EXHIBIT 13.1

SELECTED FINANCIAL DATA

        The following selected financial data of the Company is qualified by
reference to and should be read in conjunction with the consolidated financial
statements of the Company, including the notes thereto, and Management's
Discussion and Analysis of Financial Condition and Results of Operations.

<TABLE>
<CAPTION>
                                          Years Ended December 31,
                           -----------------------------------------------------
                            1998(2)  1997(1)(2)(3)   1996     1995(1)    1994
                           --------- ------------- --------- --------- ---------
                                    (in thousands, except per share data)
<S>                        <C>       <C>           <C>       <C>       <C>
Statement of operations
 data:
 Revenue ................. $106,138       $91,364   $82,475   $53,894   $33,024
 Cost of revenue .........   68,419        65,154    54,956    33,390    19,991
                           --------- ------------- --------- --------- ---------
 Gross margin ............   37,719        26,210    27,519    20,504    13,033
 Research and development.   10,690         9,794     6,681     3,994     2,781
 Selling, general, and
   administrative ........   13,597        40,609    12,166     7,649     4,574
 In-process research and
   development ...........       --           753       --     10,010       --
 Amortization of
   purchased intangibles
   and goodwill...........      777           671       --        --        --
                           --------- ------------- --------- --------- ---------
 Operating income (loss) .   12,655       (25,617)    8,672    (1,149)    5,678
 Net income (loss) .......  $12,823      ($24,679)   $7,121   ($2,819)   $2,195
 Net income (loss) per
   share-basic............    $0.92        ($1.83)    $0.59    ($0.31)    $0.38
 Net income (loss) per
   share-diluted..........    $0.87        ($1.83)    $0.54    ($0.31)    $0.29
 Weighted average
  shares-basic ...........   13,887        13,497    12,012     9,228     5,738
 Weighted average
 shares-diluted ..........   14,709        13,497    13,199     9,228     7,461

<CAPTION>
                                           As of December 31,
                           -----------------------------------------------------
                             1998        1997        1996     1995(1)    1994
                           --------- ------------- --------- --------- ---------
                                          (in thousands)
<S>                        <C>       <C>           <C>       <C>       <C>
Balance sheet data:
 Working capital .........  $54,358       $36,012   $63,243   $22,649    $5,556
 Total assets ............  112,477        94,224   113,842    56,643    23,799
 Long-term debt (less
  current portion) .......      --           --         --        --     22,519
 Convertible redeemable
  preferred stock ........      --           --         --        --     10,545
 Stockholders' equity
 (net capital deficiency).  $93,247       $76,587   $99,227   $40,500  ($18,269)
</TABLE>

----------------
(1) The results of operations for the years ended December 31, 1995 and
    1997 include a one-time write-off of in-process research and
    development of  approximately $10 million and $0.8 million,
    respectively, in connection with the acquisition of Seastar Optics and
    Mr. Laser, Inc.

(2) In 1997, the Company changed from a calendar year end to a 52-53 week
    year ending on the Friday closest to December 31.  Fiscal year 1998 and
    1997 ended January 1, 1999 and January 2, 1998, respectively.  For ease
    of discussion and presentation all fiscal year ends are referred to as
    ending on December 31.

(3) The results of operations for the year ended December 31, 1997 include
    a one-time charge totaling $27.5 million related to costs associated
    with the litigation settlement and related legal costs of the
    Spectra-Physics legal dispute.

Risk Factors

The statements contained in this annual report that are not purely 
historical are forward-looking statements within the meaning of 
Section 27(a) of the Securities Act of 1993 and Section 21(e) of the 
Securities and Exchange Act of 1934, including statements regarding the 
Company's expectations, hopes, beliefs, intentions, plans or strategies 
regarding the future.  Forward-looking statements include:  the statement 
on page 1 regarding SDL's products playing a leading role in helping to 
light the way; the statements on page 9 regarding migration to DWDM, 
projected compound annual growth of more than 100% for DWDM systems over 
the next five years, and predicted growth of the market for DWDM 
components to more than $4 billion in 2000 and $12 billion in 2005; the 
statement on page 1 regarding DWDM system channels to come on the 
horizon; the statements under the heading "To Our Stockholders" 
regarding the Company's excellent position to take advantage of expanding 
market opportunities; the forecasted five-fold expansion by the year 2000 
of the primary communications market that SDL serves, SDL's primary 
market to have grown to at least $8 billion by 2002, the fueling of SDL's 
growth by optical amplifier and multiwave transmitter applications, SDL's 
pump modules being well positioned to meet the advanced needs of the DWDM 
market place, new opportunities in 1999, and the future and prospects for 
SDL; statements on page 19 regarding SDL's movement up the integration 
chain; statements under "Management's Discussion and Analysis of 
Financial Condition and Results of Operation" ("MD&A") under the 
heading "Provision for Income Taxes" regarding generation of future 
taxable income sufficient to realize the benefit of SDL's net deferred 
tax assets recorded; statements in MD&A under the heading "Liquidity and 
Capital Resources" regarding the Company's expected expenditures for 
capital equipment purchases and leasehold improvements in 1999 and the 
sufficiency of the Company's current cash balances, cash generated from 
operations and cash available through equity markets for the foreseeable 
future; and statements in MD&A under the heading "Impact of Year 2000" 
regarding the Company's plans to have changes to critical systems 
completed and tested by mid-1999, the expected burden of remediation of 
the Company's tertiary business information systems, material exposure to 
contingencies related to the year 2000 issue, continuance of contingency 
planning activities throughout 1999, expenditures related to the year 
2000 issue and capitalization and expensing thereof, the sufficiency of 
operating activities to fund year 2000 costs and management's beliefs 
about the impact of year 2000 matters on the Company's financial 
condition and overall results of operations.  All forward-looking 
statements included in this document are based on information available 
to the Company on the date hereof and the Company assumes no obligation 
to update any such forward-looking statement.  It is important to note 
that the Company's actual results could differ materially from those in 
such forward-looking statements.  Among the factors that could cause 
actual results to differ materially are the factors detailed.  You should 
consult the risk factors listed from time to time in the Company's 
Reports on Forms 10-Q and 8-K.


MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS 
OF OPERATIONS

         SDL designs, manufactures and markets semiconductor lasers, fiber 
optic related products and optoelectronic systems.  Since 1996, the 
Company strategy has strongly focused on providing solutions for optical 
communications.  The Company's optical communications products power the 
transmission of data, voice and Internet information over fiber optic 
networks to meet the needs of telecommunications, dense wavelength 
division multiplexing, cable television and satellite communications 
applications.  With the increased focus on commercial communications 
products, the proportion of SDL's revenue derived from U. S. government 
related projects has declined from 43% in 1996 to 28% in 1998.  SDL's 
optical products also serve a wide variety of non-communications 
applications, including materials processing, printing, medical and 
scientific instrumentation.  From the original products introduced in 
1984, the Company has expanded its product offering to over 200 standard 
products in addition to providing custom design and packaging for OEM 
customers.  The Company's revenue also includes revenue from customer-
funded research programs.

        Because of the diversity of products, customers and applications, 
gross margins tend to fluctuate based in part on the mix of revenue in 
each reported period.  SDL's revenue growth in 1997-1998 was constrained 
by a shortage in qualified manufacturing capacity, especially in the 
wafer fabrication area.  The Company's new wafer fabrication facility 
received full qualification in June 1998, allowing a faster ramp-up in 
production.

        In  1997, the Company changed its year-end from a calendar year ending 
December 31, to a 52-53 week year ending on the Friday closest to 
December 31.  The Company's fiscal 1998 and 1997 ended January 1, 1999 
and January 2, 1998, respectively.  For ease of discussion and 
presentation, all fiscal year ends are referred to as ending on December 31.

        Certain of the statements contained in this Management's Discussion 
and Analysis of Financial Condition and Results of Operations are 
forward-looking statements regarding the Company's business, operations 
and prospects. The Company's actual results could differ materially from 
those in such forward-looking statements. See "Factors Affecting 
Earnings and Stock Price."

        The following table sets forth certain operating results expressed as a
percentage of total revenue for the periods indicated.

<TABLE>
<CAPTION>
                                               Years Ended December 31,
                                          ---------------------------------
                                             1998    1997(1)(2)    1996
                                          ---------- ---------- -----------
<S>                                       <C>        <C>        <C>
Revenue:
  Product revenue ......................       90.8%      84.0%       84.6%
  Research revenue .....................        9.2%      16.0%       15.4%
                                          ---------- ---------- -----------
Total revenue ..........................      100.0%     100.0%      100.0%
                                          ---------- ---------- -----------
Cost of revenue:
  Cost of product revenue (3)...........       63.2%      69.7%       65.0%
  Cost of research revenue (3)..........       76.9%      79.6%       75.5%
                                          ---------- ---------- -----------
Total cost of revenue ..................       64.5%      71.3%       66.6%
                                          ---------- ---------- -----------
Gross margin ...........................       35.5%      28.7%       33.4%

Operating expenses:
  Research and development .............       10.1%      10.7%        8.1%
  Selling, general, and administrative..       12.7%      44.4%       14.0%
  In-process research and development...        --         0.8%       --
  Amortization of purchased intangibles
   and goodwill.........................        0.8%       0.8%        0.8%
                                          ---------- ---------- -----------
Total operating expense ................       23.6%      56.7%       22.9%
                                          ---------- ---------- -----------
Operating income (loss) ................       11.9%     -28.0%       10.5%
Interest income and other, net .........        1.1%       1.5%        1.8%
                                          ---------- ---------- -----------
Income (loss) before income taxes ......       13.0%     -26.5%       12.3%
Provision for income taxes .............        1.0%       0.5%        3.7%

Net income (loss) ......................       12.0%     -27.0%        8.6%
                                          ========== ========== ===========
</TABLE>
----------------------

(1) The results of operations for the years ended December 31, 1997 
    include a one-time write-off of in-process research and development 
    of approximately  $0.8 million in connection with the acquisition of  
    Mr. Laser, Inc.

(2) The results of operations for the year ended December 31, 1997 
    includes a one-time charge of $27.5 million related to costs 
    associated with the litigation settlement and related legal costs of 
    the Spectra Physics legal dispute. 

(3) Cost of product revenue and cost of research revenue are stated as a 
    percentage of product revenue and research revenue, respectively.

