equipment from a Japanese licensee, Nippon Conlux Co., Ltd.,
currently the Company's sole supplier of reader/writers. The Company's inventory
level for reader/writers fluctuates from zero up to approximately 300 units
based on the timing of purchases and sales. The Company can give no assurance
that increased production of card reader/writers will occur in the near term or
that high-volume sales and correspondingly lower prices will result. If market
demand increases sharply over a short period of time, an initial shortage of
reader/writers could result. Also, an interruption or change in the supply of
reader/writers could cause a delay in both reader/writer and optical memory card
shipments and a possible loss of sales, which would adversely affect operating
results.

      Workstation Revenues. The Company recorded fiscal 1998 revenues of
$820,000 for the delivery of six prototype multi-technology card readers
("multi-card workstations") for an existing customer. These multi-card
workstations can write and/or read cards with one or more of the following
technologies: optical memory stripe, IC chip, magnetic stripe, OCR-B (optical
character recognition), and 2-dimensional bar code. Costs for the development
and manufacture of these workstations were charged to cost of sales. There were
no revenues of this type in fiscal 1997 or 1996.

      License Revenues. Revenues from license fees were $400,000 in fiscal 1998
and $200,000 in fiscal 1996. The license fee payments were received in the
respective fiscal periods. There were no license fee revenues in fiscal 1997.
The fiscal 1996 license agreement included a trademark license and a LaserCard
distribution license payment. The fiscal 1998 agreement licensed the Company's
Canadian patent covering motion picture digital sound, with certain rights for
conversion to other license rights. License fees received by the Company are
unconditional and nonrefundable, and no significant obligations remain
unfulfilled by the Company under any of its licenses. The Company no longer
relies on license fees to finance operations.

      Royalty Revenues. Royalty revenues were $17,000 for fiscal 1998, $19,000
for fiscal 1997, and $36,000 for fiscal 1996. The Company cannot predict whether
or when equipment or card sales by its licensees will result in material
royalties to the Company. Therefore, the Company is not relying on royalty
income and does not expect it to be a significant factor in the near term.

Backlog

      As of March 31, 1998, the backlog for LaserCard optical memory cards was
approximately $7.6 million. Deliveries are estimated to be at an average of
225,000 cards or more per month through about December 1998. About 93% of the
backlog is for U.S. government orders; as is the case in all U.S. government
procurement, the government reserves the right to change specifications, delay
deliveries, and cancel all or part of the orders.

Margins

      The combined gross margin of product sales and workstation contract
revenues for fiscal 1998 was 44% compared with 32% for fiscal 1997 and 28% for
fiscal 1996, due largely to the increase in card sales volume. With the increase
in card manufacturing for customer orders, the Company's optical memory card
manufacturing facility is used less for the purposes of research and
engineering. Therefore, more of the manufacturing facility costs (depreciation
expense, building lease payments, and other costs) are allocated to cost of card
manufacturing, and less of these costs are charged to research and engineering.
For fiscal 1998, the Company allocated substantially all of the facility
expenses to card manufacturing versus approximately 42% and 47%, respectively,
of these expenses for fiscal years 1997 and 1996.

Income and Expenses

      Selling, General, and Administrative Expenses (SG&A). Fiscal year 1998
SG&A expenses were $2,978,000 compared with $2,602,000 and $2,400,000,
respectively, for fiscal 1997 and 1996. The majority of the increases for fiscal
1998 and 1997 versus prior years is attributable to increased payroll and
marketing expenses. SG&A spending is expected to increase during fiscal 1999 due
to increased marketing and customer technical support activities.


                                       23
<PAGE>   24
      Research and Engineering Expenses. Research and engineering expenses,
excluding customer-funded engineering programs, were $435,000 for fiscal 1998
compared with $938,000 for fiscal 1997 and $1,092,000 for fiscal 1996. The
expense reduction is due primarily to accounting for facility costs rather than
an actual reduction in research and engineering. The optical memory card
facility is used for both engineering and manufacturing. Therefore, the facility
costs (depreciation expense, building lease payments, and other costs) are
allocated between manufacturing and engineering based upon the level of activity
in the respective areas. Substantially all of these expenses were allocated to
card production during fiscal 1998 because of the substantial increase in card
production to meet orders. During fiscal 1997 and 1996, approximately 42% and
47%, respectively, of these expenses were allocated to card production. The
Company continues to undertake ongoing research and engineering project
activities related to optical memory cards. Future projects will require
increased spending as the optical card industry grows.

      Other Income and Expense. Other income for fiscal 1998 was $154,000
compared with $64,000 for fiscal 1997 and $272,000 for fiscal 1996. The Company
purchases Japanese yen for payment of reader/writers purchased from a Japanese
supplier. Thus, the Company's normal operations are subject to gains or losses
on fluctuations in the yen/dollar exchange rate. Net other income for fiscal
1998 included a $16,000 gain on foreign currency exchange versus a $22,000 gain
for fiscal 1997. There was no income of this type for fiscal 1996. During the
first quarter of fiscal 1996, the Company received a $200,000 nonrefundable
deposit toward a license agreement. The license agreement was not consummated
and the deposit was forfeited by the licensee. The income from the forfeiture of
the deposit is recorded as other income in fiscal 1996. There was no income of
this type for fiscal 1998 or fiscal 1997.

      Interest income for fiscal 1998 was $148,000 compared with $50,000 for
fiscal 1997 and $78,000 for fiscal 1996. The changes in interest income for each
year were due generally to changes in average invested funds. The Company's
interest expense on short-term loans was $10,000 for fiscal 1998, $8,000 for
fiscal 1997, and $8,000 for fiscal 1996.

LIQUIDITY

      As of March 31, 1998, the Company had cash and cash equivalents of
$4,830,000, a current ratio of 4.9 to 1, and no long-term debt. Net cash used
for operating activities was $71,000 for fiscal 1998 compared with $813,000 for
fiscal 1997 and $940,000 for fiscal 1996.

      The current level of revenues is sufficient to generate cash from
operations after expenses. Fluctuations in operating assets and liabilities will
use cash in some quarters and provide cash in other quarters. Losses could recur
if U.S. government orders decrease and there are delays in other customers'
development of optical-card-based programs and corresponding commercialization
of the Company's optical cards and related products.

      The Company has not established a line of credit and has no current plans
to do so. The Company may negotiate a line of credit if and when it becomes
appropriate, although no assurance can be made that such financing would be
available, if needed.

