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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934
 
    FOR THE FISCAL YEAR ENDED DECEMBER 27, 1997

                                      OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934
 
  FOR THE TRANSITION PERIOD FROM  TO
 
                        COMMISSION FILE NUMBER 0-19640
 
                               ----------------
 
                                     RETIX
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
                 CALIFORNIA                                      95-3948704
        (STATE OR OTHER JURISDICTION                          (I.R.S. EMPLOYER
      OF INCORPORATION OR ORGANIZATION)                     IDENTIFICATION NO.)
 
     21300 VICTORY BOULEVARD, SUITE 1200, WOODLAND HILLS, CALIFORNIA 91367
                   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
 
                                (818) 227-1400
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
 
                               ----------------
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
 
                                     NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
 
                                     NONE
 
                         COMMON STOCK, $.01 PAR VALUE
                               (TITLE OF CLASS)
 
                               ----------------
 
  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period as the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past ninety days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
 
  As of February 26, 1998 the aggregate market value of voting stock held by
non-affiliates was approximately $106,498,000. Shares of Common Stock held by
each officer, director and holder of 5% or more of the outstanding Common
Stock of the Registrant have been excluded in that such persons may be deemed
to be affiliates of the Registrant. This determination of affiliate status is
not necessarily a conclusive determination for other purposes.
 
  As of February 26, 1998 there were 24,146,518 shares of the Registrant's
Common Stock outstanding.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
(1) Part III incorporates information by reference from the definitive proxy
    statement for the Annual Meeting of Shareholders to be held on March 31,
    1998.
 
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                            INTRODUCTORY STATEMENT
 
  Except for the historical information presented, the matters discussed in
this Annual Report on Form 10-K are forward looking statements that involve
risks and uncertainties, including the risks of the timely deployment and
success of new and enhanced telecommunications management network (TMN)
products, the loss of key customer relationships, the impact of competitive
products and the dependence on key partners and alliances, the length of the
Company's sales cycle, the size and timing of license fees closed during the
fiscal year, the likely continued significant percentage of quarterly revenues
recorded in the last month of the quarter which makes forecasting difficult
and subject to a substantial risk of variance with actual results, a likely
decline in the Company's ownership position in its investment in Sonoma
Systems if additional funding is required and the Company is unable or
unwilling to participate, the acceptance of new technologies like TMN, the
impact of competitive products and pricing and the other risks detailed from
time to time in the Company's public disclosure filings with the U.S.
Securities and Exchange Commission (SEC). Copies of such filings are available
upon request from Retix's Investor Relations Department.
 
                                    PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
  Retix through its only operating subsidiary, Vertel Corporation ("Vertel"),
develops and markets software for the management and operations of
telecommunications networks. The Company provides advanced telecommunications
management software and solutions, including communications infrastructure
products, network management platforms and applications software for
telecommunication carrier networks worldwide. In addition, the Company
provides products and services to telecommunications equipment manufacturers,
computer systems OEMs and Internet access providers.
 
  In December 1997, the Company announced plans to discontinue further
investment in its broadband access equipment subsidiary, Sonoma Systems, Inc.
("Sonoma"). As a result of the successful completion of financing by outside
private investors in early 1998, the Company's voting ownership in this
subsidiary has been reduced to 19.9%. The remaining operating subsidiary,
Vertel comprises substantially all of the Company's operating activities. The
Company has announced plans to change its name from Retix to Vertel assuming
shareholder approval is obtained at the 1998 annual shareholders' meeting.
References made in this report to the "Company" or "Retix" generally include
the operations of all ongoing subsidiaries except where otherwise specifically
described.
 
  The Company is a leader in developing, marketing and supporting vertically
integrated, object oriented TMN based software solutions for the management of
public telecommunications networks. The Company's solutions, which are based
upon the International Telecommunications Union's TMN standard, support
seamless network operation and management over diverse transmission media and
protocols. The Company believes that it offers the only commercially
available, fully-interoperable suite of products and tools that span the
network element, element management, network management and service management
layers of the TMN model. The Company offers embedded software for network
equipment and software solutions to allow telecommunications service providers
to integrate proprietary or SNMP based network management systems with a TMN
standards based solution. In addition the Company offers object oriented
software platforms that facilitate the rapid development of network and
service management applications and features such as fault detection and
automatic response, remote improvement of network configuration, automation of
accounting and billing functions and optimization of network traffic and
security. The Company provides professional services that enable service
providers to deploy and maintain a complete TMN solution complementing
Vertel's software products and development platforms. The Company's
professional services include system analysis and design, source code
portation and interface, custom application development, conformance and
certification testing and technical support services.
 
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  The Company offers what it believes to be the only commercially available,
fully interoperable suite of products and tools that span the network element,
element management, network management and service management layers of the
TMN model. In addition, the Company's TMN solutions utilize object-oriented
interfaces, with object definitions that serve as reusable building blocks.
The object interfaces hide the complexity of underlying implementations while
providing all the functionality of the services and protocols of that
implementation. The Company's TMN solutions therefore reduce the complexity of
management system interoperability and provide systems that are more efficient
and simpler to build and deploy.
 
  The Company believes that its TMN solutions allow telecommunications service
providers and their customers to reduce network operations costs, manage
diverse networks and network equipment with a single, integrated management
system, derive incremental revenue by bringing new functionality and services
to market more rapidly, implement a complete network management solution and
preserve existing investments by integrating existing proprietary, TL1 and
SNMP-based systems.
 