Results of Operations

Revenue.  The Company recorded a 16 percent increase in revenue to $106.1 
million during 1998, following an 11 percent increase in 1997 revenue to 
$91.4 million.  Product revenue reported in 1998 increased 26 percent or 
$19.6 million, following a 10 percent or $7.0 million increase in 1997.  
The 1998 and 1997 increases in product revenue resulted primarily from 
growth in dense wavelength division multiplexing (DWDM) product sales 
caused by a continued strong demand for SDL's 980nm pump module. Research 
revenue decreased 33 percent or $4.8 million during 1998 as a result of 
the Company continuing to focus on commercial product opportunities.   
Research revenue grew 15 percent during 1997 and accounted for 16 percent 
and 15 percent of revenue for 1997 and 1996, respectively.  There can be 
no assurances that the applications markets for SDL's products will grow 
in future periods at historical percentages.  Further, there can be no 
assurances that the Company will be able to increase or maintain its 
market share in the future or to sustain historical growth rates.

The Company derived 28 percent, 38 percent, and 43 percent of its 1998, 
1997 and 1996 revenue, directly or indirectly from a variety of Federal 
government sources.  The demand for certain of the Company's services and 
products is directly related to the level of funding of government 
programs.  The Company believes that the success and further development 
of its government business is dependent, in significant part, upon the 
continued existence and funding of such programs and upon the Company's 
ability to participate in such programs.  For example, a majority of the 
Company's research revenue for 1998, 1997, and 1996 was funded by Federal 
programs.  There can be no assurances that such programs will continue to 
be funded even if government agencies have available financial resources 
or that the Company will continue to be awarded contracts under such 
programs.

Approximately 14 percent, 19 percent, and 21 percent of 1998, 1997 and 
1996 revenue was received from Lockheed-Martin through numerous 
government and commercial programs.  Most of the revenue from Lockheed-
Martin during this three year period was, and during 1999 is expected to 
be, derived from Federally-funded programs, which are subject to renewal 
every one or two years and to termination for convenience by the 
government agency.  It is expected that revenue received under these 
current Lockheed-Martin programs will continue to decrease as a 
percentage of the Company's total revenue.  However, a loss of the 
Company's contracts or failure to win new contracts with Lockheed-Martin 
could have an adverse effect on the Company's results of operations.

Revenues from customers outside of the United States represented 24 
percent, 17 percent, and 15 percent of total revenue for 1998, 1997, and 
1996, respectively.  The 1998 growth was primarily within the European 
region, due to the growth in the communications market business, where 
revenue increased 98 percent compared to 1997.

Gross margin.  Gross margin as a percentage of revenue was 36 percent in 
1998, compared to 29 percent and 33 percent for 1997 and 1996, 
respectively.  The increase in gross margin during 1998 as compared to 
1997 resulted from: (i) increased yields and volumes from the new wafer 
fab and reduction of costs related to the 980nm pump module, and (ii) a 
more favorable mix in the ratio of commercial product revenue as compared 
to revenue derived from U.S. government sources.  The decline in gross 
margin during 1997 as compared to 1996 primarily resulted from: (i) 
start-up costs for expansion of the Company's wafer fab and transition of 
the various product lines to the new fabrication equipment, and (ii) 
changes in estimable reimbursable costs in the June quarter. 

The Company's gross margin can be affected by a number of factors, 
including product mix, customer mix, applications mix, pricing pressures 
and product yield.  Generally, the cost of newer products has tended to 
be higher as a percentage of product revenue than that of more mature, 
higher volume products.  In addition, the cost of research revenue is 
significantly higher as a percentage of revenue, as research revenue is 
typically based on costs incurred rather than market pricing.  
Considering these factors, gross margin fluctuations are difficult to 
predict and there can be no assurance that the Company will achieve or 
maintain gross margins at historical levels in future periods.

Research and development. The Company's future results depend, to a 
considerable extent, on its ability to maintain a competitive advantage 
in the products it provides.  For this reason, SDL believes it is 
critical to continue to make investments in research and development to 
promote the flow of innovative, productive, and high-quality products.  
Research and development increased to $10.7 million compared to $9.8 
million and $6.7 million during 1998, 1997 and 1996, respectively.  
Research and development as a percentage of revenue was 10 percent, 11 
percent and 8 percent in 1998, 1997 and 1996, respectively.  The 1998 
research and development emphasis has been to bring new communication 
products to market.  The 1997 research and development spending was on 
manufacturing process development efforts, together with the development 
of new communications and laser system products.

The Company is committed to continuing its significant research and 
development expenditures and expects that the absolute dollar amount of 
research and development expenses will increase as it invests in 
developing new products, expanding and enhancing its existing product 
lines, and reducing its costs, although research and development expenses 
may vary as a percentage of revenue. 

Selling, general and administrative (SG&A).   Selling, general and 
administrative (SG&A) expense of $13.6 million or 13 percent of revenue 
represents a decrease of $27.0 million or 44 percent of revenue from 
1997.  Excluding non-recurring amounts of approximately $27.5 million for 
the settlement and related legal costs incurred in 1997 for the Spectra-
Physics vs. SDL, Inc. legal dispute, SG&A increased $0.5 million and $1.6 
million from 1997 and 1996, respectively.  Excluding non-recurring 
amounts, the increase in SG&A expense during 1998 was primarily due to 
continued expansion of the Company's sales and marketing staff and the 
commencement of the implementation process for the Company's new 
enterprise resource planning software.  The Company expects that SG&A 
amounts, exclusive of the settlement and related legal costs, will 
continue to increase to support the Company's current and expected future 
volumes of business, including the expansion of SDL's domestic and 
international sales and marketing efforts.  However, there can be no 
assurances that current SG&A levels as a percentage of total revenue are 
indicative of future SG&A as a percentage of total revenue. 

In-process research and development.  The acquisition of Mr. Laser, Inc. 
during 1997 resulted in the write-off of purchased in-process research 
and development of $0.8 million.  In the future, additional in-process 
research and development write-offs can be anticipated as the Company may 
from time to time acquire companies or new product lines.

Amortization of purchased intangibles and goodwill.  Amortization expense 
of $777,000 represents an increase of $106,000 and $132,000 compared to 
1997 and 1996, respectively.  The increase in 1998 compared to 1997 and 
1996 is a result of the acquisition of Mr. Laser in November 1997.

Interest income, net. Interest income decreased slightly during 1998 
compared to 1997 as result of lower average cash and investment balances 
during 1998.  During 1997, the Company liquidated a portion of its 
interest income generating investments for payment of $27.5 million in 
settlement and related legal costs associated with the resolution of the 
Spectra-Physics legal dispute.  The early liquidation of certain of these 
investment securities resulted in a realized loss of approximately $0.3 
million, which is included within interest income on the statement of 
operations.  Excluding that loss, interest income recorded during 1997 
increased slightly from that recorded during 1996.

Provision for Income Taxes.  The income tax provision for the years 
ending December 31, 1998 and December 31, 1997 of $1.0 million and $0.4 
million, respectively, consist primarily of current foreign income taxes 
for the earnings of SDL Optics and federal and state minimum taxes.  The 
federal and state tax provisions were reduced due to the utilization of 
previously unbenefitted net operating loss carryforwards.   The deferred 
income tax benefit for 1998 and 1997 has been limited because realization 
of the deferred tax asset is dependent upon future taxable income, the 
amount and timing of which are uncertain.  Accordingly, a partial 
valuation allowance has been established to record a net deferred tax 
asset that the Company believes is more likely than not to be realized.

The effective tax rate for the year ending December 31, 1996 was 30%.  
This rate was lower than the statutory rate due primarily to the benefits 
of State tax credits and tax-exempt interest income.

Although realization is not assured, the Company believes that it will 
generate future taxable income sufficient to realize the benefit of the 
$4.0 million of net deferred tax assets recorded.  The amount of the net 
deferred tax assets considered realizable could be reduced or increased 
in the near term if estimates of future taxable income are changed.   
Management intends to evaluate the realizability of the net deferred tax 
assets on a quarterly basis to assess the need for the valuation 
allowance.

Quarterly Results of Operations

The following tables set forth certain unaudited quarterly financial data for
the four quarters of each 1998 and 1997. The Company believes that all necessary
adjustments, consisting only of normal recurring adjustments, have been included
in the amounts below to present fairly the selected quarterly information when
read in conjunction with the Financial Statements and the Notes thereto included
elsewhere herein. The results of operations for any quarter are not necessarily
indicative of results that may be expected for any future period or for the
entire year.

<TABLE>
<CAPTION>
                                                      Quarters Ended
                      --------------------------------------------------------------------------------
                                        1998                                     1997
                      ---------------------------------------  ---------------------------------------

                       Mar. 31   June 30  Sept. 30   Dec. 31    Mar. 31  June 30(1)Sept. 30  Dec. 31(2)
                      --------- --------- --------- ---------  --------- --------- --------- ---------
<S>                   <C>       <C>       <C>       <C>        <C>       <C>       <C>       <C>
Revenue ...........    $25,357   $25,810   $25,571   $29,400    $21,016   $21,570   $23,951   $24,827
Cost of revenue ...     17,150    16,895    16,342    18,032     14,018    18,333    16,325    16,478
                      --------- --------- --------- ---------  --------- --------- --------- ---------
Gross margin ......     $8,207    $8,915    $9,229   $11,368     $6,998    $3,237    $7,626    $8,349
Operating income
  (loss) ..........     $2,646    $2,832    $3,015    $4,162       $104  ($29,577)   $2,324    $1,532
Net income (loss)..     $2,699    $2,906    $3,099    $4,119       $507  ($29,471)   $2,451    $1,834
                      ========= ========= ========= =========  ========= ========= ========= =========
Net income (loss)
  per share-basic..      $0.20     $0.21     $0.22     $0.29      $0.04    ($2.19)    $0.18     $0.13
                      ========= ========= ========= =========  ========= ========= ========= =========
Net income (loss)
 per share-
 diluted ..........      $0.19     $0.20     $0.21     $0.28      $0.04    ($2.19)    $0.17     $0.13
                      ========= ========= ========= =========  ========= ========= ========= =========
Weighted average
  shares-basic ....     13,708    13,830    13,882    14,125     13,331    13,462    13,546    13,643
Weighted average
  shares-diluted...     14,545    14,700    14,666    14,925     14,265    13,462    14,431    14,444
</TABLE>

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

(1) The results of operations for the quarter ended June 30, 1997 include a
    one-time charge totaling $27.5 million for the settlement and related legal
    costs associated with the Spectra-Physics vs. SDL, Inc. legal dispute.