      As a result of the profit recorded for fiscal 1998, the Company's
accumulated deficit was reduced to $25,717,000 at March 31, 1998. During fiscal
1998, stockholders' equity increased by $5,650,000, to $9,709,000, due to the
$1,831,000 profit, the $1,880,000 (net of expenses) received by the Company from
the sale of 200,000 shares of common stock in private-placement transactions in
October of 1997, and $1,939,000 received by the Company for stock issued during
fiscal 1998 under the Employee Stock Purchase Plan and the 1991 Stock Option
Plan.

      The Company's total deferred income tax asset was $15,445,000 at March 31,
1998. If utilized, the total deferred income tax asset would reduce future tax
expense and payments. Included are amounts derived from federal income tax net
operating losses that will expire at various dates from 2001 through 2012,
amounts from state income tax net operating losses that will expire at various
dates from 1999 through 2002, and amounts from tax credits that will expire from
2000 through 2004, except for alternative minimum tax credits which have no
expiration. The ability of the Company to utilize this deferred tax asset is
contingent upon generating sufficient income within the stated time periods. In
view of the uncertain value of this asset, the Company has recorded a full
valuation allowance against it; therefore, no part of the total deferred tax
asset of $15,445,000 has been added to stockholders' equity on the Company's
balance sheet.


                                       24
<PAGE>   25
      The Company is planning to install an additional $1.5 million of capital
equipment and leasehold improvements in its card production facility by the end
of September 1998. These assets are for the production of advanced optical cards
with new features and for manufacturing-process improvements and will result in
a production capacity of 8 million cards annually. The Company believes that an
additional investment of about $7 million to $10 million in production equipment
and automatic inspection equipment may be required to produce the more advanced
optical cards at a rate of up to 25 million cards per year. Currently, the
Company intends to purchase such equipment incrementally as commercial orders
for optical memory cards justify increased production capacity. In addition to
the investment used for expansion, the Company also will make additional capital
expenditures for cost savings, quality improvements, and other purposes.

      During fiscal 1998, Company employees and consultants purchased from the
Company 283,600 shares of registered common stock, at an average price of $6.52
per share, through the exercise of stock options under the Company's 1991 Stock
Option Plan, which resulted in additional cash receipts to the Company of
$1,850,000. As of March 31, 1998, Company employees and consultants held
unexercised, vested, in-the-money options to purchase 543,200 shares of common
stock at exercise prices ranging from $4.56 to $13.06 per share, for a weighted
average of $8.07 per share. These stock options, if exercised, would provide the
Company with cash in the amount of $4,381,000.

NEW ACCOUNTING PRONOUNCEMENTS

      In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard (SFAS) No. 130, "Reporting
Comprehensive Income," which establishes standards for reporting comprehensive
income and its components (revenues, expenses, gains, and losses) in financial
statements. SFAS 130 requires classification of other comprehensive income in a
financial statement, and the display of the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital. SFAS 130 is effective for fiscal years beginning after December 15,
1997. The Company believes this pronouncement will not have a material effect on
its financial statements.

      In June 1997, the FASB also issued SFAS 131, "Disclosures about Segments
of an Enterprise and Related Information." This pronouncement established
standards for reporting information about operating segments in annual financial
statements and requires that enterprises report selected information about
operating segments in interim financial reports to shareholders. SFAS 131 also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. SFAS 131 is effective for fiscal years
beginning after December 15, 1997, although earlier application is encouraged.
The Company has yet to determine the impact, if any, of adoption of this new
pronouncement.

FORWARD-LOOKING STATEMENTS

      Certain statements made above relating to plans, objectives, and economic
performance go beyond historical information and may provide an indication of
future results. To that extent, they are forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and
each is subject to factors that could cause actual results to differ from those
in the forward-looking statement. In particular, the ability of the Company to
maintain a profitable level of optical memory card sales is subject to risks and
uncertainties with respect to customer diversification, customer expansion, the
economic availability of reader/writers, the implementation of ongoing
commercial applications by customers, and the economic configuration and
operation of the Company's card manufacturing facility for increased output
levels. Such factors are described above, in the narrative section of this Form
10-K, and in other documents filed by the Company from time to time with the
Securities and Exchange Commission.


                                       25
<PAGE>   26
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To Drexler Technology Corporation:

      We have audited the accompanying consolidated balance sheets of Drexler
Technology Corporation (a Delaware corporation) and subsidiaries as of March 31,
1997 and 1998, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended March 31, 1998. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

      In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Drexler Technology
Corporation and subsidiaries as of March 31, 1997 and 1998, and the results of
their operations and their cash flows for each of the three years in the period
ended March 31, 1998, in conformity with generally accepted accounting
principles.

      Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The Schedule II included in this Form
10-K is the responsibility of the Company's management and is presented for
purposes of complying with the Securities and Exchange Commission's rules and is
not part of the basic financial statements. This schedule has been subjected to
the auditing procedures applied in the audit of the basic financial statements
and, in our opinion, fairly states in all material respects the financial data
required to be set forth therein in relation to the basic financial statements
taken as a whole.


                                       /s/Arthur Andersen LLP

                                       ARTHUR ANDERSEN LLP


San Jose, California
May 4, 1998

                                       26
<PAGE>   27
                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
                             March 31, 1997 and 1998
               (In thousands, except share and per share amounts)


<TABLE>
<CAPTION>
                                                                                 1997           1998
                                                                              ----------     ----------
<S>                                                                           <C>            <C>       
                                    Assets
Current assets:
   Cash and cash equivalents ...........................................      $    2,916     $    4,830
   Accounts receivable, net of product return reserve of $260 in 1998 ..             615          1,045
   Inventories .........................................................             852          1,470
   Other current assets ................................................             205            216
                                                                              ----------     ----------
      Total current assets .............................................           4,588          7,561
                                                                              ----------     ----------

Property and equipment, at cost ........................................          13,404         15,122
   Less--accumulated depreciation and amortization .....................         (11,790)       (12,244)
                                                                              ----------     ----------
      Property and equipment, net ......................................           1,614          2,878

Patents, net ...........................................................             887            809
                                                                              ----------     ----------

         Total assets ..................................................      $    7,089     $   11,248
                                                                              ==========     ==========


                     Liabilities and Stockholders' Equity
Current liabilities:
   Accounts payable ....................................................      $      501     $      593
   Accrued payroll costs ...............................................             230            300
   Advance payments from customers .....................................           2,183            463
   Other accrued liabilities ...........................................             116            183
                                                                              ----------     ----------
      Total current liabilities ........................................           3,030          1,539
                                                                              ----------     ----------

Commitments (Note 6)
Stockholders' equity:
   Preferred stock, $.01 par value:
      Authorized--2,000,000 shares
      Outstanding--none ................................................              --             --
   Common stock, $.01 par value:
      Authorized--15,000,000 shares
      Outstanding--9,150,416 shares in 1997 and 9,640,747 shares in 1998              91             96
Additional paid-in capital .............................................          31,516         35,330
Accumulated deficit ....................................................         (27,548)       (25,717)
                                                                              ----------     ----------
      Total stockholders' equity .......................................           4,059          9,709
                                                                              ----------     ----------