  The Company's products enhance communications among service providers and
customers by enabling telecommunications service providers to develop and
deploy systems that manage new and existing services across multiple service
providers and enabling enterprise network operators to develop and deploy
systems to manage services from multiple service providers.
 
  The Company has committed itself to customer services including: 24 hours a
day, 7 days a week technical support worldwide, training in the Company's
office or at customer sites and customized software design and engineering
professional services.
 
  The Company believes that the broad adoption and deployment of TMN will be
key to its success and that the adoption of TMN will depend, in part, upon the
ability of service providers to implement TMN solutions quickly and cost-
effectively. The Company targets and will continue to target
telecommunications service providers and network equipment manufacturers for
adoption of its TMN solutions, and at the same time will commit substantial
resources to the promotion of the TMN standard for telecommunications network
management. The Company has, as its customers, virtually all U.S. Regional
Bell Operating Companies, as well as many other service providers, network
operators worldwide and network element (NE) vendors worldwide. Not all of
these customer names are mentioned in this document because, due to
contractual obligations and OEM agreements, some customers have requested that
the Company not use their names in documents published for distribution
outside of Vertel.
 
  The Company derives revenue from license fees and royalties from its
software products, professional services and technical support services,
including maintenance. The Company licenses binary or source code to
customers. Customers may distribute binary or embedded versions of the
Company's software in their products. Revenue from license fees generally is
recognized upon shipment of the binary or source code. Royalties from the
distribution of the binary or embedded versions of the software are recognized
upon notification by the licensee that products incorporating the Company's
software have been shipped by the licensee or, for products for which the
Company has sufficient historical information, upon estimated amounts which
the Company expects the customer to report. The Company sells its products in
the United States and internationally primarily through a direct sales
organization of highly technical sales people and, in certain territories, the
Company utilizes commissioned third party agents.
 
  During 1997, the Company also announced plans to develop, market and sell
certain products jointly with Hewlett Packard's OpenView Telecom division.
Jointly developed products are co-marketed and sold through both companies'
sales and distribution channels. In addition, the Company plans to continue to
license code to service providers, network equipment manufacturers and
independent software developers; licensing includes a right to distribute
products, services and applications based on such source code in exchange for
royalty payments. The Company believes that its distribution strategy will
help to establish its TMN solutions as the premier TMN products and to
accelerate the general adoption of TMN.
 
 
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<PAGE>
 
  The Company is a California corporation incorporated in 1985. The Company's
principal offices are located at 21300 Victory Boulevard, Suite 1200, Woodland
Hills, California 91367 and its telephone number at that location is (818)
227-1400.
 
INDUSTRY BACKGROUND
 
  The worldwide telecommunications industry continues to undergo significant
transformation. Global deregulation and international privatization have
resulted in intense intra-industry, cross-industry and geographic competition
in providing telecommunications services. Long distance and local
telecommunications service providers are beginning to compete in each other's
markets. Wireless service providers, cable television operators and utilities
are leveraging existing infrastructure to provide voice, video and data
transmission and switching networks. In addition, independent service
providers are leasing transmission facilities from long distance carriers;
local telephone companies and other emerging network providers to provide
competing voice, video and data services. At the same time, the complexity and
size of public networks have increased. The emergence of the Internet,
intranets, graphical user interfaces and telecommuting, as well as numerous
new telecommunications services such as high-speed data services, video
teleconferencing and video-on-demand have increased demand for bandwidth,
reliability, data integrity and security. In this dynamic environment, service
providers are being forced to interoperate with external public and private
networks and to differentiate themselves on the basis of price,
responsiveness, services offered, reliability and security.
 
  To meet increased demands and remain competitive in this dynamic
environment, traditional telecommunications service providers must upgrade
existing voice-based public networks. In addition, these providers, along with
new competitors, must deploy new networks to provide increased functionality
and more reliable and secure services. Upgrading and deploying new
telecommunications networks and services requires the integration of diverse
transmission media and protocols, network equipment, network operations
platforms and network management systems. Moreover, the competitive
environment requires more effective network management, such as detection of
and automatic response to fault indications, remote configuration of networks
and equipment, automation of accounting and billing functions, optimization of
network performance and improvement of security. Network management systems
must operate seamlessly among service providers and interface with customer
network management systems.
 
  Until recently, most telecommunications service providers managed their
voice networks exclusively with mainframe-based, proprietary systems written
in early generation programming languages. While these systems are tightly
integrated and can provide operating efficiencies within a single network,
they are expensive to develop, operate and maintain, often requiring a large,
specialized and expensive technical organization. In addition, because these
legacy systems are not based on a common standard, management among
telecommunications service providers and the provision of end-to-end services
are more difficult, and the equipment choices of service providers are limited
to vendors who conform to the provider's standard. Furthermore, because these
systems are proprietary and are based on earlier-generation programming
languages, they generally do not easily scale, usually require substantial
development effort to add new functionality and provide new services, and are
often incompatible with the additional software and hardware service providers
require to upgrade networks.
 
  Service providers have augmented their proprietary systems by incorporating
the Simple Network Management Protocol (SNMP) to manage their data networks.
SNMP has been widely accepted as a de facto network management standard in
private enterprise data networks. SNMP-based systems interoperate, permit the
addition of incremental functionality, hardware and software without
substantial additional development effort and are generally adequate to manage
equipment in enterprise data networks. A major drawback of SNMP-based systems,
however, is in bandwidth-constrained public networks, where their polling
architecture requires continuous communication among equipment and management
platforms; this communication can consume substantial bandwidth and limit
network scalability. In addition, SNMP provides for limited data integrity,
does not identify a security protocol and does not effectively manage the flow
of data on networks. While SNMP has
 
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permitted service providers to begin their transition away from proprietary
systems, it has also identified the need for a new family of systems that is
highly scalable, cost-effective and offers high bandwidth.
 