(2) The results of operations for the quarter ended December 31, 1997
    include a one-time write-off of in-process research and development of
    approximately  $0.8 million in connection with the acquisition of  Mr.
    Laser, Inc.

Liquidity and Capital Resources.

The Company generated $12.6 million of cash from operating activities 
during 1998 principally from net income from operations adjusted for non-
cash depreciation and amortization changes.  These were offset by an 
increase in accounts receivables and inventories.  In addition, the 
Company received $3.5 million for the issuance of stock under employee 
stock plans, which was offset by investments of $13.4 million for 
facilities expansion and capital equipment purchases.  As a result cash, 
cash equivalents, and marketable securities increased from $26.6 million 
at December 31, 1997 to $29.4 million at December 31, 1998.

The payment of settlement and related legal costs of $27.5 million to 
conclude the Spectra-Physics legal dispute resulted in the use of cash by 
operating activities for the year ended December 31, 1997.  An increase 
in accounts receivable in 1997, as compared with 1996, also contributed 
to a use of operating cash in 1997.  In addition, the Company received 
$2.1 million from the issuance of stock under employee stock plans, which 
was offset by investments of $9.4 million for facilities expansion and 
capital equipment purchases and a cash payment of $2.7 million which 
completed the SDL Optics acquisition.  As a result, cash, cash 
equivalents, and marketable securities decreased from $58.3 million at 
December 31 1996 to $26.6 million at December 31, 1997.

The Company currently expects to spend in the range of $18 million to $20 
million for capital equipment purchases and leasehold improvements during 
1999.

The Company believes that current cash balances, cash generated from 
operations, and cash available through the bank and equity markets will 
be sufficient to fund capital equipment purchases, acquisitions of 
complementary businesses, products or technologies and working capital 
requirements for the foreseeable future.  However, there can be no 
assurances that events in the future will not require the Company to seek 
additional capital sooner or, if so required, that adequate capital will 
be available on terms acceptable to the Company.

Impact of Year 2000

Like many other companies, the year 2000 computer issue creates risks for 
SDL.  Some of the Company's older computer programs were written using 
two digits rather than four to define the applicable year. As a result, 
those computer programs have time-sensitive software that recognize a 
date using "00" as the year 1900 rather than the year 2000.  If  
internal systems do not correctly recognize and process date information 
beyond the year 1999, there could be a material adverse impact on the 
Company's business and results of operations.

To address these year 2000 issues within its internal systems, the 
Company has established a task team and initiated a comprehensive program 
designed to deal with the most critical systems first.  Assessment and 
remediation are proceeding in tandem, and the Company currently plans to 
have changes to critical systems completed and tested by mid-1999. These 
activities are intended to encompass all systems software applications in 
use by the Company, including front and back-end manufacturing, 
facilities, sales, finance and human resources.  

As newer, more functional software solutions are currently available and 
are Year 2000 compliant, the Company has concluded that the conversion to 
enterprise resource planning software programs supporting the Company's 
manufacturing, finance, distribution / logistics and human resource 
operations is more cost effective.  The project is estimated to be 
completed during the quarter ended June 30, 1999.  In addition, as a 
contingency plan, the Company's existing management information software 
applications have been successfully upgraded to a year 2000 compliant 
version.

Assessment and remediation of year 2000 issues in tertiary business 
information systems is on-going.  Well over 80% of the Company's 
investment in desktop PC hardware is known to be year 2000 compliant.  
Additionally, the Company has concluded that the purchase of newer, more 
functional software for its network server applications is more cost 
effective than upgrading its existing software to a year 2000 compliant 
version.  Completing the remediation of the Company's tertiary  business 
information systems is not expected to be a significant burden on the 
Company.

To date, based on its current manufacturing process, SDL believes it has 
no material exposure to contingencies directly related directly to the 
Year 2000 issue for the products it has sold or will sell in the future.

SDL is also actively working with critical suppliers of products and 
services to determine that the suppliers' operations and the products and 
services they provide are year 2000 compatible or to monitor their 
progress toward year 2000 compatibility. In addition, the Company has 
commenced work on various types of contingency planning to address 
potential problem areas with internal systems and with suppliers and 
other third parties.  It is expected that assessment, remediation and 
contingency planning activities will be on-going throughout 1999 with the 
goal of appropriately resolving all material internal systems and third 
party issues.

The costs incurred to date related to these programs are less than $1.9 
million.  The Company currently expects that the total cost of these 
programs, including both incremental spending and redeployed resources, 
will total approximately $2.8 million, more or less, which includes $1.8 
million for the purchase of new software and hardware that will be 
capitalized and $1.0 million that will be expensed as incurred.    The 
Company expects that operating activities will fund the year 2000 costs.  
In some instances, the installation schedule of new software and hardware 
in the normal course of business is being accelerated to also afford a 
solution to year 2000 capability issues.  The Company has not delayed any 
non year 2000 projects. The costs of these projects and dates on which 
the Company believes it will complete the year 2000 modifications are 
based on management's best estimates, which were derived utilizing 
numerous assumptions of future events, including the continued 
availability of certain resources and other factors.

Based on currently available information, management does not believe 
that the year 2000 matters discussed above related to internal systems or 
products sold to customers will have a material adverse impact on the 
Company's financial condition or overall trends in results of operations;  
however, it is uncertain to what extent the Company may be affected by 
such matters.  Any failure to timely, successfully and cost-effectively 
assess, remediate and resolve the Company's year 2000 issues, including 
those regarding its own as well as suppliers' and third parties' internal 
systems, products, services and contingency plans, may have a material 
adverse effect on the Company's business and results of operations.  The 
Company is continuing its efforts to ensure year 2000 readiness, and 
there can be no assurance that there will not be new year 2000 issues not 
identified above and significant delays in or increased costs associated 
with such efforts which could have a material adverse effect on the 
Company's business and results of operations.

Interest Rate Risk

The Company's cash equivalents and short-term and long-term marketable 
securities are subject to market risk and changes in interest rates.  The 
Company's marketable securities are managed by outside professional 
managers within guidelines established by the Company.   The guidelines, 
which include security type, credit quality, and maturity, are intended 
to limit market risk by restricting the Company's high quality debt 
instruments.  The Company's investments in debt securities are classified 
as available-for-sale; therefore, gains and  losses due to changes in 
interest rates are included in other accumulated comprehensive income 
unless such securities are sold prior to maturity.   The Company 
generally holds securities until maturity and carries the securities at 
fair value.


<PAGE>


                                    SDL, INC.
                           CONSOLIDATED BALANCE SHEETS
                       (In thousands, except share data)
<TABLE>
<CAPTION>
                                                            As of December 31,
                                                         ----------------------
                                                            1998        1997
                                                         ----------  ----------
<S>                                                      <C>         <C>
                            ASSETS
Current Assets:
  Cash and cash equivalents .......................        $13,370      $4,593
  Short-term investments ..........................         12,494      10,400
  Accounts receivable, net ........................         22,070      19,960
  Inventories .....................................         19,679      13,938
  Prepaid expenses and other current assets .......          3,306       2,738
                                                         ----------  ----------
Total current assets ..............................         70,919      51,629
Property and equipment, net .......................         32,931      26,298
Long-term investments .............................          3,552      11,613
Note due from related party .......................            512         536
Other assets ......................................          4,563       4,148
                                                         ----------  ----------
Total assets ......................................       $112,477     $94,224
                                                         ==========  ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable ................................         $9,385      $8,469
  Accrued payroll and related expenses ............          2,354       2,945
  Income taxes payable ............................          1,890         828
  Unearned revenue ................................            643         393
  Other accrued liabilities .......................          2,289       2,982
                                                         ----------  ----------
Total current liabilities .........................         16,561      15,617
Long-term liabilities .............................          2,669       2,020

Commitments and contingencies

Stockholders' equity:
  Preferred stock, $0.001 par value:
    Authorized shares - 1,000,000; none issued.....             --          --
  Common stock, $0.001 par value:
    Authorized shares - 21,000,000;
      issued and outstanding shares -
      14,285,938 and 13,674,534 in
      1998 and 1997, respectively .................             15          14
  Additional paid-in capital ......................        120,033     116,268
  Accumulated other comprehensive income...........             (4)        (73)
  Accumulated deficit, $26.3 million relating
    to the repurchase of common stock in 1992
    and $5.8 million relating to a
    recapitalization in 1992 ......................        (26,757)    (39,580)
                                                         ----------  ----------
                                                            93,287      76,629
  Less common stockholders' notes receivable ......            (40)        (42)
                                                         ----------  ----------
Total stockholders' equity ........................         93,247      76,587
                                                         ----------  ----------
Total liabilities and stockholders' equity ........       $112,477     $94,224
                                                         ==========  ==========
</TABLE>
                             See accompanying notes.
<PAGE>

                                    SDL, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                      (In thousands, except per share data)
<TABLE> 
<CAPTION> 
                                               Years Ended December 31,
                                          ---------------------------------
                                             1998       1997       1996
                                          ---------- ---------- -----------
<S>                                       <C>        <C>        <C>
Revenue:
  Product revenue ......................    $96,358    $76,750     $69,772
  Research revenue .....................      9,780     14,614      12,703
                                          ---------- ---------- -----------
Total revenue ..........................    106,138     91,364      82,475
                                          ---------- ---------- -----------
Cost of revenue:
  Cost of product revenue ..............     60,898     53,523      45,365
  Cost of research revenue .............      7,521     11,631       9,591
                                          ---------- ---------- -----------
Total cost of revenue ..................     68,419     65,154      54,956
                                          ---------- ---------- -----------
Gross margin ...........................     37,719     26,210      27,519