         Total liabilities and stockholders' equity ....................      $    7,089     $   11,248
                                                                              ==========     ==========
</TABLE>


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


                                       27
<PAGE>   28
                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS
           For the Fiscal Years Ended March 31, 1996, 1997, and 1998
                    (In thousands, except per share amounts)


<TABLE>
<CAPTION>
                                                                       1996           1997           1998
                                                                     --------       --------       --------
<S>                                                                  <C>            <C>            <C>     

Revenues ......................................................      $  5,295       $  3,529       $ 11,081

Costs and expenses:
   Cost of sales ..............................................         3,659          2,388          5,923
   Selling, general, and administrative expenses ..............         2,400          2,602          2,978
   Research and engineering expenses ..........................         1,092            938            435
                                                                     --------       --------       --------
      Total costs and expenses ................................         7,151          5,928          9,336
                                                                     --------       --------       --------

       Operating income (loss) ................................        (1,856)        (2,399)         1,745

Other income and expense:
   Other income, net ..........................................           202             22             16
   Interest income ............................................            78             50            148
   Interest expense ...........................................            (8)            (8)           (10)
                                                                     --------       --------       --------
      Total other income, net .................................           272             64            154
                                                                     --------       --------       --------

       Income (loss) before income taxes ......................        (1,584)        (2,335)         1,899

Provision for income taxes ....................................            --             --             68
                                                                     --------       --------       --------

       Net income (loss) ......................................      $ (1,584)      $ (2,335)         1,831
                                                                     ========       ========       ========

Net income (loss) per share:
       Basic ..................................................      $   (.18)      $   (.26)      $    .19
       Diluted ................................................      $   (.18)      $   (.26)      $    .19

Weighted average number of common and common equivalent shares:
       Basic ..................................................         8,692          9,006          9,391
       Diluted ................................................         8,692          9,006          9,677
</TABLE>


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


                                       28
<PAGE>   29
                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
            For the Fiscal Years Ended March 31, 1996, 1997, and 1998
                    (In thousands, except per share amounts)


<TABLE>
<CAPTION>
                                                                          Additional
                                                    Common Stock            Paid-In      Accumulated
                                                Shares        Amount        Capital        Deficit         Total
                                               --------      --------     ----------     -----------     --------
<S>                                            <C>           <C>          <C>             <C>            <C>  

Balance, March 31, 1995 .................         8,358            83        27,082        (23,629)         3,536
   Shares issued under stock option
      and stock purchase plans ..........           359             4         1,914             --          1,918
   Compensation related to
      stock plan activity ...............            --            --            11             --             11
   Shares issued under private placement
      at $4.00 per share, net of issuance
      costs of $14 ......................           115             1           445             --            446
   Net loss .............................            --            --            --         (1,584)        (1,584)
                                               --------      --------      --------       --------       --------

Balance, March 31, 1996 .................         8,832            88        29,452        (25,213)         4,327
   Shares issued under stock option
      and stock purchase plans ..........           318             3         2,064             --          2,067
   Compensation related to
      stock plan activity ...............            --            --            16             --             16
   Stock plan registration costs ........            --            --           (16)            --            (16)
   Net loss .............................            --            --            --         (2,335)        (2,335)
                                               --------      --------      --------       --------       --------

Balance, March 31, 1997 .................         9,150      $     91      $ 31,516       $(27,548)      $  4,059
   Shares issued under stock option
      and stock purchase plans ..........           291             3         1,907             --          1,910
   Compensation related to
      stock plan activity ...............            --            --            29             --             29
   Stock issued under private placement
      at $9.50 per share, net
      of issuance costs of $20 ..........           200             2         1,878             --          1,880
   Net income ...........................            --            --            --          1,831          1,831
                                               --------      --------      --------       --------       --------

Balance, March 31, 1998 .................         9,641      $     96      $ 35,330       $(25,717)      $  9,709
                                               ========      ========      ========       ========       ========
</TABLE>


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


                                       29
<PAGE>   30
                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES

                  CONSOLIDATED STATEMENTS OF CASH FLOWS For the
                Fiscal Years Ended March 31, 1996, 1997, and 1998
                                 (In thousands)


<TABLE>
<CAPTION>
                                                                             1996          1997          1998
                                                                          ----------    ----------    ----------
<S>                                                                       <C>           <C>           <C>       
Cash flows from operating activities:
   Net income (loss) from continuing operations ....................      $   (1,584)   $   (2,335)   $    1,831
   Adjustments to reconcile net income (loss) to
        net cash used for operating activities:
      Depreciation and amortization ................................             449           504           619
      Provision for doubtful accounts receivable ...................               1            --            --
      Provision for product return reserve .........................              --            --           260
      Compensation on stock plan activity ..........................              11            16            29
   Changes in operating assets and liabilities:
      (Increase) decrease in accounts receivable ...................            (570)           52          (690)
      (Increase) decrease in inventories ...........................            (278)           12          (618)
      Increase in other assets .....................................             (18)          (48)          (11)
      Increase (decrease) in accounts payable and accrued expenses .           1,102        (1,020)          229
      (Decrease) increase in advance payments from customers .......             (39)        2,006        (1,720)
      Decrease in liabilities related to discontinued operations ...             (14)           --            --
                                                                          ----------    ----------    ----------

        Net cash used for operating activities .....................            (940)         (813)          (71)
                                                                          ----------    ----------    ----------

Cash flows from investing activities:
   Purchases of property and equipment .............................            (313)         (343)       (1,723)
   Increase in patents .............................................             (67)          (73)          (82)
                                                                          ----------    ----------    ----------

        Net cash used for investing activities .....................            (380)         (416)       (1,805)
                                                                          ----------    ----------    ----------

Cash flows from financing activities:
   Proceeds from sale of common stock ..............................           2,364         2,051         3,790
                                                                          ----------    ----------    ----------

        Net cash provided by financing activities ..................           2,364         2,051         3,790
                                                                          ----------    ----------    ----------

        Net increase in cash and cash equivalents ..................           1,044           822         1,914

Cash and cash equivalents:
   Beginning of year ...............................................           1,050         2,094         2,916
                                                                          ----------    ----------    ----------
   End of year .....................................................      $    2,094    $    2,916    $    4,830
                                                                          ==========    ==========    ==========

Supplemental disclosures--cash payments for the following items are:
   Income taxes ....................................................      $        6    $        4    $        5
                                                                          ==========    ==========    ==========
   Interest ........................................................      $        8    $        8    $       10
                                                                          ==========    ==========    ==========
</TABLE>


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


                                       30
<PAGE>   31
                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 March 31, 1998


1.    ORGANIZATION AND OPERATIONS

      Drexler Technology Corporation and its wholly owned subsidiary, LaserCard
Systems Corporation, (the "Company") develop, manufacture, and market optical
data storage products used with personal computers for information recording,
storage, and retrieval. The Company's customers are mainly value-added reseller
(VAR) companies throughout the world that develop commercial applications for
LaserCard(R) products. The Company's target markets include consumer, business,
and government applications for portable, recordable, unitary record cards.
These applications include healthcare, secure access, immigration/ID cards, and
vehicle maintenance cards.