  In response to the shortcomings of available network management solutions,
the International Telecommunications Union (ITU), an organization of
telecommunications companies and governments, identified the need for a
standard that, permitted interoperability among network management solutions
independent of the telecommunications service providers operating systems,
management systems and network equipment. In addition, the ITU recognized the
need for the standard to provide a framework within which network management
systems could more cost-effectively be designed, developed and deployed and at
the same time provide functionality beyond that enabled by proprietary and
SNMP-based systems. The standard established by the ITU is known as the
telecommunication management network (TMN) standard. The specifications
comprising the TMN standard divide the telecommunications management
infrastructure into a framework of five logical layers: network elements
(equipment), element management, network management, service management and
business management. The TMN standard includes a set of interface
specifications for communicating within and among layers to enable
interoperability among service providers (and their customers), network
operating systems, network management systems and network equipment.
 
  TMN has been established as the international standard for public
telecommunications network management. If implemented correctly, TMN has the
potential to offer significant advantages over proprietary and SNMP-based
systems, including a reduction in network operations costs, the ability to
derive incremental revenue from new services and enhanced communications with
other service providers and with customers.
 
STRATEGY AND PRODUCTS
 
  The Company's products provide TMN capabilities through configurable
components and platforms. Vertel products incorporate easy-to-use, high
performance development environments, platforms, tools, applications and
components. The Company's products provide solutions at the network element,
element management, network management and service management layers of the
TMN model. Products include TMN-conformant management application development
environments, distributed platforms, RTOS-based embedded TMN software,
wireless applications, FCAPS TMN applications, OSI protocol components and
tools and aeronautical telecommunications network (ATN) routers.
 
  The Company's products fall into four families: TMN Telecore, TMN Access,
Wireless Applications and ATN Router Software products.
 
  The Company considers the engineering services, provided through its
technical support and the professional services unit, to be key to its success
of its customers. The technical support department provides pre-and post-sales
support, training and maintenance services, while PSU provides customized
software design and engineering, including designing, developing, deploying
and maintaining turnkey telecommunications management solutions.
 
  The Company's TMN solutions allow telecommunications service providers and
their customers to:
 
  Reduce costs. The Company's TMN solutions enable telecommunications services
providers to reduce costs by efficiently managing diverse networks and network
equipment with a single, integrated management system. Unlike many proprietary
systems, the Company's TMN solutions adhere to an object-oriented architecture
and do not require large, expensive technical organizations for additional
development and maintenance. Because the Company's TMN solutions use standard
interfaces, the solutions enable interoperability across applications,
networks, vendors and systems. This interoperability enables service providers
to purchase the most cost-effective equipment from a broad range of vendors.
In addition, by taking advantage of the Company's professional services unit,
customers can reduce the cost of in-house development.
 
  Derive incremental revenue. The Company's TMN solutions enable
telecommunications services providers to bring new functionality and services
to market more rapidly by providing an integrated, standards-
 
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based suite of tools that facilitate the rapid development and deployment of
new applications across heterogeneous networks. For example, the Company's
agent, manager and adapter products have been used by telecommunications
switch equipment manufacturers, operation support system (OSS) vendors and
telecommunications service providers to provide data collection information to
support billing, support trouble ticketing and enable electronic bonding.
 
  Implement complete solutions. Successful implementation of the TMN standard
requires seamless vertical integration of all the layers of the TMN standard.
The Company believes that it provides the only commercially available complete
family of products and services for implementing a fully integrated TMN
network management system. Network management systems based on Vertel's full
suite of products and services operate seamlessly with other TMN systems as
well as with proprietary legacy systems and can be adapted to SNMP systems.
The Company's products are fully integrated within and across the layers of
the TMN architecture.
 
  Preserve existing investments. The Company's TMN solutions enable
telecommunications services providers to continue to use and integrate their
existing TL1, ASCii message-based and SNMP-based network components in a total
TMN solution. The Company's Q-Adapter technology and solutions manage TL1,
SNMP and other legacy equipment and systems within Vertel's TMN solution
framework.
 
  Enhance communications across service providers and with customers. The
Company's TMN products enable the deployment of systems that allow
telecommunications service providers and network operators to manage new and
existing services and equipment across multiple service provider domains. The
products also enable enterprise network operators to deploy systems that
manage services of multiple service providers. Vertel TMN agent and manager
products have been deployed by key service providers who used the products in
electronically bonded OSSs that manage trouble tickets and work orders across
service providers.
 
Strategy
 
  The Company's goal is to be the leading provider of complete, vertically
integrated TMN solutions to telecommunications services providers, equipment
manufacturers, platform vendors and independent software developers. Key
elements of the Company's strategy include:
 
  EXTEND VERTICAL SOLUTIONS. The Company's strategy is to provide complete
suites of software and services that enable businesses to implement
telecommunications management solutions efficiently. The Company intends to
provide management applications that leverage the Company's experience in TMN
implementation across layers and use the unique features of the TMN
architecture. The Company currently plans to develop applications for inter-
service provider exchange of management information (electronic bonding),
integrated alarm management and ATM element management.
 