Operating expenses:
  Research and development .............     10,690      9,794       6,681
  Selling, general, and administrative..     13,597     40,609      11,521
  In-process research and development...        --         753        --
  Amortization of purchased intangibles
   and goodwill.........................        777        671         645
                                          ---------- ---------- -----------
Total operating expense ................     25,064     51,827      18,847
                                          ---------- ---------- -----------
Operating income (loss) ................     12,655    (25,617)      8,672
Interest income and other, net .........      1,211      1,355       1,501
                                          ---------- ---------- -----------
Income (loss) before income taxes ......     13,866    (24,262)     10,173
Provision for income taxes .............      1,043        417       3,052
                                          ---------- ---------- -----------
Net income (loss) ......................    $12,823   ($24,679)     $7,121
                                          ========== ========== ===========

Net income (loss) per share-basic ......      $0.92     ($1.83)      $0.59
                                          ========== ========== ===========

Net income (loss) per share-diluted ....      $0.87     ($1.83)      $0.54
                                          ========== ========== ===========
Number of weighted average
 shares-basic ..........................     13,887     13,497      12,012
                                          ========== ========== ===========
Number of weighted of average
 shares-diluted ........................     14,709     13,497      13,199
                                          ========== ========== ===========
</TABLE>
                             See accompanying notes.
<PAGE>

                                    SDL, INC.
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                       (In thousands, except share data)
<TABLE>
<CAPTION>
                                                                Accumu-
                                                                 lated              Stock-
                                                                 Other             holder's     Total
                                    Common Stock    Additional  Compre-   Accumu-    Notes      Stock-
                                -------------------  Paid-in    hensive    lated    Receiv-    holders'
                                  Shares    Amount    Capial    Income    Deficit    able       Equity
                                ----------- ------- ---------- --------- --------- --------- ------------
<S>                             <C>         <C>     <C>        <C>       <C>       <C>       <C>
Balance at, December 31, 1995.  10,628,115     $11    $62,995       ($6) ($22,022)    ($478)     $40,500
  Net income .................         --      --         --        --      7,121       --         7,121
  Unrealized loss on
    investments...............         --      --         --        (44)      --        --           (44)
                                                                                             ------------
  Comprehensive income........                                                                     7,077
                                                                                             ------------
  Issuance of stock
    pursuant to
    employee stock plans .....     921,168     --       1,509       --        --        --         1,509
  Proceeds from issuance
    of common stock (less
    offering expenses of
    $362) ....................   1,755,000       2     44,650       --        --        --        44,652
  Issuance of treasury
    stock ....................       1,827     --          33       --        --        --            33
  Payments on
    stockholders' notes
    receivable ...............         --      --         --        --        --        222          222
  Income tax benefit from
    exercise of employee
    stock options ............         --      --       5,234       --        --        --         5,234
                                ----------- ------- ---------- --------- --------- --------- ------------
Balance at, December 31, 1996.  13,306,110      13    114,421       (50)  (14,901)     (256)      99,227
  Net loss ...................         --      --         --        --    (24,679)      --       (24,679)
  Unrealized loss on
    investments...............         --      --         --        (23)      --        --           (23)
                                                                                             ------------
  Comprehensive loss..........                                                                   (24,702)
                                                                                             ------------
  Issuance of stock
    pursuant to
    employee stock plans .....     368,424       1      1,847       --        --        --         1,848
  Payments on
    stockholders' notes
    receivable ...............         --      --         --        --        --        214          214
                                ----------- ------- ---------- --------- --------- --------- ------------
Balance at, December 31, 1997.  13,674,534      14    116,268       (73)  (39,580)      (42)      76,587
  Net income .................         --      --         --        --     12,823       --        12,823
  Unrealized gain on
    investments...............         --      --         --         69       --        --            69
                                                                                             ------------
  Comprehensive income........                                                                    12,892
                                                                                             ------------
  Issuance of stock
    pursuant to
    employee stock plans .....     611,404       1      3,547       --        --        --         3,548
  Payments on
    stockholders' notes
    receivable ...............         --      --         --        --        --          2            2
  Income tax benefit from
    exercise of employee
    stock options.............         --      --         218       --        --        --           218
                                ----------- ------- ---------- --------- --------- --------- ------------
Balance at, December 31, 1998.  14,285,938     $15   $120,033       ($4) ($26,757)     ($40)     $93,247
                                =========== ======= ========== ========= ========= ========= ============
</TABLE>
                             See accompanying notes.
<PAGE>



                                    SDL, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOW

                                  (In thousands)
<TABLE>
<CAPTION>
                                                    Years Ended December 31,
                                                  -----------------------------
                                                    1998      1997      1996
                                                  --------- --------- ---------
<S>                                               <C>       <C>       <C>
Operating activities
Net income (loss) ...............................  $12,823  ($24,679)   $7,121
                                                  --------- --------- ---------
Adjustments to reconcile net income (loss) to
  net cash provided by (used in)operating
  activities:
    Depreciation and amortization ...............    7,583     5,800     4,948
    In-process research and development .........      --        753        --
    Deferred income taxes .......................     (948)       --      (223)
    Changes in operating assets and liabilities:
      Accounts receivable .......................   (2,110)   (8,076)    1,719
      Inventories ...............................   (5,741)     (485)   (4,435)
      Accounts payable ..........................      916     1,599       520
      Accrued payroll and related expenses ......     (591)      730       195
      Income taxes payable ......................    1,280     2,392        --
      Unearned revenue ..........................      250       (62)     (517)
      Other accrued liabilities .................     (693)      339      (135)
      Other .....................................     (139)      435     2,879
                                                  --------- --------- ---------
Total adjustments ...............................     (193)    3,425     4,951
                                                  --------- --------- ---------
Net cash provided by (used in) operating
       activities ...............................   12,630   (21,254)   12,072
                                                  --------- --------- ---------
Investing activities
Acquisition of property and equipment, net ......  (13,439)   (9,407)   (9,909)
Purchase of marketable securities................  (75,838)  (57,064) (100,620)
Sales and maturities of marketable securities....   81,874    90,707    53,413
Acquisition of Businesses .......................       --    (3,055)   (1,560)
                                                  --------- --------- ---------
Net cash provided by (used in) investing
       activities ...............................   (7,403)   21,181   (58,676)
                                                  --------- --------- ---------
Financing activities
Issuance of stock pursuant to employee stock
  plans .........................................    3,548     1,847     1,509
Payments on stockholders' notes receivable ......        2       214       222
Proceeds from issuance of common stock ..........       --        --    44,652
Reissuance of treasury stock ....................       --        --        33
                                                  --------- --------- ---------
Net cash provided by financing activities .......    3,550     2,061    46,416
                                                  --------- --------- ---------
Net increase (decrease) in cash and cash
  equivalents ...................................    8,777     1,988      (188)
Cash and cash equivalents at beginning of year...    4,593     2,605     2,793
                                                  --------- --------- ---------
Cash and cash equivalents at end of year.........  $13,370    $4,593    $2,605
                                                  ========= ========= =========
Supplemental disclosures of cash flow information
  Cash paid for income taxes ....................     $803        $1      $170
  Cash received from income taxes refunded ......     $214    $1,941      $773
</TABLE>
                             See accompanying notes.
<PAGE>

                              SDL, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Summary of Significant Accounting Policies

Organization
SDL, Inc. (the Company), a Delaware corporation, designs, manufactures, 
and markets semiconductor lasers, fiber optic related products, and 
optoelectronic systems. The Company's revenue is derived from: (i) the 
sale of standard and customized products to a diverse worldwide customer 
base utilizing various market applications and, (ii) customer-funded 
research programs, principally through various government agencies.

Basis of Presentation
The consolidated financial statements include the accounts of SDL, Inc. 
and its wholly-owned subsidiary, SDL Optics, Inc. Intercompany accounts 
and transactions have been eliminated in consolidation. The functional 
currency of the Company's foreign subsidiary is the U.S. dollar. 
Subsidiary financial statements are remeasured into U.S. dollars for 
consolidation. Foreign currency transaction gains and losses are included 
in interest income and other, net and were immaterial for all periods 
presented.  Beginning with 1997, the Company operates and reports 
financial results on a fiscal year of 52 or 53 weeks ending on the Friday 
closest to December 31.   Accordingly, fiscal 1997 ended on January 2, 
1998 and was a 53 week year with the fourth fiscal quarter having 14 
weeks;  fiscal 1998 ended on January 1, 1999 and was a 52 week year.  For 
ease of discussion and presentation all years are referred to as ending 
on December 31.

Certain amounts in prior year financial statements and notes thereto have 
been reclassified to conform to current year presentation.

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

Cash and Cash Equivalents
The Company considers all highly liquid investments with original 
maturities of three months or less at the time of purchase to be cash 
equivalents.  Cash equivalents are carried at cost, which approximates 
fair value.

Marketable Securities
The Company has classified its entire investment portfolio as available-
for-sale. Available-for-sale securities are stated at fair market value. 
The amortized cost of debt securities is adjusted for amortization of 
premiums and accretion of discounts to maturity. Such amortization is 
included in interest income. Realized gains and losses are included in 
interest income and other, net. The cost of securities sold is based on 
the specific identification method.

Inventories
Inventories are stated at the lower of standard cost (which approximates 
actual costs on a first-in, first-out basis) or market. The market value 
is based upon estimated net realizable value.

Equipment and Leasehold Improvements
Property and equipment are stated at cost. Equipment and fixtures are 
depreciated using the straight-line method over estimated useful lives 
ranging from three to eight years. Leasehold improvements are amortized 
using the straight-line method over the shorter of the estimated useful 
lives or the remaining lease terms.

Goodwill and Purchased Intangibles
Goodwill and other purchased intangibles are being amortized using the 
straight-line method over three to seven years.


Revenue Recognition
Revenue recognition is based on the terms of the underlying sales 
agreements (purchase orders or contracts). Revenue for product sales is 
recognized upon shipment. Revenue for costs incurred plus specified fee 
contracts is recognized on the percentage-of-completion method. Revenue 
for fixed price milestone contracts is recognized upon the completion of 
the milestone. Customers entering into cost incurred and fixed price 
contracts with the Company include the U.S. government, prime or 
subcontractors for which the U.S. government may be the end customer, and 
other domestic and international end-users.