      The Company is subject to certain risks including, but not limited to,
competition from substitute products and larger companies.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      Principles of Consolidation and Basis of Presentation

      The consolidated financial statements include the accounts of Drexler
Technology Corporation and its wholly owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in consolidation.

      The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

      Fiscal Period

      For purposes of presentation, the Company has indicated its accounting
period as ending on March 31 and its interim quarterly periods as ending on the
corresponding month end. The Company, in fact, operates and reports quarterly
periods ending on the Friday closest to month end. Fiscal 1996 and 1997 were
52-week years. Fiscal 1998 was a 53-week year.

      Cash and Cash Equivalents

      The Company considers all highly liquid investments, consisting primarily
of commercial paper, with original maturities of three months or less to be cash
equivalents.

      Inventories

      Inventories are stated at the lower of cost or market, with cost
determined on a first-in, first-out basis and market based on the lower of
replacement cost or estimated realizable value.

      The components of inventories as of March 31 are (in thousands):


<TABLE>
<CAPTION>
                             1997        1998
                            ------      ------
<S>                         <C>         <C>   

Raw materials ............  $  353      $  579
Work-in-process ..........     133         235
Finished goods ...........     288         178
Systems and components
  held for resale ........      78         478
                            ------      ------
                            $  852      $1,470
                            ======      ======
</TABLE>


                                      31
<PAGE>   32
      The Company currently buys all of its optical memory card reader/writers,
an important component of its systems, from one supplier. An interruption or
change in the supply of reader/writers could cause a delay in product shipments
and a possible loss of sales, which would adversely affect operating results.

      Property and Equipment

      The components of property and equipment as of March 31 are (in
thousands):

<TABLE>
<CAPTION>
                               1997         1998
                             -------      -------
<S>                          <C>          <C>    

Equipment and furniture....  $11,581      $13,148
Leasehold improvements.....    1,823        1,974
                             -------      -------
                             $13,404      $15,122
                             =======      =======
</TABLE>

      Depreciation is provided over the estimated useful lives (five to seven
years) of equipment and furniture using the double-declining balance and
straight-line methods. Leasehold improvements are amortized over the shorter of
the life of the asset or the life of the lease using the straight-line method.

      Patent Costs

      Costs incurred in connection with patents are capitalized and amortized
over the estimated useful lives of the patents of 9 to 17 years.

      Gross patent expenditures capitalized and accumulated amortization as of
March 31 are as follows (in thousands):

<TABLE>
<CAPTION>
                                 1997          1998
                               -------       -------
<S>                            <C>           <C>    

Gross patent expenditures ...  $ 2,385       $ 2,467
Accumulated amortization ....   (1,498)       (1,658)
                               -------       -------
                               $   887       $   809
                               =======       =======
</TABLE>

      Software Development Costs

      Under the criteria set forth in Statement of Financial Accounting Standard
(SFAS) No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased, or Otherwise Marketed," capitalization of software development costs
begins upon the establishment of technological feasibility of the product, which
the Company defines as a beta version of the software. The period of time
commencing when a product achieves beta status and ending when a product is
available for general release is typically very short. Accordingly, amounts that
could have been capitalized under SFAS 86 after consideration of the above
factors were immaterial and, therefore, no software development costs have been
capitalized by the Company to date.

      Advance Payments from Customers

      The Company customarily receives advance payments on orders placed by its
customers. The advance payments are deferred until the related orders are
shipped. At March 31, 1998 approximately 93% of total advance payments related
to a contract with one customer.

      Revenue Recognition

      Product sales primarily consist of card sales and sales of reader/writers.
The Company generally recognizes revenue from product sales at the time of
shipment. Where appropriate, provision is made at that time for estimated
warranty costs. Due to significant increases in volume during fiscal 1998, the
Company recorded a product-return reserve for estimated returns.

      During fiscal 1998, the Company recorded $820,000 of revenues for the
delivery of six prototype multi-technology card readers for an existing
customer. Costs for the development and manufacture of these workstations were
charged to cost of sales.


                                       32
<PAGE>   33
      License revenues include front-end license fees and long-term royalty
payments. License fees are generally recognized as revenues when the license
agreement is signed. Long-term royalty payments are recognized as revenue when
realized.

      Fiscal 1996 license revenue included $200,000 from an agreement comprised
of a trademark license and an installment payment toward a possible future
license for optical memory card distribution. Optical memory card distribution
licenses grant the right to purchase such cards at the Company's most favorable
pricing. No licenses were sold in fiscal 1997. Fiscal 1998 license revenue
included $400,000 from the sale of a patent license.

      The cost of license revenue is not material and is included in selling,
general, and administrative expenses.

      Stock-Based Compensation

      Effective April 1, 1996, the Company adopted the disclosure provisions of
SFAS 123, "Accounting for Stock-Based Compensation." In accordance with the
provisions of SFAS 123, the Company applies Accounting Principles Board Opinion
(APBO) No. 25 and related interpretations in accounting for its stock option
plan. Note 5 to the consolidated financial statements contains a summary of the
pro forma effects on reported net income and earnings per share for fiscal 1996,
1997, and 1998 based on the fair value of the options granted at grant date as
prescribed by SFAS 123.

      New Accounting Pronouncements

      In June 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS 130, "Reporting Comprehensive Income," which establishes standards for
reporting comprehensive income and its components (revenues, expenses, gains,
and losses) in financial statements. SFAS 130 requires classification of other
comprehensive income in a financial statement, and the display of the
accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital. SFAS 130 is effective for fiscal years
beginning after December 15, 1997. The Company believes this pronouncement will
not have a material effect on its financial statements.

      In June 1997, the FASB also issued SFAS 131, "Disclosures about Segments
of an Enterprise and Related Information." This pronouncement established
standards for reporting information about operating segments in annual financial
statements and requires that enterprises report selected information about
operating segments in interim financial reports to shareholders. SFAS 131 also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. SFAS 131 is effective for fiscal years
beginning after December 15, 1997, although earlier application is encouraged.
The Company has yet to determine the impact, if any, of adoption of this new
pronouncement.