  LEVERAGE TECHNOLOGICAL LEADERSHIP. The Company believes that its
technological leadership, as evidenced by the breadth and functionality of its
products and services are, in part, the result of its 11 years of experience
deploying products that implement the protocols and services that adhere to
the ITU-specified open system interconnection (OSI) model and its associated
standards and specifications. The OSI model defines seven hierarchical layers
of communication between network management entities. Because the ITU M.3100
standard is based directly upon and incorporates the OSI specifications, the
Company leads the industry in experience and expertise in OSI and, hence, TMN
standards-based solutions. The Company plans to continue to invest significant
resources in research and development to extend its technological leadership
in TMN technologies, maintain a time-to-market advantage and develop
management solutions that leverage its TMN implementation expertise.
 
  TARGET SERVICE PROVIDERS. The Company believes that increased penetration of
telecommunications service providers is necessary to hasten the broad
deployment of TMN. To this end, the Company provides management platforms,
solutions for OSSs, customization and implementation services, software that
is easy to use and install and high quality training, consulting and support.
In addition, the Company offers Q-Adapter
 
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products that enable customers to maintain their investment in legacy systems,
bringing TL1, proprietary and enterprise network components into the realm of
TMN. The Company has, as its customers, virtually all U.S. Regional Bell
Operating Companies, as well as many other service providers, network operator
worldwide and network element vendors worldwide. Not all of these customer
names are mentioned in this document because, due to contractual obligations
and OEM agreements, some customers have requested that the Company not use
their names in documents published for distribution outside of the Company.
 
  LEVERAGE EXISTING RELATIONSHIPS WITH EQUIPMENT MANUFACTURERS. Historically,
the Company has derived a significant portion of its TMN revenue from the sale
of software to be embedded by telecommunications equipment manufacturers. The
Company believes that the availability of its products in telecommunications
equipment will facilitate the adoption of the Company's TMN solutions in the
marketplace by service providers.
 
  ESTABLISH LEADERSHIP IN NEW MARKETS. One of the first areas to adopt the TMN
standard was the SONET/SDH (fiber optic transmission) market, where new
networks were being deployed without the requirement to interoperate with
legacy systems. As data has become a greater portion of the traffic on
telecommunications networks and SNMP is proving inadequate for the performance
and traffic demands of public networks, the Company has also begun to target
leading data communications companies.
 
  EXPAND GLOBAL SALES AND DISTRIBUTION CAPABILITY. The Company currently sells
its products primarily through a direct sales force in the United States and
internationally. The Company intends to expand its sales and distribution
infrastructure in the United States and internationally to increase sales
coverage and position itself to capture market share. The Company plans to
leverage its direct sales efforts by pursuing sales prospects generated by
partners and by selling through select systems integrators and other indirect
sales channels. In addition, the Company plans to continue to license binary
and source code to service providers, network equipment manufacturers and
independent software developers. The Company's customers have the right to
distribute products, services and applications, developed using the Company's
binary and source code, in exchange for royalty payments. The Company believes
that its distribution strategy will help to establish its TMN solutions as the
premier TMN products; and accelerate the general adoption of TMN.
 
  PROMOTE THE DEPLOYMENT OF TMN. The Company believes that the broad adoption
and deployment of TMN will be key to its success. Correspondingly, it commits
substantial resources to the promotion of the TMN standard for
telecommunications network management. The Company is working with leading
industry experts, forums and working groups to define, refine and develop
specifications for TMN and OSI solutions. In addition, the Company sponsors
the Global TMN Summit and is a participant in trade shows, seminars and
industry conferences.
 
  DEVELOP STRATEGIC RELATIONSHIPS. The Company believes that it can expand its
visibility, improve its product offerings and broaden its potential market
through the development of relationships with other companies within the
telecommunications network market. To date, relationships with companies such
as Hewlett Packard and Microsoft have been established resulting in the
introduction of a number of new products and the increased visibility of TMN
within the telecommunications marketplace.
 
Products
 
  For the past two years, Vertel has focused primarily on developing,
marketing, selling and supporting TMN software products and services.
 
  The Company generally licenses its binary and source code to customers who
may either sublicense the code in binary form or integrated into additional
products. Revenue is derived from license fees received upon the shipment of
the source code and royalties relating to the distribution of the binary or
embedded versions of the software.
 
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  The Company's product families provide full TMN capabilities through
configurable components and platforms. Its products and platforms incorporate
high performance communications stacks, transport providers, routing software
and application services. The following sections briefly describe the
Company's principal product families and the market segments they serve.
 
VERTEL TMN TELECORE PRODUCTS
 
 Development Environment Products
 
  Vertel TMN Development Environment products provide tools, platforms and
components that automate the development of TMN-conformant management
applications. TMN Development Environment product interfaces are standards-
conformant and object-oriented. The products include:
 
  TMN Agent Development Environment (TMN ADE) and TMN Manager Development
Environment (TMN MDE) enable TMN-conformant agent and manager applications to
be quickly and easily developed. The TMN ADE and TMN MDE are foundations for
TMN-conformant OSS applications deployed in element management, network
management and service management layers of the TMN model.
 
  TMN Qx Development Environment (TMN QxDE) allows service providers, network
operators, systems integrators and others build TMN-based OSSs that can manage
Network Elements (NEs) with TL1 or other proprietary interfaces. Q-adaption
the process that translates between TMN and TL1 or proprietary protocols is
automated with the QxDE. The QxDE provides tools that quickly and easily build
"TMN-manageable" descriptions of the proprietary interfaces of NEs. The QxDE
includes run-time configurable "engines" that provide immediate, transparent
adaption between the NE protocol and TMN operations.
 