Concentrations

   Dependence Upon Government Programs and Contracts - In 1998, 1997, 
   and 1996, the Company derived approximately 28 percent, 38 percent, 
   and 43 percent, respectively, of its revenue directly and 
   indirectly from a variety of Federal government sources. The demand 
   for certain of the Company's services and products is directly 
   related to the level of funding of government programs. The Company 
   believes that the success and further development of its business 
   is dependent, in significant part, upon the continued existence and 
   funding of such programs and upon the Company's ability to 
   participate in such programs. For example, substantially all of the 
   Company's research revenue for 1998, 1997, and 1996 was funded by 
   Federal programs. There can be no assurance that such programs will 
   continue to be funded even if government agencies have available 
   financial resources or that the Company will continue to be awarded 
   contracts under such programs.

   Dependence on Single Source and Other Third Party Suppliers - The 
   Company depends on a single or limited number of outside 
   contractors and suppliers for raw materials, packages and standard 
   components, and to assemble printed circuit boards. The Company 
   generally purchases these single or limited source products through 
   standard purchase orders or one-year supply agreements and has no 
   long-term guaranteed supply agreements with such suppliers. While 
   the Company seeks to maintain a sufficient safety stock of such 
   products and also endeavors to maintain ongoing communications with 
   its suppliers to guard against interruptions or cessation of 
   supply, the Company's business and results of operations have in 
   the past been and could in the future be adversely affected by a 
   stoppage or delay of supply, substitution of more expensive or less 
   reliable products, receipt of defective parts or contaminated 
   materials, an increase in the price of such supplies, or the 
   Company's inability to obtain reduced pricing from its suppliers in 
   response to competitive pressures.

   Credit Risk - The Company performs ongoing credit evaluations of 
   its customers' financial condition and generally requires no 
   collateral from its customers. The Company maintains reserves for 
   potential credit losses. Although such losses have been within 
   management's expectations to date, there can be no assurance that 
   such reserves will continue to be adequate.

Principal Business and Export Sales
The Company's operations are conducted in one principal line of business, 
the design, manufacture, and sale of semiconductor lasers, fiber optic 
products, and optoelectronic systems. The Company has operations in the 
United States and international operations in Canada.  All sales are 
denominated in U.S. dollars

All U.S. operations sales to international customers constitute export 
sales. Export sales to Europe totaled approximately $9.3 million, $5.9 
million, and $3.9 million for 1998, 1997, and 1996, respectively. Export 
sales to the Pacific Rim totaled approximately $8.9 million, $6.9 
million, and $6.0 million for 1998, 1997, and 1996, respectively. 

Net Income (Loss) Per Share

The following table sets forth the computation of basic and diluted net 
income (loss) per share (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                               Years Ended December 31,
                                          ---------------------------------
                                             1998       1997       1996
                                          ---------- ---------- -----------
<S>                                       <C>        <C>        <C>
Numerator:
Net income (loss) ......................    $12,823   ($24,679)     $7,121
                                          ========== ========== ===========
Denominator:
Denominator for basic earnings per
  share-weighted average shares.........     13,887     13,497      12,012
Incremental common shares attributable
  to shares issuable under employee
  stock plans(1)........................        822        --        1,187
                                          ---------- ---------- -----------
Denominator for diluted earnings per
  share - adjusted weighted average
  shares and assumed conversions........     14,709     13,497      13,199
                                          ========== ========== ===========

Net income (loss) per share - basic.....      $0.92     ($1.83)      $0.59
                                          ========== ========== ===========
Net income (loss) per share - diluted...      $0.87     ($1.83)      $0.54
                                          ========== ========== ===========
</TABLE>

(1) Potential common shares relating to shares issuable under employee stock
    plans are not included in the 1997 calculation due to their
    anti-dilutive effect on the loss per share.

Options to purchase 62,363 shares of common stock were not included in 
the computation of the 1998 diluted earnings per share because the 
options' exercise price was greater than the average market price of 
common shares.

Comprehensive Income

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

Accumulated other comprehensive income presented in the accompanying 
consolidated balance sheets consists of the accumulated net unrealized 
gains and losses on available-for-sale marketable securities, net of the 
related tax effect for all periods presented.  The tax effects for other 
comprehensive income were immaterial for all periods presented.

Segments of an Enterprise

Effective January 1, 1998, the Company adopted the Financial Accounting 
Standards Board's Statement of Financials Accounting Standards No. 131, 
Disclosures about Segments of an Enterprise and Related Information 
(Statement 131).  Statement 131 superseded FASB Statement No. 14, 
Financial Reporting for Segments of a Business Enterprise.  Statement 131 
establishes standards for the way that public business enterprises report 
information about operating segments in annual financial statements and 
requires that those enterprises report selected information about 
operating segments in interim financial reports.  Statement 131 also 
establishes standards for related disclosures about products and 
services, geographic areas, and major customers.  The adoption of 
Statement 131 did not affect results of operations or financial position, 
but did affect the disclosure of segment information.  See note 14. 

Statement of Position 98-1

In March 1998, the Accounting Standards Executive Committee of the AICPA 
issued Statement of Position (SOP) 98-1, Accounting for the Costs of 
Computer Software Developed or Obtained for Internal Use.  The SOP, which 
has been adopted prospectively as of September 30, 1998, requires the 
capitalization of certain costs incurred in connection with developing or 
obtaining internal use software.  Prior to adoption of SOP 98-1, the 
Company expensed all internal use software related costs as incurred.  
The effect of adopting the SOP was to increase net income for the year 
ended December 31, 1998 by $71,000.

Recent Financial Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement 
No. 133, Accounting for Derivative Instruments and Hedging Activities, 
which is required to be adopted in years beginning after June 15, 1999.  
Because the Company has never used derivatives, management does not 
anticipate that the adoption of the new Statement will have a significant 
effect on earnings or the financial position of the Company.

2. Marketable Securities

Available-for-sale marketable securities consist of the following (in
thousands):  

<TABLE>
<CAPTION>
                                                  Gross      Gross 
                                     Amortized  Unrealized Unrealized Estimated 
                                        Cost      Gains      Losses   Fair Value
                                     ---------- ---------- ---------- ----------
<S>                                  <C>        <C>        <C>        <C>
December 31, 1998:
 Medium term notes.................    $10,091         $1        $25    $10,067
 Commercial Paper..................      4,959         20        --       4,979
 Tax-exempt auction rate preferred
   stock...........................      5,950        --         --       5,950
 Money Market Funds................        564        --         --         564
                                     ---------- ---------- ---------- ----------
                                       $21,564        $21        $25    $21,560
                                     ========== ========== ========== ==========

 Included in cash and cash equivalents...............................    $5,514
 Included in short-term marketable securities........................    12,494
 Included in long-term marketable securities.........................     3,552
                                                                      ----------
                                                                        $21,560
                                                                      ==========
<CAPTION>

                                                  Gross      Gross 
                                     Amortized  Unrealized Unrealized Estimated 
                                        Cost      Gains      Losses   Fair Value
                                     ---------- ---------- ---------- ----------
<S>                                  <C>        <C>        <C>        <C>
December 31, 1997:
 Municipal bonds...................    $13,686         $1        $74    $13,613
 Tax-exempt auction rate preferred
   stock...........................      8,400        --         --       8,400
 Money Market Funds................      1,017        --         --       1,017
                                     ---------- ---------- ---------- ----------
                                       $23,103         $1        $74    $23,030
                                     ========== ========== ========== ==========

 Included in cash and cash equivalents...............................    $1,017
 Included in short-term marketable securities........................    10,400
 Included in long-term marketable securities.........................    11,613
                                                                      ----------
                                                                        $23,030
                                                                      ==========

<CAPTION>
The following is a summary of contractual maturities of the Company's marketable
securities (in thousands):


                                     Amortized                        Estimated 
                                        Cost                          Fair Value
                                     ----------                       ----------
<S>                                  <C>                              <C>
December 31, 1998:
 Money Market Funds................       $564                             $564
 Amounts maturing within one year..     17,436                           17,444
 Amounts maturing after one year...      3,564                            3,552
                                     ----------                       ----------
                                       $21,564                          $21,560
                                     ==========                       ==========
</TABLE>

Realized losses on the sale of available-for-sale securities were $0.1 
million and $0.3 million in 1998 and 1997, respectively.


3. Accounts Receivable

Accounts receivable consist of the following:

<TABLE>
<CAPTION>
                                                  As of December 31,
                                                ---------------------
                                                   1998       1997
                                                ---------- ----------
                                                   (In thousands)
<S>                                             <C>        <C>
Trade receivables..............................   $20,488    $17,334
Receivables under long-term contracts:
  Billed.......................................     1,865        765
  Unbilled costs and estimated earnings,
   current portion.............................       722      3,051
                                                ---------- ----------
                                                   23,075     21,150
Allowance for doubtful accounts................    (1,005)    (1,190)
                                                ---------- ----------
                                                  $22,070    $19,960
                                                ========== ==========
</TABLE>

The majority of unbilled costs and estimated earnings on uncompleted cost 
incurred and fixed price contracts are billable in the subsequent year.

Pursuant to the retainage provisions in certain long-term contracts, a 
specified portion of receivables do not become due and payable until 
completion of a final audit by the Defense Contract Audit Agency. Such 
retainage amounts total approximately $0.5 million in 1998 and 1997 and 
are included in other assets in the accompanying balance sheets.


4. Inventories

Inventories consist of the following:

<TABLE>
<CAPTION>
                                                  As of December 31,
                                                ---------------------
                                                   1998       1997
                                                ---------- ----------
                                                   (In thousands)
<S>                                             <C>        <C>
Raw materials..................................    $6,620     $6,087
Work-in-process................................    13,059      7,851
                                                ---------- ----------
                                                  $19,679    $13,938
                                                ========== ==========
</TABLE>

No significant amounts of finished goods or work-in-process related to long-term
contracts are maintained.


5. Property and Equipment

Property and equipment consist of the following:

<TABLE>
<CAPTION>
                                                  As of December 31,
                                                ---------------------
                                                   1998       1997
                                                ---------- ----------
                                                   (In thousands)
<S>                                             <C>        <C>
Machinery and equipment........................   $48,636    $37,946
Leasehold improvements.........................     8,431      7,697
Furniture and fixtures.........................       898        846
Construction-in-progress.......................     3,897      1,934
                                                ---------- ----------
                                                   61,862     48,423
Less accumulated depreciation and amortization.   (28,931)   (22,125)
                                                ---------- ----------
                                                  $32,931    $26,298
                                                ========== ==========
</TABLE>


6. Goodwill and Purchased Intangibles

Purchased intangibles, which are included in other assets, consist of the 
following:

<TABLE>
<CAPTION>
                                                  As of December 31,
                                                ---------------------
                                                   1998       1997
                                                ---------- ----------
                                                   (In thousands)
<S>                                             <C>        <C>
Goodwill.......................................    $1,363     $1,363
Other purchased intangibles....................     1,945      1,945
                                                ---------- ----------
                                                    3,308      3,308
Less accumulated amortization..................    (2,147)    (1,370)
                                                ---------- ----------
                                                   $1,161     $1,938
                                                ========== ==========
</TABLE>

See Note 11, Acquisitions.