      Reclassifications

      Certain reclassifications were made to the prior year presentation to
conform with the current year presentation.

3.    NET INCOME (LOSS) PER SHARE

      In February 1997, the FASB issued SFAS 128, "Earnings Per Share," which
simplifies the standards for computing earnings per share previously found in
APBO 15. SFAS 128 replaces the presentation of primary earnings per share with a
presentation of basic earnings per share, which excludes dilution. SFAS 128 also
requires dual presentation of basic and diluted earnings per share on the face
of the income statement for all entitles with complex capital structures and
requires a reconciliation. SFAS 128 must be adopted for financial statements
issued for periods ending after December 15, 1997, including interim periods.
SFAS 128 requires restatement of all prior-period earnings per share data
presented.

      The Company adopted SFAS 128, "Earnings Per Share," in the quarter ended
December 31, 1997. SFAS 128 requires the computation of basic and diluted
earnings per share. The adoption of SFAS 128 has not had a material impact on
the Company's financial statements. Basic earnings (loss) per share is computed
using the weighted average number of common shares outstanding. Diluted earnings
per share for the fiscal year ended March 31, 1998 is computed using the
weighted average number of shares of common stock outstanding and dilutive
common stock equivalents (using the treasury stock method). Diluted loss per
share for the fiscal years ended March 31, 1996 and 1997 equals basic loss per
share, as the common stock equivalents were anti-dilutive. Fiscal 1996 and 1997
amounts have been restated in accordance with the provisions of SFAS 128.


                                       33
<PAGE>   34
      The Company adopted SFAS 128 for the fiscal year ended March 31, 1998. The
reconciliation of the numerators and denominators of the basic and diluted
earnings per share computation is as follows:

<TABLE>
<CAPTION>
                                                        Income (Loss)         Shares        Per Share
                                                        (Numerator)       (Denominator)       Amount
                                                       --------------    --------------    ------------
<S>                                                    <C>               <C>               <C>          
                                                       (In thousands)    (In thousands)

For fiscal year 1996
  Basic and diluted loss per share
  Income available to common stockholders ....          $     (1,584)            8,692     $       (.18)
                                                        ============      ============     ============
For fiscal year 1997
  Basic and diluted loss per share
  Income available to common stockholders ....          $     (2,335)            9,006     $       (.26)
                                                        ============      ============     ============
For fiscal year 1998
  Basic earnings per share
  Income available to common stockholders ....          $      1,831             9,391     $        .19
                                                                                           ============
  Common shares issuable upon exercise of
     stock options using treasury stock method                    --               286
                                                        ------------      ------------
  Diluted earnings per share
  Income available to common stockholders ....          $      1,831             9,677     $        .19
                                                        ============      ============     ============
</TABLE>

Stock options representing 407,950 shares are excluded from the calculation of
fiscal 1998 diluted earnings per share, as they have an exercise price greater
than the average market value for the period.

4.    MAJOR CUSTOMERS AND EXPORT SALES

      The Company operates in one industry segment--the development,
manufacture, and sale of optical data products used for computer data storage.
Three customers each accounted for more than 10% of revenues for one or more
years during fiscal 1996, 1997, and 1998, as follows: 

<TABLE>
<CAPTION>
                                  Fiscal Year
                           -----------------------
                           1996      1997     1998
                           ----      ----     ----
<S>                        <C>       <C>      <C>

  Customer A.............   39%       22%      74%
  Customer B.............   13%       35%      15%
  Customer C.............   18%       14%      NA
</TABLE>

                (NA = Not applicable, less than 10% of revenues.)

      Two substantial U.S. customers comprised 96% of accounts receivable at
March 31, 1996, 70% of accounts receivable at March 31, 1997, and 99% of
accounts receivable at March 31, 1998, primarily for products sold under one
U.S. government subcontract in 1996 and 1997, and two U.S. government
subcontracts in 1998.

      Revenues by region are as follows (in thousands):

<TABLE>
<CAPTION>
                                       Fiscal Year
                       --------------------------------------------
                           1996             1997             1998
                       ----------       ----------       ----------
<S>                    <C>              <C>              <C>       

United States          $    3,083       $    2,294       $    9,980
Asia ........               1,263              747              462
Europe ......                 684              321              558
Rest of world                 265              167               81
                       ----------       ----------       ----------
                       $    5,295       $    3,529       $   11,081
                       ==========       ==========       ==========
</TABLE>

      One foreign country accounted for more than 10% of revenues for fiscal
1996 and 1997, as follows: Philippine Islands, 19% for fiscal 1996 and 14% for
fiscal 1997. No foreign country accounted for more than 10% of revenues for
fiscal 1998.


                                       34
<PAGE>   35
5.    COMMON STOCK

      Stock Option Plan

      The Company has one stock option plan, the 1991 Stock Option Plan ("1991
Option Plan"), under which 1,567,420 shares of common stock are reserved as of
March 31, 1998. The Company accounts for this plan under APBO 25; accordingly,
no compensation expense has been recognized in the consolidated financial
statements. SFAS 123 requires the disclosure of pro forma net loss and loss per
share as if the Company had adopted the fair value method as of the beginning of
fiscal 1996. Under the fair value method, compensation cost is measured at the
grant date based on the value of the award and is recognized over the service
period. Under SFAS 123, the fair value of stock-based awards to employees is
calculated through the use of option pricing models. Such models require
subjective assumptions, including future stock price volatility and estimated
term.

      These calculations were made using the Black-Scholes option-pricing model
with the following weighted-average assumptions used for grants in fiscal 1996,
1997, and 1998: risk-free interest rate of 6%; expected lives of two to five
years; and expected volatility of 55% for fiscal 1996, 55% for fiscal 1997, and
40% for fiscal 1998. The fair value of each option grant was estimated on the
date of grant. The calculations resulted in weighted average fair values of
$3.25, $6.42, and $4.33, respectively, for options granted in fiscal 1996, 1997,
and 1998; pro forma net loss of $2,701,000 ($0.31 per share) for fiscal 1996 and
$3,397,000 ($0.38 per share) for fiscal 1997; and pro forma net income of
$598,000 ($.06 per share) for fiscal 1998.

      Because the SFAS 123 method of accounting has not been applied to options
granted prior to April 1, 1995, the resulting pro forma compensation costs may
not be representative of what such costs would be expected to be in future
years.

      The Company's 1991 Option Plan provides that stock options may be granted
to employees, officers, and consultants of the Company and that option prices
may be no less than 100% of the fair market value of the shares at the date of
grant. Options are exercisable, as determined by the board of directors, during
the term of the option, which cannot exceed ten years (except that the option
term cannot exceed five years in the case of incentive stock options granted to
a principal shareholder).