  TMN Agent and Manager Simulators may be used with the DE products above, or
with any TMN-conformant agent or manager. The Simulators use standard TCL
scripts to emulate the behavior of a TMN-conformant agent, manager, or both.
Simulators have graphical user interfaces, read in the latest network
information (are dynamically configurable) at run-time and provide script
generation tools that produce test cases for an information model.
 
  UNIX/NT Telecommunications Solutions (UTS) family includes standards
compliant OSI products that provide LAN and WAN communications, directory
services and file transfer for the TMN Telecore product family. These products
also integrate with other vendors' products that require OSI based networking.
The UTS LAN, WAN and TCP over OSI products provide wide area and local area
network communications. UTS FTAM (File, Transfer, Access and Management)
provides development kits to create file transfer client applications, server
applications and the server staff. UTS X.500 provides directory service client
and server. TARP is utilized in SONET networks for networked system address
resolution. UTS TARP can be used with TMN Telecore products licensed for
development of management systems in SONET networks.
 
  Vertel/HP OpenView Telecom TMN Product Suite combines the strengths of HP
OpenView Telecom platforms and the Company's TMN development environments.
Products include TMN Designer, for prototyping and designing TMN-conformant
information models. The Designer includes HP OpenView Modeling Tool, as well
as the Company's TMN Agent and Manager Simulators, TMN Agent and TMN Manager
products, for developing and deploying agent and manager applications. These
products include HP OpenView DM platform and Event Correlation Services (ECS),
as well as the Company's TMN development environment components and TMN Proxy,
for developing TL1-to-TMN adaption applications which combines the HP OpenView
DM Platform and ECS with the Company's QxDE components for automated, run-time
adaption.
 
VERTEL TMN ACCESS PRODUCTS
 
 Embedded Telecommunications Solutions (ETS)
 
  The Company's Embedded Telecommunication Solutions (ETS) products provide
TMN software for deployment in NEs and gateway network elements (GNEs). These
products are designed to be ported to an
 
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embedded system running a Real-Time Operating System (RTOS). ETS was designed
with NE hardware and software vendors in mind. The ETS product family is
standards based and is comprised of a variety of integrated, modular products
and components. The core product is the ETS-ADE. Based on the TMN ADE, the
ETS-ADE enables developers to quickly design, develop and deploy fully
functional TMN-conformant embedded agents. ETS products also include fully
implemented, standards-conformant information models specifically for targeted
technologies and network configurations. ETS products also provide
encapsulated portation functions, OSI software and transport interfaces.
 
VERTEL WIRELESS PRODUCTS
 
  The Company's wireless applications provide cellular service providers,
telecommunications systems integrators, mobile equipment vendors and other
suppliers of wireless data services with vertical solutions for wireless data
communications.
 
 Configuration Management Tool (CMT) Wireless Base Station Products
 
  Include configuration, operation and management tools for CDPD base
stations. The products are easily adaptable to support CDMA, GSM and TDMA base
stations. The flagship product is the Configuration Management Tool, which
enables wireless service providers and base station manufacturers to deploy
configuration, operational management and automatic radio frequency update
applications.
 
 IS-124 Products
 
  Include the IS-124 Development Environment and IS-124 Integration
Environment. IS-124 products implement the TIA IS-124 standard. These products
allow equipment and systems in a wireless network to format and communicate
call detail information used in billing. IS-124 components include the stacks,
interfaces and platform tools to lead project teams through IS-124/DMH
function development, testing and deployment.
 
 The Data Message Handler (DMH)
 
  A North American Standard, implemented by TIA/IS-124, defines a standard for
exchange call details (CDRS), including billing information between wireless
service providers. IS-124 is a standard that defines all services involving
non-signaling data communications that require intersystem cooperation. The
standard defines a data message handler (DMH) to manage the exchange of call
detail records.
 
VERTEL ATN ROUTER SOFTWARE PRODUCTS
 
  The Company's ATN Router Software products implement the Aeronautical
Telecommunications Network (ATN) specifications, the aeronautics industry's
version of TMN. ATN router products are specifically for routing end systems
and intermediate systems in air-to-ground and ground communication. The
products provide complete ATN-compliant design, implementation; test and
deployment based on the ATN specifications.
 
  Vertel high performance platforms and products are built upon standards
based technology that can be easily integrated into the customer's products
and/or network. The Vertel platforms and application development environments
include products that automate the deployment of agent and manager
applications. Vertel supplies fully implemented information models for OSI,
CDPD, ATM SONET/SDH and other technologies. Vertel platforms incorporate
object-oriented, fully integrated building blocks and development
environments. Vertel TMN Platforms and tools use the NMF TMN/C++ API as the
upper interface to the product. The TMN/C++ API hides the complexities of the
underlying agent or manager functionality behind easy-to-use C++ object
classes. Vertel's communications stacks employ the seven layer Open Systems
Interconnect (OSI) model and TCP/IP. Routing software packages and other
specialized stacks are also available. Vertel produced the industry's first
fully functional, portable and/or ported, OSI protocols for all seven OSI
stack layers.
 
 
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COMPETITION
 
  The Company offers Telecommunication Management Solutions for
telecommunications equipment manufacturers, service providers and network
management platform suppliers. The Company competes on the basis of product,
including quality, performance, ease of use, functionality, interoperability,
reliability, scalability and extensibility and speed of implementation; price;
implementation and development services; technical support; training and
maintenance.
 
  Competition in this market is intense and is characterized by rapidly
changing technologies, evolving industry standards, in-house or proprietary
solutions, frequent new product introductions and rapid changes in customer
requirements. Moreover, it is expected that this market will continue to
experience several new entrants in the foreseeable future. To maintain and
improve its competitive position, the Company must continue to develop and
introduce, in a timely and cost-effective manner, new services, products and
product features that keep pace with competitors' offerings, technological
developments and changing industry standards.
 