7.  Note due from Related Party

On May 1, 1997 the Company loaned an officer $612,000 secured by a deed 
of trust.  The note is due on the tenth anniversary of the date of the 
note, however; certain amounts may be forgiven.  After five years 
continuous employment with the Company, $200,000 will be forgiven.  After 
ten years continuous employment with the Company, an additional $200,000 
will be forgiven.  Other terms provide for mandatory prepayment if 
certain events of default occur.  The note shall bear interest at 8% only 
in the event of a default.  The amount expected to be forgiven is being 
amortized to compensation expense over ten years.  


8. Income Taxes

The provision for income taxes consists of the following:

<TABLE>
<CAPTION>
                                                     Years Ended December 31,
                                                --------------------------------
                                                   1998       1997       1996
                                                ---------- ---------- ----------
                                                          (In thousands)
<S>                                             <C>        <C>        <C>
Current:
  Federal......................................      $181     $  --      $2,617
  State........................................        26        --         312
  Foreign......................................     1,784        417        346
                                                ---------- ---------- ----------
                                                    1,991        417      3,275
Deferred:
  Federal......................................      (948)       --        (371)
  State........................................       --         --         148
                                                ---------- ---------- ----------
                                                     (948)       --        (223)
                                                ---------- ---------- ----------
                                                   $1,043       $417     $3,052
                                                ========== ========== ==========
</TABLE>

The tax benefits resulting from the exercise of nonqualified stock 
options and the disqualifying disposition of shares acquired under the 
Company's incentive stock option and employee stock purchase plans were 
$0.2 million, zero and $5.2 million in 1998, 1997 and 1996, respectively. 
Such benefits were credited to additional paid-in capital.

Pre-tax income from foreign operations was $4.6 million, $1.1 million and 
$0.8 million in 1998, 1997 and 1996, respectively.

The difference between the provision for income taxes and the amount 
computed by applying the Federal statutory income tax rate to income 
before taxes is explained below:

<TABLE>
<CAPTION>
                                                     Years Ended December 31,
                                                --------------------------------
                                                   1998       1997       1996
                                                ---------- ---------- ----------
                                                          (In thousands)
<S>                                             <C>        <C>        <C>
Tax at federal statutory rate..................    $4,853    ($8,492)    $3,560
State income tax, net of federal
  tax benefit..................................        17       --          299
Non-deductible in-process, research
  and development write-off....................      --          264       --
Net operating loss not benefited (utilized)....    (3,809)     9,057       --
Valuation allowance............................      (216)      --         --
Tax-exempt interest income.....................      (124)      (453)      (455)
Other..........................................       322         41       (352)
                                                ---------- ---------- ----------
Provision for income taxes.....................    $1,043       $417     $3,052
                                                ========== ========== ==========
</TABLE>

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

<TABLE>
<CAPTION>
                                                  As of December 31,
                                                ---------------------
                                                   1998       1997
                                                ---------- ----------
                                                   (In thousands)
<S>                                             <C>        <C>
Deferred tax assets:
  Net operating loss carryforwards.............    $9,132     $9,680
  Reserves and other accrued expenses
    not yet deductible for tax.................     1,832      2,070
  Inventory....................................     3,088      1,584
  Intangible assets............................     4,157      3,838
  Tax credit carryforward......................     1,800        970
  Other........................................       --          52
                                                ---------- ----------
  Total deferred tax assets....................    20,009     18,194
  Valuation allowance..........................   (15,128)   (14,030)
                                                ---------- ----------
  Net deferred tax assets......................     4,881      4,164
                                                ---------- ----------
Deferred tax liabilities:
  Depreciation.................................      (743)      (550)
  Other........................................      (138)      (562)
                                                ---------- ----------
  Total deferred tax liabilities...............      (881)    (1,112)
                                                ---------- ----------
Net deferred tax assets........................    $4,000     $3,052
                                                ========== ==========
</TABLE>

The valuation allowance increased by approximately $1.1 million and  
$12.0 million in 1998 and 1997, respectively. Approximately $7.6 million 
of the valuation allowance is related to the benefits of stock option 
deductions, which will be credited to paid-in capital when realized.

As of December 31, 1998, the Company had federal and state net operating 
loss carryforwards of approximately $26.0 million and $4.8 million, 
respectively, and federal and state tax credit carryforwards of 
approximately $0.9 million and $1.3 million, respectively. The net 
operating loss and credit carryforwards will expire at various dates 
beginning in years 2001 through 2018, if not utilized.

Management has determined, based on the Company's history of prior 
operating earnings, its expectations for the future, and the extended 
period over which the benefits of certain deferred tax assets will be 
realized, that a partial valuation allowance should be provided.  The 
realization of the Company's net deferred tax assets, which relate 
primarily to temporary differences, net operating loss carryforwards and 
tax credit carryforwards is dependent on generating sufficient taxable 
income during the periods in which the temporary differences are expected 
to reverse. Although realization is not assured, management believes it 
is more likely than not that the net deferred tax assets will be 
realized.

9.  Stockholders' Equity

Common Stock Offerings

On June 26, 1996, the Company issued 1,500,000 shares of common stock in 
a follow-on public stock offering at a per share price of $27.00. In 
addition, SDL's Underwriters exercised their over-allotment option to 
purchase 255,000 additional shares of the Company's common stock. Net 
proceeds to the Company approximated $44.7 million.

Shareholder Rights Plan 

The Company has adopted a Shareholder Rights Plan (Rights Agreement).  
Pursuant to the Rights Agreement, rights were distributed at the rate of 
one right for each share of Common Stock owned by the Company's 
stockholders of record on November 17, 1997.  The rights expire on 
November 5, 2007 unless extended or earlier redeemed or exchanged by the 
Company.  Under the Rights Agreement, each right entitles the registered 
holder to purchase one-hundredth of a Series B Preferred share of the 
Company at a price of $110. The rights will become exercisable only if a 
person or group acquires beneficial ownership of 15 percent or more of 
the Company's common stock or commences a tender offer or exchange offer 
upon consummation of which such person or group would beneficially own 15 
percent or more or the Company's common stock.


Stockholders' Notes Receivable

Certain exercises of stock options occurred in conjunction with the 
issuance of full-recourse stockholders' notes receivable. The notes bear 
interest between 5 percent and 8 percent per annum with annual interest 
payments. The principal on the notes is due beginning in 1999 through 
2001. 

10.     Stock-Based Compensation Plans

Stock Option Plans

The 1992 Stock Option Plan provided for the granting of incentive stock 
options and nonqualified options to purchase up to 4,558,125 shares of 
the Company's common stock to officers, directors and key employees at 
exercise prices of not less than fair value on the date of grant as 
determined by a committee of the Board of Directors. Options granted were 
immediately exercisable; however, unexercised options and shares 
purchased upon the exercise of the options are subject to vesting over a 
one- to five-year period. Shares not vested at the date of termination of 
employment may be repurchased by the Company at the original exercise 
price. No further options will be granted under the 1992 Stock Option 
Plan.

The Company's 1995 Stock Option Plan was approved by the Board of 
Directors in January 1995 and by the stockholders in February 1995. The 
purposes of the 1995 Option Plan are to give the Company's employees and 
others who perform substantial services to the Company incentive, through 
ownership of the Company's common stock, to continue in service to the 
Company, and to help the Company compete effectively with other 
enterprises for the services of qualified individuals. The 1995 Stock 
Option Plan permits the grant of incentive stock options to employees, 
including officers and Directors who are employees, and the award of 
nonqualified stock options to the Company's employees, officers, 
Directors, independent contractors, and consultants. The number of shares 
available for grant was initially 712,500 shares. Beginning on the first 
day of each fiscal year, the number of shares reserved for grant will be 
increased by 5 percent of the number of shares of common stock 
outstanding as of the end of the preceding fiscal year. Options granted 
under the 1995 Stock Option Plan are subject to vesting over a one to 
five year period and must generally be exercised by the optionee during 
the period of employment or service with the Company or within a 
specified period following termination of employment or service. Options 
currently expire no later than ten years from the date of grant.

The Company has reserved 3,323,738 shares of common stock for future 
issuance under its Stock Option Plans as of December 31, 1998.

Information with respect to stock option activity is summarized as follows:

<TABLE>
<CAPTION>
                                                   Outstanding Options
                                                 -----------------------
                                                              Weighted-
                                      Available                Average
                                         for      Number of    Exercise
                                        Grant       Shares      Price
                                     ----------- ------------ ----------
<S>                                  <C>         <C>          <C>
Balance at December 31, 1995......      130,350    2,860,863      $3.59
  Options granted.................     (373,642)     373,642      20.53
  Options canceled................      182,274     (182,274)     15.32
  Options exercised...............         --       (821,569)      0.70
  Additional options authorized...      531,375          --         --
  Option authorizations canceled..      (14,520)         --         --
                                     ----------- ------------
Balance at December 31, 1996......      455,837    2,230,662       6.48
  Options granted.................     (552,645)     552,645      16.06
  Options canceled................      140,268     (140,268)     16.79
  Options exercised...............         --       (249,734)      2.33
  Additional options authorized...      665,305          --         --
                                     ----------- ------------
Balance at December 31, 1997......      708,765    2,393,305       8.51
  Options granted.................     (646,863)     646,863      22.58
  Options canceled................      156,080     (156,080)     19.58
  Options exercised...............         --       (462,059)      4.06
  Additional options authorized...      683,727          --         --
                                     ----------- ------------
Balance at December 31, 1998......      901,709    2,422,029     $12.41
                                     =========== ============
</TABLE>