      The total option price paid for options exercised during fiscal 1996,
1997, and 1998 was $1,893,609, $2,036,559, and $1,850,229, respectively.

      The following table lists option activity in the 1991 Option Plan which
has occurred since March 31, 1995:


<TABLE>
<CAPTION>
                                  Options                              Weighted Average
                                 Available           Outstanding           Exercise
                                 for Grant             Options               Price            Per Share Price
                                 ---------           -----------       ----------------       ---------------
<S>                              <C>                 <C>               <C>                   <C>           

Balance March 31, 1995             418,220            1,002,650             $ 5.96           $ 3.375 - $ 8.125
   Authorized ........             400,000                   --
   Granted ...........            (530,400)             530,400             $ 7.63           $ 5.57  - $12.313
   Exercised .........                  --             (355,350)            $ 5.33           $ 3.375 - $ 8.125
   Expired ...........               2,100               (2,100)            $ 6.81           $ 6.813
                                ----------           ----------
Balance March 31, 1996             289,920            1,175,600             $ 6.90           $ 4.25  - $12.313
   Authorized ........             250,000                   --
   Granted ...........            (356,880)             356,880             $13.14           $11.813 - $16.313
   Exercised .........                  --             (314,500)            $ 6.48           $ 5.69  - $ 8.563
   Expired ...........               2,500               (2,500)            $ 7.41           $ 6.938 - $ 8.125
                                ----------           ----------
Balance March 31, 1997             185,540            1,215,480             $ 8.84           $ 4.25  - $16.313
   Authorized ........             450,000                   --
   Granted ...........            (398,500)             398,500             $11.16           $ 9.563 - $ 15.25
   Exercised .........                  --             (283,600)            $ 6.52           $ 4.25  - $12.625
   Expired ...........              10,050              (10,050)            $10.96           $ 9.563 - $12.625
                                ----------           ----------
Balance March 31, 1998             247,090            1,320,330             $10.02           $ 4.563 - $16.313
                                ==========           ==========
</TABLE>


                                       35
<PAGE>   36
      The following table summarizes information about stock options outstanding
at March 31, 1998:

<TABLE>
<CAPTION>
                                          Options Outstanding                           Options Exercisable
                          -------------------------------------------------    ------------------------------------
                             Number      Weighted-Average                        Number
     Range of             Outstanding       Remaining      Weighted-Average    Exercisable   Weighted-Average
 Exercise Prices           At 3/31/98    Contractual Life   Exercise Price     At 3/31/98     Exercise Price
 ---------------          -----------    ----------------  ----------------    -----------   ---------------
<S>                       <C>            <C>               <C>                 <C>           <C>

$ 4.563 - $ 7.000            373,150        2.7 years           $ 6.51           306,850          $ 6.43
$ 8.125 - $11.813            533,050        3.9 years           $10.01           178,850          $ 9.37
$12.313 - $16.313            414,130        4.3 years           $13.20            73,500          $13.51
                           ---------                                             -------
      Totals               1,320,330                                             559,200
                           =========                                             =======
</TABLE>


Employee Stock Purchase Plan

      The Company has an Employee Stock Purchase Plan ("Stock Purchase Plan"),
under which 58,439 shares are reserved as of March 31, 1998. Under the Stock
Purchase Plan, eligible employees may designate from 2% to 6% of their
compensation to be withheld for the purchase of shares of common stock at 67% of
fair market value. The 33% differential in the price of shares sold under the
Stock Purchase Plan is charged to operations as compensation. Under the Stock
Purchase Plan, employees purchased 3,295 shares in fiscal 1996, 4,242 shares in
fiscal 1997, and 6,731 shares in fiscal 1998, at an average purchase price per
share of $7.00, $7.49, and $8.78, respectively. The weighted average fair value
per share for shares purchased during fiscal 1996, 1997, and 1998 was $10.45,
$11.17, and $13.11, respectively.

6.    COMMITMENTS

      The Company occupies its facilities under various operating leases. The
rent expense relating to these facilities was approximately $369,000 in fiscal
1996, $372,000 in fiscal 1997, and $373,000 in fiscal 1998. As of March 31,
1998, future minimum rental payments relating to these leases are (in
thousands):


<TABLE>
<CAPTION>
     Fiscal Year
     -----------

<S>                               <C>    
        1999..................... $   374
        2000.....................     342
        2001.....................      60
        2002.....................       6
        2003.....................       6
        Thereafter...............      22
                                  -------
                                  $   810
                                  =======
</TABLE>

7.    INCOME TAXES

      There was no provision for taxes in fiscal 1997 and 1996, due to net
operating losses. The provision for income taxes for fiscal 1998 consists of the
following (in thousands):

<TABLE>
<CAPTION>
                                        Fiscal Year
                                           1998
                                        -----------
<S>                                     <C>        
Current provision
  Federal.............................  $        51
  State ............................             17
                                        -----------
                                                 68
Deferred provision
  Federal.............................  $      (214)
  State ............................            (48)
                                        -----------
                                               (262)
Change in valuation allowance.......            262
                                        -----------
Provision for income taxes............  $        68
                                        ===========
</TABLE>


                                       36
<PAGE>   37
      The Company's effective tax rate differs from the statutory rate as
follows:

<TABLE>
<CAPTION>
                                            Fiscal Year
                                               1998
                                            -----------
<S>                                         <C>
Tax rate reconciliation:
  Federal statutory rate....................    34%
  State tax, net of federal benefit.........     6%
  Utilization of net operating
    loss carryforwards......................   (40%)
  Alternative minimum taxes.................   3.6%
                                               ---
                                               3.6%
                                               ===
</TABLE>

      The major components of the net deferred tax asset as of March 31 are as
follows (in thousands):


<TABLE>
<CAPTION>
                                         1997               1998
                                      ----------         ----------
<S>                                   <C>                <C>       
Net operating losses:
  Federal ..................          $   14,432         $   14,014
  State ....................                 813                342
Tax credits ................               1,109              1,126
Reserves and accruals not
  currently deductible
  for tax purposes .........                 145                361
Depreciation ...............                 (14)               (91)
Capitalized patent costs ...                (329)              (300)
Other ......................                 (42)                (7)
                                      ----------         ----------
  Total deferred tax asset .              16,114             15,445
Valuation allowance ........             (16,114)           (15,445)
                                      ----------         ----------
  Net deferred tax asset ...          $       --         $       --
                                      ==========         ==========
</TABLE>

      The Company has established a valuation allowance for the total deferred
tax asset, as it is uncertain that the deferred tax asset will be realized. The
change in the valuation allowance from fiscal 1997 to 1998 includes current year
timing differences (deferred provision) and the expiration of certain state
carryforward balances.