  The Company's current and prospective competitors offer a variety of
solutions to address the telecommunications network management systems and
management applications market. These competitors generally fall within four
categories:
 
  Customers' internal design and development organizations that produce
   telecommunications network management systems and management applications
   for their particular needs (e.g., Bellcore-based systems)
 
  Current TMN software providers including DSET and to a more limited extent
   ONE, NetMansys, ISR Global, Cabletron, Euristix, Object Stream and Bull
 
  Hardware and software vendors including IBM, Sun Microsystems and DEC
 
  Providers of specific market applications, including TCSI and OSI
 
  Many of the Company's current and potential customers continuously evaluate
whether to design, develop and support their own telecommunications network
management systems and applications or purchase them from outside vendors.
These customers have traditionally designed and developed their own software
solutions internally for their particular needs and may therefore be reluctant
to purchase products offered by independent vendors such as the Company. The
Company estimates that a significant percentage of telecommunications network
management solutions are still developed in-house. In addition, despite its
limitations for deployment in public or very large enterprise networks, SNMP
continues to serve as the de facto standard for managing enterprise data
networks.
 
  As a result, the Company must continuously educate existing and prospective
customers as to the advantages of TMN and of its products in particular versus
internally developed telecommunication network management systems and
management applications.
 
  The global acceptance of TMN could lead to increased competition as third
parties develop telecommunications network management systems and management
applications competitive with those offered by the Company. Any of these
competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements and to devote greater
resources to the development, promotion and sale of their products than the
Company. There can be no assurance that the Company's current or potential
competitors will not develop products comparable or superior to those
developed by the Company or adapt more quickly than the Company to new
technologies, evolving industry standards, new product introduction or
changing customer requirements.
 
PROPRIETARY TECHNOLOGY
 
  The Company primarily relies on a combination of copyright, trade secret and
trademark laws and nondisclosure and other contractual restrictions on copying
and distribution to protect its proprietary technology.
 
                                      10
<PAGE>
 
In addition, as part of its confidentiality procedures, the Company generally
enters into nondisclosure agreements with its employees, consultants,
distributors and corporate partners and limits access to and distribution of
its software, documentation and other proprietary information. It may be
possible for a third party to copy or otherwise obtain and use the Company's
products or technology without authorization, or to develop similar
technology, particularly in light of the fact that the Company licenses
portions of its source code to certain customers and distributors, there can
be no assurance that the foregoing measures used by the Company are adequate
to protect its proprietary technology. In addition, the Company's products are
licensed in other countries and the laws of such countries may treat the
protection of proprietary rights differently from, and may not protect the
Company's proprietary rights to the same extent as the law in the United
States. See "Risk Factors Dependence upon Proprietary Technology."
 
SALES, MARKETING AND CUSTOMERS
 
  The Company markets and sells its products and services through an internal
sales and marketing organization that consisted of 36 people as of December
27, 1997. The Company's marketing efforts are focused on increasing awareness
of Vertel and its TMN solutions, and TMN in general, among telecommunications
service providers, network equipment manufacturers, independent software
developers and platform vendors, and on positioning the Company as the leading
provider of TMN software solutions. The Company's marketing programs have
three primary goals: market education and awareness, sales effectiveness and
product management. The Company's education and awareness activities include
seminars, speaking engagements, sponsorship of conferences, including the
Global TMN Summit, articles in industry publications, participation in
industry forums and working groups, and inclusion in market studies by leading
industry analysts. In addition, to disseminate its marketing message and
improve sales effectiveness, Vertel uses direct mail, advertising,
presentations, demos, press releases, press/analyst tours, marketing
literature, public relations, trade shows and a world-wide web site. Vertel's
product management staff works with customers and industry experts to ensure
that the Company's products will satisfy market requirements.
 
  The sales cycle for the Company's products is lengthy and often requires the
Company to provide a significant level of education to prospective customers
regarding the use and benefits of the Company's products. As a result, the
Company sells its products primarily through a direct sales organization of
highly technical sales people. See "Risk Factors--Lengthy Sales and
Implementation Cycle." Of the 36 people engaged in sales and marketing, the
Company's direct sales organization consisted of 18 people as of December 31,
1997.
 
  In addition, the Company sells software through distributors and agents in
certain other countries, and enables its customers through source code
licenses to distribute the Company's products in exchange for royalty
payments.
 
 
  The Company currently transacts business in U.S. currency worldwide.
International sales totaled approximately 40.3%, 52.6% and 46.6% of net
revenues for each of the fiscal years 1997, 1996 and 1995. See "Risk Factors--
International Sales and Operations" and "Currency Fluctuations."
 
  Historically, the Company has not had significant backlog because it fills
substantially all orders within 30 days after receipt of a firm purchase
order.
 
CUSTOMER SERVICE AND SUPPORT
 
 Professional Services
 
  The Company believes that the adoption of TMN will depend, in part, upon the
ability of service providers, network operators, network hardware and software
vendors, and systems integrators to implement TMN solutions quickly and cost-
effectively. The Company's professional services organization works with
systems integrators, application developers and in-house customer engineers to
enable customers to deploy a complete TMN solution. Professional services
include system analysis and design, source code portation, conformance testing
and
 
                                      11
<PAGE>
 
certification and custom application development. Many of the Company's
customers contract for professional services. The Company generally provides
professional services based on a detailed statement of work. Fees generally
depend upon the size, timing and complexity of the implementation and are
typically billed upon attainment of certain milestones or on a time and
materials basis. Professional services are typically delivered in the second
and third quarter following delivery of the source code.
 