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

<TABLE>
<CAPTION>
                        Options Oustanding              Options Exercisable
                 ------------------------------------ ----------------------
                               Weighted-
                                Average    Weighted-              Weighted-
                               Remaining    Average                Average
   Range of         Number    Contractual   Exercise    Number     Exercise
Exercise Prices  Outstanding  Life (Years)   Price    Exercisable   Price
---------------- ------------ ------------ ---------- ----------- ----------
<S>              <C>          <C>          <C>        <C>         <C>
 $0.34 -  $5.10      822,109          3.7      $0.84     822,109      $0.84
  5.11 -  11.00      237,409          6.1      10.02     184,471       9.87
 11.01 -  16.00      336,695          8.2      13.60     107,346      14.11
 16.01 -  21.00      470,679          8.4      18.60     120,169      18.44
 21.01 -  25.00      492,774          9.0      24.01      40,041      22.79
 25.01 -  30.00       53,313          7.5      27.64      25,925      27.74
 30.01 -  39.63        9,050         10.0      39.63         --         --
                 ------------                         -----------
 $0.34 - $39.63    2,422,029          6.7     $12.41   1,300,061      $6.05
                 ============                         ===========
</TABLE>

Employee Stock Purchase Plan
To provide employees with an opportunity to purchase common stock of the 
Company through payroll deductions, the Company established the 1995 
Employee Stock Purchase Plan (the ESPP) and initially reserved 450,000 
shares of common stock for issuance to participants.  In May 1998, 
400,000 additional shares of common stock were reserved for issuance to 
participants.  Under the ESPP, the Company's employees, subject to 
certain restrictions, may purchase shares of common stock at the lesser 
of 85 percent of the fair market value at either the beginning of each 
two-year offering period or the end of each six-month purchase period 
within the two-year offering period. Under the ESPP, the Company sold 
149,345, 118,690, and 110,658 shares in 1998, 1997 and 1996, 
respectively. 


Stock-Based Compensation
The Company has elected to follow Accounting Principles Board Opinion No. 
25, "Accounting for Stock Issued to Employees" (APB 25), and related 
interpretations in accounting for its employee stock-based awards 
because, as discussed below, the alternative fair value accounting 
provided for under Statement of Financial Accounting Standards No. 123, 
"Accounting for Stock-Based Compensation" (SFAS 123), requires use of 
option valuation models that were not developed for use in valuing stock-
based compensation plans. Under APB 25, the Company generally recognizes 
no compensation expense with respect to such awards.

Pro forma information regarding net income and earnings per share is 
required by SFAS 123 as if the Company has accounted for its employee 
stock options granted subsequent to December 31, 1994 under the fair 
value method. The fair value for these options was estimated at the date 
of grant using a Black-Scholes option pricing model. The Black-Scholes 
option valuation model was developed for use in estimating the fair value 
of traded options which have no vesting restrictions and are fully 
transferable. In addition, option valuation models require the input of 
highly subjective assumptions including the expected stock price 
volatility. Since the Company's stock-based awards have characteristics 
significantly different from those of traded options, and since changes 
in the subjective input assumptions can materially affect the fair value 
estimate, in management's opinion, the existing models do not necessarily 
provide a reliable single measure of the fair value of its stock-based 
awards. The fair value of the Company's stock-based awards to employees 
was estimated assuming no expected dividends and the following weighted-
average assumptions:

<TABLE>
<CAPTION>
                                   Options                      ESPP
                          -------------------------- --------------------------
                            1998     1997     1996     1998     1997     1996
                          -------- -------- -------- -------- -------- --------
<S>                       <C>      <C>      <C>      <C>      <C>      <C>
Expected Life...........  4 years  4 years  3 years  6 months 6 months 6 months
Expected Volatility.....     0.72     0.66      0.6     0.84     0.82     0.72
Risk Free Interest Rate.     5.15%    6.17%    6.04%    5.06%    5.64%    5.45%
</TABLE>

For the purpose of pro forma disclosures, the estimated fair value of the above
stock-based awards is amortized over the awards' vesting period. The Company's
pro forma information follows (in thousands, except for per share information):

<TABLE>
<CAPTION>
                                      Years Ended December 31,
                                   --------------------------------
                                      1998       1997       1996
                                   ---------- ---------- ----------
<S>                                <C>        <C>        <C>
Pro forma net income (loss).....      $6,789   ($27,523)    $5,947
Pro forma net income (loss)
  per share - basic.............       $0.49     ($2.04)     $0.50
Pro-forma net income (loss)
  per share - diluted...........       $0.46     ($2.04)     $0.45
</TABLE>

Because SFAS 123 is applicable only to options granted subsequent to 
December 31, 1994, its pro forma effect will not be fully reflected until 
approximately 1999.

Weighted-average fair value of options granted during 1998, 1997 and 1996 
were $13.02, $8.92 and $9.65, respectively. The weighted-average fair 
value of ESPP rights granted in 1998, 1997 and 1996 were $7.53, $5.64 and 
$3.97, respectively.

11.  Acquisitions

In November 1997, the Company acquired all of the outstanding stock of 
Mr. Laser, Inc., a company involved in the design and development of 
compact laser marking systems. The acquisition was accounted for under 
the purchase method of accounting.  The total purchase price was 
approximately $1,202,000, which includes related transaction costs of 
$22,000, $187,000 for net acquired liabilities.  At the time of 
acquisition, the Company recorded $753,000 as in-process research and 
development for development projects that had not yet reached technologic 
feasibility. To determine the value of in-process research and 
development, the Company considered, among other factors, the state of 
development of the compact laser marking system, the costs needed to 
complete development, and the expected income and risks associated with 
the inherent difficulties and uncertainties in completing development. 
Purchase price in excess of amounts allocated to in-process research and 
development and net acquired liabilities was approximately $453,000 and 
was allocated to goodwill. Goodwill is being amortized straight-line over 
a three year life.  Mr. Laser's operating results are included in the 
accompanying consolidated financial statements beginning with November 
1997.  The results of Mr. Laser prior to the acquisition were not 
material to the Company's consolidated results of operations.

12.  Commitments

The Company leases all of its facilities and certain equipment under 
operating leases. The operating facilities leases contain renewal 
options. The future minimum rental payments as of December 31, 1998, 
under operating leases are as follows (in thousands):

<TABLE>
<CAPTION>
           Fiscal Year               Amount
---------------------------------- ----------
<S>                                <C>
  1999............................    $2,218
  2000............................     2,275
  2001............................     2,246
  2002............................       640
  2003............................       167
                                   ----------
                                      $7,546
                                   ==========
</TABLE>

Rental expense was approximately $2.2 million, $1.7 million and $1.4 
million, for 1998, 1997 and 1996, respectively.

13. Contingencies

In 1985, Rockwell International Corporation (Rockwell) asserted, and in 
1995 filed suit in the Northern California Federal District Court against 
the Company alleging that a Company fabrication process infringed certain 
Rockwell patent rights.  Rockwell sought to permanently enjoin the 
Company from infringing Rockwell's alleged patent rights and sought 
unspecified actual and treble damages plus costs.  The Company answered 
Rockwell's complaint asserting, among other defenses, that Rockwell's 
patent is invalid.  Rockwell's suit was stayed in 1995 pending resolution 
of another suit, involving the same patent, brought by Rockwell against 
the Federal government, and in which SDL had intervened.  The suit 
between the Federal government and Rockwell was resolved in Janaury 1999, 
by way of a settlement payment from the Federal government to Rockwell.  
The Company did not participate in the settlement.  As a result of that 
settlement, the Company anticipates that the stay of Rockwell's suit 
against the Company will be lifted.  A status conference is scheduled in 
that case for March 8, 1999.  The resolution of this litigation is fact 
intensive so that the outcome cannot be determined and remains uncertain.  
If Rockwell prevailed in the litigation, it could be awarded monetary 
damages against the Company.  The Company believes, however, that it has 
meritorious defenses to the Rockwell's allegations in the litigation.

Shortly after the aforementioned suit between Rockwell and the Federal 
government was filed, the Federal government had notified the Company 
that, if the Federal government were liable to Rockwell, then the Federal 
government might seek indemnification for a portion of its liability from 
the Company.  The Federal government never stated the amount of the 
Company's alleged indemnity obligation, nor has it ever repeated its 
assertion that the Company might have some indemnity obligation to the 
Federal government.

SDL is engaged in various cost-reimbursement type contracts with the 
Federal government.  These contracts utilize allowable costs plus 
contract fee to determine revenue.  Federally-funded contracts are 
subject to audit of pricing and actual costs incurred, which have 
resulted and could result in the future, in price adjustments.  The 
government has in the past and could in the future, challenge the 
Company's accounting methodology for computing indirect rates and 
allocating indirect costs to government contracts.  The government is 
currently challenging certain indirect cost allocations.  While 
management believes that amounts recorded on its financial statements are 
adequate to cover all related risks, the government has not concluded its 
investigation or agreed to a settlement with the Company.  Although the 
outcome of this matter cannot be determined at this time, management does 
not believe that its outcome will have a material adverse affect on the 
Company's financial position, results of operations or cash flows.  
Nevertheless, based on future developments, the Company's estimate of the 
outcome of these matters could change in the near term.

Trial of the Spectra-Physics vs. SDL, Inc. litigation began before the 
Santa Clara County, California Superior Court on May 7, 1997. On May 19, 
1997, before the trial was concluded, the Company, Spectra-Physics and 
its subsidiary Opto Power Corporation, and Xerox Corporation made a 
comprehensive settlement of their disputes.

During the second quarter of fiscal 1997, the Company included 
approximately $27.5 million in general and administrative expenses for 
settlement and related legal costs associated with the resolution of the 
dispute with Spectra-Physics, Inc.

14. Segments of an Enterprise and Related Information

Reportable Segments

SDL has three reportable segments: communications, research, and printing 
and materials processing.  The communications business unit develops, 
designs, manufactures and distributes lasers for applications in the 
telecom, cable television, satellite and dense wavelength division 
multiplexing markets.   The research business unit conducts research, 
development or product customization, involving both communications and 
printing and material processing applications, for Fortune 500 companies, 
major international customers, smaller domestic and international 
companies, and multiple Federal government agencies.   The operating 
results of the research business unit include solely the results 
generated from that business unit.  Research revenue on the Consolidated 
Statement of Operations included research, development, and product 
customization conducted by all segments of the Company. The printing and 
materials processing business unit develops, designs, manufacturers and 
distributes lasers for applications in the surface heat treating, product 
labeling, digital imaging, digital proofing, and thermal printing 
solutions markets.