      The Company's federal net operating losses will expire at various dates
from 2001 through the year 2012. The Company's state net operating losses will
expire at various dates from 1999 through the year 2002. The tax credit
carryforwards will expire at various dates from 2000 through the year 2004.

8.    OTHER INCOME

      During the first quarter of fiscal 1996, the Company received a $200,000
nonrefundable deposit toward a license agreement. The license agreement was not
consummated and the deposit was forfeited by the licensee. The income from the
forfeiture of the deposit is recorded as other income in fiscal 1996.


                                       37
<PAGE>   38
                   QUARTERLY FINANCIAL INFORMATION (Unaudited)

    The unaudited quarterly results of operations of the Company for fiscal 1997
and fiscal 1998 are as follows (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                                       Fiscal Quarters
                                                   -------------------------------------------------------
                                                      1st            2nd             3rd            4th
                                                      ---            ---             ---            ---
                                                             (In thousands, except per share data)
<S>                                                <C>             <C>             <C>            <C>    
Fiscal 1997
   Revenues...................................     $   618         $ 1,018         $   815        $ 1,078
   Net income (loss)..........................        (646)           (437)           (694)          (558)
   Income (loss) per share:
      Basic...................................     $  (.07)        $  (.05)        $  (.08)       $  (.06)
      Diluted.................................     $  (.07)        $  (.05)        $  (.08)       $  (.06)

Fiscal 1998
   Revenues...................................     $ 1,489         $ 2,902         $ 3,229        $ 3,461
   Net income (loss)..........................        (158)            460             676            853
   Income (loss) per share:
      Basic...................................     $  (.02)        $   .05         $   .07        $   .09
      Diluted.................................     $  (.02)        $   .05         $   .07        $   .09

</TABLE>

                                       38

<PAGE>   39


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

      None.

                                    PART III

      Pursuant to Paragraph G(3) of the General Instructions for Form 10-K, the
information called for by Items 10, 11, and 12 under Part III of Form 10-K is
incorporated by reference from the Company's Proxy Statement to be filed with
the Commission in connection with the Company's 1998 Annual Meeting of
Stockholders (the "Proxy Statement").

ITEM 10.       DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

      Information concerning directors and executive officers of the Company is
included in the Proxy Statement under the title "Stock Ownership by Directors
and Officers" and is incorporated herein by reference.

      Information concerning compliance with Section 16(a) of the Securities
Exchange Act of 1934, as amended, is set forth in the Proxy Statement under the
title "Section 16(a) Beneficial Ownership Reporting Compliance" and is
incorporated herein by reference.

ITEM 11.       EXECUTIVE COMPENSATION

      Information concerning executive compensation appears in the Company's
Proxy Statement, under the titles "Director Compensation," "Executive
Compensation," "Stock Option Grants to Executive Officers," "Aggregated Option
Exercises and Options Held by Executive Officers," and "Compensation Committee
Interlocks and Insider Participation" and is incorporated herein by reference.

ITEM 12.       SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
               MANAGEMENT

      Information concerning the security ownership of certain beneficial owners
and management appears in the Company's Proxy Statement under the titles "Stock
Ownership by Directors and Officers" and "Principal Stockholder" and is
incorporated herein by reference.

ITEM 13.       CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      None.


                                       39

<PAGE>   40

                                     PART IV

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

(a)  List of Documents Filed as Part of this Report

     1. The Consolidated Financial Statements of the Company, filed herewith
under Item 8, as follows:

<TABLE>
<CAPTION>
                                                                           Page
                                                                           Number
<S>            <C>                                                         <C>
         (1)   Report of Independent Public Accountants                      26

         (2)   Consolidated Balance Sheets at March 31, 1997
               and March 31, 1998                                            27

         (3)   Consolidated Statements of Operations for
               Fiscal Years 1996, 1997, and 1998                             28

         (4)   Consolidated Statements of Stockholders' Equity
               for Fiscal Years 1996, 1997, and 1998                         29

         (5)   Consolidated Statements of Cash Flows for Fiscal
               Years 1996, 1997, and 1998                                    30

         (6)   Notes to Consolidated Financial Statements                    31
</TABLE>

     2.  Financial Statement Schedules:

         The schedule supporting the Company's Consolidated Financial
         Statements, filed herewith under Item 14(d), as follows:

<TABLE>
<CAPTION>
               Schedule                                                               Page
               Number               Description                                      Number
               ------               -----------                                      ------
<S>                       <C>                                                        <C>
                II        Valuation and Qualifying Accounts                            44
</TABLE>

         Schedules not listed above are not applicable or not required, or the
         information required to be set forth therein is included in the
         Consolidated Financial Statements or the notes thereto.

     3.  Exhibits

         The Exhibits to this Report, filed herewith under Item 14(c) or
         incorporated by reference from other documents previously filed with
         the Securities and Exchange Commission, as follows:


<TABLE>
<CAPTION>
               Exhibit                                                       Filed Herewith or Incorporated
               Number               Description                              Herein by Reference to
               ------               -----------                              ------------------------------
<S>            <C>          <C>                                              <C>
         (1)   Exhibits 3.1 and 3.2 through 3.2.5, Articles of Incorporation 
               and By-Laws of the Company, as follows:

               3.1          Articles of Incorporation                        Exhibit 3.1 to Report on
                                                                             Form 10-Q for period
                                                                             ended September 25, 1987
</TABLE>

                                       40

<PAGE>   41



<TABLE>
<CAPTION>
               Exhibit                                                       Filed Herewith or Incorporated
               Number               Description                              Herein by Reference to
               ------               -----------                              ------------------------------
<S>            <C>          <C>                                              <C>
               3.2          By-Laws                                          Exhibit 3.2 to Report on
                                                                             Form 10-Q for period
                                                                             ended September 25, 1987

               3.2.1        By-Law Amendment Adopted                         Exhibit 3.2.1 to Report on
                            during Fiscal 1991                               Form 10-K for period
                                                                             ended March 31, 1992

               3.2.2        By-Law Amendments Adopted                        Exhibit 3.2.2 to Report on
                            during Fiscal 1992                               Form 10-K for period
                                                                             ended March 31, 1992

               3.2.3        By-Law Amendment Adopted                         Exhibit 3.2.3 to Report on
                            during Fiscal 1994                               Form 10-Q for period
                                                                             ended September 30, 1993

               3.2.4        By-Laws of the Company, as Amended               Exhibit 3.2.4 to Report on
                            through February 21, 1997                        Form 10-K for period
                                                                             ended March 31, 1997