  The Company has devoted substantial resources to the provision of
professional services in order to facilitate the implementation of its TMN
products by service providers and to differentiate itself from competitors. As
of December 27, 1997, the Company's professional services organization
consisted of 20 people, including consultants and employees.
 
 Technical Support
 
  In order to assist customers in fully designing and operating integrated TMN
solutions, the Company believes it is important to offer a broad range of
technical support services for its customers. The Company charges customers
separately for training, product support and maintenance and on-site
consulting. Product support and maintenance revenues have historically
constituted a substantial majority of overall technical support revenues and
are typically realized beginning in the third quarter following delivery of
the source code. Annual product support and maintenance fees typically range
from 10% to 20% of the initial license fee. Technical support consists of the
following services:
 
  TRAINING. The Company provides training to its customers on a per-product
basis. Training services range from detailed technical tutorials on technology
products to product configuration, management and administration training on
end user products.
 
  PRODUCT SUPPORT. The Company can provide global coverage 24 hours per day,
seven days per week with direct access to technicians and product support
engineers on demand. In response to great demand for expert-level, on site-
support, product support also offers an on-demand service staffed by highly
competent product experts. The Company's product support is provided by
personnel primarily located in the Company's California and Ireland
facilities.
 
  MAINTENANCE. Customers subscribing for product support also receive software
updates and maintenance releases. The Company typically issues software
updates every six to twelve months.
 
  ONSITE CONSULTING. The Company's engineers travel to customer sites for an
initially specified period and provide expert level consultation including
additional system design, training, customization and development support.
 
  As of December 27, 1997, the Company's technical support organization
consisted of 9 people.
 
  The Company typically warrants software for 90 days. To date, the Company
has not encountered any significant product maintenance problems. See "Risk
Factors--New Products and Technological Changes; Dependence upon New Products;
Regulation."
 
RESEARCH AND PRODUCT DEVELOPMENT
 
  The Company has made substantial investments in the development of its
products. The Company believes that its future success depends in a large part
on its ability to enhance existing products and to develop new products in
order to maintain technological competitiveness and meet a wide range of
customer needs. Accordingly, the Company intends to continue to make
substantial investments in research and development for the foreseeable
future. Overall product development efforts include:
 
  Vertel/HP OpenView Telecom TMN Product Suite. The Vertel/HP OpenView Telecom
product suite will continue to build upon the combined strengths of HP
OpenView Telecom platforms and the Company's TMN development products.
Products include TMN Designer, TMN Agent and TMN Manager Developer and runtime
products and TMN Proxy.
 
                                      12
<PAGE>
 
  TMN Managers and Agents. Vertel deployed the industry's first TMN agent
toolkit in the early 1990's and the industry's first TMN agent and manager
products based upon the NMF TMN/C++ API (NMF API)--an emerging standard for a
three-tiered, object-oriented interface. The TMN Agent Development Environment
(ADE) and TMN Manager Development Environment (MDE) are two industry-leading
products in the market today. The MDE is highly regarded as the most easy-to-
use C++ implementation of TMN available.
 
  Vertical Integration and Optimization. The Company uniquely provides a
single-vendor, object-oriented, integrated implementation of OSI stacks, TMN
agent and manager products, Q-adaption and MIB translation. The Company's
product software modules can be tightly integrated and optimized for
performance and efficient memory usage.
 
  Portability. The Company's products can be ported in network elements, on
UNIX and NT platforms, in popular run-time operating systems, in a wide range
of client-server, fault-tolerant architectures and environments. These
products provide: encapsulations of the underlying communication network
portation details and flexible OSI and transport stack interfaces and
communication networks. Portability allows the Company to implement changes
and enhancements to the core technology once and to host those changes to many
environments simultaneously. Currently, the Company supports five Real-Time
Embedded Operating Systems (RTOSs), Solaris, HP-UX and Windows NT.
 
  Standards Conformance. The Company's implementations have successfully
undergone many conformance tests in a variety of contexts and environments.
Conformance testing guarantees that the standards have been implemented
properly and enables interoperability to occur.
 
  The Company's research and development organization is located principally
in Woodland Hills, California. As of December 27, 1997, the Company's research
and development group consisted of 51 people.
 
  In fiscal years 1997, 1996 and 1995, the Company's research and development
expenditures net of customer reimbursements were approximately $5,600,000,
$5,461,000 and $5,156,000, respectively.
 
                                      13
<PAGE>
 
                                 RISK FACTORS
 
  The following risk factors should be considered carefully in addition to the
other information contained in this document in evaluating the Company and its
prospects:
 
  Adoption of Standards. The Company's success is based in large part on the
adoption of the TMN standard by major telecommunications service providers in
the United States and abroad. There can be no assurance regarding the timing
of such acceptance, that telecommunications service providers will adopt
standards different from those currently employed, or that if they choose to
do so, TMN will be the standard adopted. In light of the industry's historical
dependence on proprietary systems and the emergence of competing standards
such as SNMP2 and CMIP, the Company's focus on TMN-based systems represents a
risk for the Company. While the Company invests substantial efforts in
encouraging the adoption of the TMN standard, the Company does not have direct
control over such adoption. Delays in the adoption of the TMN standard or the
adoption by the telecommunications service providers of a standard other than
TMN would have the effect of materially adversely affecting the Company's
financial condition and results of operations.
 