The operating segments reported below are the segments of the Company for 
which separate financial information is available and for which operating 
income/loss amounts are evaluated regularly by executive management in 
deciding how to allocate resources and in assessing performance. The 
accounting policies of the operating segments are the same as those 
described in the summary of accounting policies. 

The Company's reportable segments are business units that offer different 
products.  The reportable segments are each managed separately because 
they manufacture and distribute distinct products with different 
applications.  The Company does not allocate assets to its individual 
operating segments.

Information about reported segment income or loss is as follows (in 
thousands):



<TABLE>
<CAPTION>
                                                          Printing
                                   Communica-               and
                                      tion                Material
                                    Products   Research  Processing   Total
                                   ---------- ---------- ---------- ---------
<S>                                <C>        <C>        <C>        <C>
Year ended December 31, 1998:
Revenue from external customers...   $55,391     $7,354    $43,393  $106,138
Amortization......................       645        --         132       777
Segment Operating Income..........    $7,744       $135     $4,776   $12,655

<CAPTION>
                                                          Printing
                                   Communica-               and
                                      tion                Material
                                    Products   Research  Processing   Total
                                   ---------- ---------- ---------- ---------
<S>                                <C>        <C>        <C>        <C>
Year ended December 31, 1997:
Revenue from external customers...   $38,354    $11,020    $41,990   $91,364
Amortization......................       645        --          26       671
In Process R&D....................       --         --         753       753
Segment Operating Income (Loss)...    $2,657       $138      ($912)   $1,883

<CAPTION>
                                                          Printing
                                   Communica-               and
                                      tion                Material
                                    Products   Research  Processing   Total
                                   ---------- ---------- ---------- ---------
<S>                                <C>        <C>        <C>        <C>
Year ended December 31, 1996:
Revenue from external customers...   $35,557    $11,900    $35,018   $82,475
Amortization......................       645        --         --        645
Segment Operating Income..........    $3,804       $518     $4,350    $8,672
</TABLE>


A reconciliation of the totals reported for the operating segments to the 
applicable line items in the consolidated financial statements is as 
follows (in thousands):
<TABLE> 
<CAPTION> 
                                                   Years Ended December 31,
                                              -------------------------------
                                                 1998       1997      1996
                                              ---------- ---------- ---------
<S>                                           <C>        <C>        <C>
Operating Income (Loss)
  Total operating income from operating
     segments...............................    $12,655     $1,883    $8,672
  Spectra Physics Lawsuit and related
     legal costs............................        --     (27,500)       --
                                              ---------- ---------- ---------
Total consolidated operating income (loss)..    $12,655   ($25,617)   $8,672
                                              ========== ========== =========
</TABLE>

Geographic Information

Information regarding geographic areas for the years ended December
31, 1998, 1997 and 1996 is as follows (in thousands):


<TABLE>
<CAPTION>
                                                           Long-
                                                           Lived
                                              Revenue(a)   Assets
                                              ---------- ----------
<S>                                           <C>        <C>
Year ended December 31, 1998:
  United States.............................    $80,665    $33,624
  Canada....................................      6,503      3,016
  Germany...................................      4,771        --
  France....................................      4,308        --
  Japan.....................................      6,886        --
  Other foreign countries...................      3,005        --
                                              ---------- ----------
         Total                                 $106,138    $36,640
                                              ========== ==========

<CAPTION>
                                                           Long-
                                                           Lived
                                              Revenue(a)   Assets
                                              ---------- ----------
<S>                                           <C>        <C>
Year ended December 31, 1997:
  United States.............................    $75,832    $28,249
  Canada....................................      2,175      1,366
  Germany...................................      2,936        --
  France....................................      3,221        --
  Japan.....................................      4,123        --
  Other foreign countries...................      3,077        --
                                              ---------- ----------
         Total                                  $91,364    $29,615
                                              ========== ==========

<CAPTION>
                                                           Long-
                                                           Lived
                                              Revenue(a)   Assets
                                              ---------- ----------
<S>                                           <C>        <C>
Year ended December 31, 1996:
  United States.............................    $69,883    $23,777
  Canada....................................      1,144      1,075
  France....................................      3,329        --
  Japan.....................................      3,740        --
  Other foreign countries...................      4,379        --
                                              ---------- ----------
         Total                                  $82,475    $24,852
                                              ========== ==========
</TABLE>

(a) Revenue is attributed to countries based on the location of customers.

Major Customers

The Company received approximately 14 percent, 19 percent and 21 percent 
of its 1998, 1997, and 1996, respectively, revenue from Lockheed-Martin 
through several government and commercial programs.  Sales to Lockheed-
Martin are reported in the communication products and printing and 
material processing segments.  Almost all of the Company's revenue from 
this customer during 1998, 1997 and 1996 was derived from Federally-
funded programs. Most of the Company's Federally-funded programs are 
subject to renewal every one or two years and to termination for 
convenience by the government agency. The loss of the Company's contracts 
or failure to win new contracts with Lockheed-Martin, or other major 
customers, could have an adverse effect on the Company's results of 
operations.

15.  Employee Benefit Plan

In 1990, the Company established the SDL, Inc. Profit Sharing and Saving 
Plus Plan (the Plan) that covers substantially all U.S. full-time 
employees and is qualified under Sections 401(a) and 401(k) of the 
Internal Revenue Code. Participants may defer up to 20 percent of their 
pre-tax earnings (up to the Internal Revenue Service limit). The Company 
matches 50 percent of employee contributions up to a maximum of 5 percent 
of the participant's pre-tax earnings. The participants' as well as the 
Company's matching contributions are fully vested. Company contributions 
to the Plan were approximately $0.6 million, $0.5 million, and $0.4 
million for 1998, 1997, and 1996, respectively.

16. Subsequent Events (unaudited).

In February 1999, the Company acquired the fiber laser business of 
Polaroid for $5.2 million cash.  The business acquired includes all the 
physical assets, intellectual property, including the assignment of 38 
patents and the licensing of 22 patents in the fiber laser area, and the 
ongoing operation of the fiber manufacturing facilities and fiber laser 
subsystem.  The acquisition will be accounted for under the purchase 
method of accounting and the Company anticipates it will write-off in-
process research and development up to $1.5 million in the first quarter 
of 1999.  The results of the fiber laser business are not material to the 
Company's historical consolidated results of operations.


<PAGE>

                 Report of Independent Auditors


The Board of Directors and Stockholders, SDL, Inc.

We have audited the accompanying consolidated balance sheets of SDL, Inc., 
as of December 31, 1998 and 1997, and the related consolidated statements 
of operations, stockholders' equity and cash flows for each of the three 
years in the period ended December 31, 1998. These consolidated 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 consolidated financial statements referred to above 
present fairly, in all material respects, the consolidated financial 
position of SDL, Inc. at December 31, 1998 and 1997, and the consolidated 
results of its operations and its cash flows for each of the three years 
in the period ended December 31, 1998, in conformity with generally 
accepted accounting principles.


                                               /s/ Ernst & Young LLP


San Jose, California
January 29, 1999



<PAGE>


CORPORATE INFORMATION

Directors

Donald R. Scifres
Chairman of the Board
Chief Executive Officer
SDL, Inc.

Keith B. Geeslin (1)
Senior Vice President
The Sprout Group

Anthony B. Holbrook(1)
Vice Chairman (retired)
Advanced Micro Devices, Inc.

John P. Melton
Executive Vice President (retired)
SDL, Inc.

Mark B. Myers(2)
Senior Vice President
Xerox Corporation

Frederic N. Schwettmann(2)
President (retired)
Read-Rite Corporation

(1) Member of Audit Committee
(2) Member of Compensation Committee

SDL, Inc. Officers

Donald R. Scifres
Chief Executive Officer

Gregory P. Dougherty
Chief Operating Officer

David F. Welch
Vice President, Corporate Development and Chief Technology Officer

Michael L. Foster
Vice President, Finance, Chief Financial Officer and Secretary

Richard R. Craig
Vice President, Materials Processing and Printing

Robert J. Lang
Vice President, Research and Development

Dennis M. Samaritoni
Vice President, Manufacturing


SDL, Inc. General Information

Annual Meeting
The annual meeting of the stockholders of SDL, Inc. will be held on May 
13, 1999.  All stockholders are encouraged to attend.

Stockholder Report
Additional copies of this annual report and of the Company's Form 10-K as 
filed with the Securities and Exchange Commission can be obtained without 
charge by contacting the Investor Relations Department of SDL, Inc. at
Tel: (408) 943-4343
Fax: (408) 943-1258
http://www.sdli.com

Stockholder Communications
Communications concerning address changes, stock certificates, and 
stockholder accounts should be directed to: 
Chase Mellon
Shareholder Services
P.O. Box 3315
South Hackensack, NJ 07606
Tel: (800) 356-2017
Fax: (201) 329-8960
http://www.chasemellon.com

Market Price of Common Stock
The Company's common stock is traded on the Nasdaq National Market under 
the symbol SDLI.  The high and low sales prices are as reported by the 
Nasdaq National Market.



Price Range of Common Stock

<TABLE>
<CAPTION>
                                                        High       Low
                                                      --------- ---------
<S>                                                   <C>       <C>
 Q4 1998..........................................      $41.88     $9.75
 Q3 1998..........................................      $29.06    $12.50
 Q2 1998..........................................      $27.50    $19.63
 Q1 1998..........................................      $24.00    $15.13

 Q4 1997..........................................      $22.38    $13.50
 Q3 1997..........................................      $25.25    $16.00
 Q2 1997..........................................      $21.50     $8.00
 Q1 1997..........................................      $29.00    $14.00
</TABLE>


Corporate Headquarters
80 Rose Orchard Way
San Jose, CA 95134-1365
(408) 943-9411

Manufacturing
3530 Bassett Street
Santa Clara, CA 95054

SDL Optics, Inc.
6703 Rajpur Place
Saanichton, BC V8M 1Z5
(250) 544-2244

Registrar and Transfer Agent
Chase Mellon
Shareholder Services
San Francisco, California

Counsel
Morrison & Foerster LLP 
Palo Alto, California

Independent Accountants
Ernst & Young LLP
San Jose, California