               3.2.5        By-Law Amendment Adopted                         Filed herewith
                            during Fiscal 1998

         (2) Exhibits 10.1 through 10.6.6, Material Contracts, as follows:

               10.1         Building Lease with                              Exhibit 10.1 to Report on
                            Kimes Properties                                 Form 10-K for fiscal year
                                                                             ended March 31, 1993

               10.1.2       Building Lease Extension                         Exhibit 10.1.2 to Report on
                            with Kimes Properties                            Form 10-K for fiscal year
                                                                             ended March 31, 1996

               10.2         Building Lease with                              Exhibit 10.8 to Report on
                            Renault & Handley                                Form 10-K for fiscal year
                            Employees Investment Co.                         ended April 2, 1982

               10.2.1       Building Lease Extensions                        Exhibit 10.10 to Report
                            with Renault & Handley                           on Form 10-K for fiscal
                            Employees Investment Co.                         year ended March 31, 1987

               10.2.2       Building Lease Extensions                        Exhibit 10.3.2 to Report
                            with Renault & Handley                           on Form 10-K for fiscal
                            Employees Investment Co.                         year ended March 31, 1989

               10.2.3       Building Lease Extensions                        Exhibit 10.2.3 to Report on
                            with Renault & Handley                           Form 10-K for fiscal year
                            Employees Investment Co.                         ended March 31, 1992

               10.2.4       Building Lease Extensions                        Exhibit 10.2.4 to Report on
                            with Renault & Handley                           Form 10-Q for period ended
                            Employees Investment Co.                         September 30, 1994
</TABLE>

                                       41

<PAGE>   42

<TABLE>
<CAPTION>
               Exhibit                                                       Filed Herewith or Incorporated
               Number               Description                              Herein by Reference to
               ------               -----------                              ------------------------------
<S>            <C>          <C>                                              <C>


               10.2.5       Building Lease Extensions                        Filed herewith
                            with Renault & Handley
                            Employees Investment Co.

               10.3         Optical Memory Card                              Exhibit 4 to Report on
                            Manufacturing License                            Form 8-K dated
                            with Canon Inc.                                  January 10, 1989

               10.4         Optical Memory Card Manufacturing                Exhibit 10.8 to Report on
                            License with Optical Memory Card                 Form 10-K for fiscal year
                            Business Corporation                             ended March 31, 1991

               10.5         Management Bonus Plan                            Exhibit 10.9 to Report on
                                                                             Form 10-K for fiscal year
                                                                             ended April 1, 1983

               10.6         1991 Stock Option Plan                           Exhibit 10.10 to Report
                                                                             on Form 10-K for fiscal
                                                                             year ended March 31, 1991

               10.6.1       Amended 1991 Stock Option Plan                   Exhibit 10.10.1 to Report
                            Approved by Stockholders during                  on Form 10-Q for period
                            Fiscal 1994                                      ended September 30, 1993

               10.6.2       Amended 1991 Stock Option Plan                   Exhibit 10.6.2 to Report
                            Approved by Stockholders during                  on Form 10-K for period
                            Fiscal 1995                                      ended March 31, 1995

               10.6.3       Amended 1991 Stock Option Plan                   Exhibit 10.1 to Report
                            Approved by Stockholders during                  on Form 10-Q for period
                            Fiscal 1996                                      ended September 30, 1995

               10.6.4       Amended 1991 Stock Option Plan                   Exhibit 10.1 to Report
                            Approved by Stockholders during                  on Form 10-Q for period
                            Fiscal 1997                                      ended September 30, 1996

               10.6.5       Amended 1991 Stock Option Plan                   Exhibit 10.1 to Report
                            Approved by Stockholders during                  on Form 10-Q for period
                            Fiscal 1998                                      ended September 30, 1997

               10.6.6       Amended 1991 Stock Option Plan                   Filed herewith
                            (March 5, 1998)

         (3)   22           Subsidiaries                                     Filed herewith

         (4)   24           Consent of Experts and Counsel                   Filed herewith

         (5)   27           Financial Data Schedule                          Filed herewith

</TABLE>

Exhibits not listed above are not applicable to registrant.

                                       42

<PAGE>   43



(b)  Reports on Form 8-K

     The Company did not file any Reports on Form 8-K during the quarter ended
March 31, 1998.

(c)  Exhibits

     Exhibits 3.2.5, 10.2.5, 10.6.6, 22, 24, and 27 are filed herewith.

(d)  Financial Statement Schedules

     Schedule II to the Company's Consolidated Financial Statements follows
immediately.

                                       43

<PAGE>   44

                                                                     SCHEDULE II


                 DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES

                        VALUATION AND QUALIFYING ACCOUNTS
                    For the Fiscal Year Ended March 31, 1998



<TABLE>
<CAPTION>
                              Balance at       Additions        Additions                           Balance
                              Beginning        Charged to       Charged to                           at End
      Description             of Period     Profit and Loss    Other Accounts    Deductions        of Period
      -----------             ---------     ---------------    --------------    ----------       -----------
<S>                         <C>              <C>               <C>               <C>              <C>        
Product return reserve..... $       --       $  260,000          $        --      $     --        $   260,000
                            ==========       ==========          ===========      ========        ===========

</TABLE>

                                       44

<PAGE>   45


SIGNATURES

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

        Dated:  June 5, 1998

                                        DREXLER TECHNOLOGY CORPORATION



                                        By   /s/ JEROME DREXLER
                                             ---------------------------------- 
                                             Jerome Drexler, Chairman and Chief 
                                             Executive Officer



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

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

/s/  JEROME DREXLER                          Chairman of the Board of Directors              June 5, 1998
-----------------------------                and Chief Executive Officer
Jerome Drexler                               (Principal Executive Officer)


/s/ STEVEN G. LARSON                         Vice President of Finance and Treasurer         June 5, 1998
-----------------------------                (Principal Financial Officer and
Steven G. Larson                             Principal Accounting Officer)


/s/ ARTHUR H. HAUSMAN                        Director                                        June 5, 1998
-----------------------------
Arthur H. Hausman


/s/ Dan Maydan                               Director                                        June 5, 1998
-----------------------------
Dan Maydan


/s/ WILLIAM E. MCKENNA                       Director                                        June 5, 1998
-----------------------------
William E. McKenna

</TABLE>

                                       45

<PAGE>   46

                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
            Exhibit
            Number        Description
            ------        -----------
            <S>           <C>
            3.2.5         By-Law Amendment

            10.2.5        Building Lease Extensions

            10.6.6        Amended 1991 Stock Option Plan

            22            Subsidiaries

            24            Consent of Experts and Counsel

            27            Financial Data Schedule

</TABLE>