  New Products and Technological Changes; Dependence upon New Products;
Regulation. The markets for the Company's products are characterized by
rapidly changing technology and frequent new product introductions.
Accordingly, the Company believes that its future success will depend on its
ability to enhance its existing products and to develop and introduce in a
timely fashion new products that achieve market acceptance. There can be no
assurance that the Company will be able to identify, develop, manufacture,
market or support such products successfully or that the Company will be able
to respond effectively to technological changes, industry standards revisions
or product announcements by competitors. Delays in new product introductions
or product enhancements, or the introduction of unsuccessful products, could
adversely affect the Company. The Company's revenues are dependent on, among
other things, the acceptance of these products by customers, and no assurance
concerning their acceptance can be given. From time to time, the Company may
announce new products, capabilities or technologies that have the potential to
replace the Company's existing product offerings. There can be no assurance
that announcements of new product offerings will not cause customers to defer
purchasing or licensing existing Company products, adversely affecting the
Company. See "Strategy and Products" and "Research and Product Development."
 
  The Company has, from time to time, experienced delays in the development of
new products and the enhancement of existing products. There can be no
assurance that the Company will be successful in developing and marketing, on
a timely basis or at all, competitive products, product enhancements and new
products that respond to technological change, changes in customer
requirements and emerging industry standards, or that the Company's enhanced
or new products will adequately address the changing needs of the marketplace.
The inability of the Company, due to resource constraints or technological or
other reasons, to develop and introduce new products or product enhancements
in a timely manner could have a material adverse effect on the Company's
business, financial condition or results of operations.
 
  The Company expects that new products and related services will account for
a substantial portion of its revenues in the foreseeable future. As a result,
factors adversely affecting the pricing of or demand for TMN software or
wireless applications products, such as competition for new products, lack of
customer acceptance of the Company's products, or failure of the Company to
develop and introduce new and enhanced versions of its products on a timely
basis, could have a material adverse effect on its business, operating results
and financial condition. There can be no assurance of an increase in revenues
and net income attributable to the Company's TMN-based products. See "Selected
Consolidated Financial Data."
 
  The telecommunications industry is subject to regulation in the United
States and other countries, and the Company's customers could be required to
receive regulatory approvals in conducting their businesses. The enactment by
federal, state or foreign governments of new laws or regulations or change in
the interpretation of existing regulations could adversely affect the
Company's customers, and thereby affect the Company's business, operating
results and financial conditions.
 
                                      14
<PAGE>
 
  Participation in Emerging Markets. As part of its corporate strategy, the
Company has targeted emerging markets in the early stage of their development,
including the TMN and wireless applications markets. There can be no assurance
that these markets will attain broad acceptance or generate long-term growth
opportunities in line with the Company's objectives. The Company believes that
the TMN and wireless applications markets will take years to develop and that
development of the markets will require the availability of a sufficient
number of high quality, commercially successful communications applications.
Widespread adoption of the TMN standard also will depend on the availability
of communications stacks, information models and applications suites that
allow telecommunications equipment manufacturers and service providers to
implement TMN in their products. The Company cannot predict the size of the
market or the rate at which the market will grow. If the markets fail to grow,
grow more slowly than anticipated, or become saturated with competitors, the
Company's business, financial condition and results of operations would be
materially adversely affected. See "Competition," "Strategy and Products," and
"Research and Product Development."
 
  Substantial Fluctuations in Quarterly Operating Results; Timing of Orders;
Future Operating Results Uncertain. A significant portion of the Company's
software revenues have been, and will continue to be, derived from substantial
orders placed by large organizations after extended evaluation. The timing of
such orders and their fulfillment has caused and will continue to cause
material fluctuations in the Company's operating results, particularly on a
quarterly basis. In addition, the Company's quarterly operating results have
in the past and will in the future vary significantly depending upon factors
such as the timing of significant orders and shipments, the lengthy sales
cycle of the Company's products, capital spending patterns of the Company's
customers, changes in pricing policies by the Company or its competitors,
increased competition, the cancellation of service or maintenance agreements,
changes in operating expenses, personnel changes, demand for the Company's
products, the number, timing and significance of new product and product
enhancement announcements by the Company and its competitors, the ability of
the Company to develop, introduce and market new and enhanced versions of the
Company's products on a timely basis, the mix between U.S. and international
sales, the mix of direct and indirect sales and general economic factors,
among others. Due to the foregoing factors, quarterly revenues and operating
results have been and will continue to be difficult to forecast.
 
  The Company typically realizes a significant portion of its TMN-based and
wireless data software license revenues in the last month of a quarter, and
frequently in the last weeks or even days of a quarter. The Company's expense
levels are based, in part, on its expectations of future revenue levels. If
revenue levels are below expectations, operating results are likely to be
materially adversely affected. In particular, because only a small portion of
the Company's expenses varies with revenue in the short term, net income may
be disproportionately affected by a reduction in revenue. The Company's
business has experienced and is expected to continue to experience seasonality
in customer purchasing patterns. In addition, the Company currently intends to
increase its funding of research and product development, increase its sales
and market development activities and expand distribution channels. To the
extent such expenses are not subsequently followed by increased revenues, the
Company's business, operating results and financial condition could be
materially and adversely affected.
 
  Based upon all of the foregoing, the Company believes that quarterly
revenues and operating results are likely to vary significantly in the future
and that period-to-period comparisons of its results of operations are not
necessarily meaningful and should not be relied upon as indications of future
performance. There can be no assurance that the Company's revenue will
increase or be sustained in future periods or that the Company will be
profitable in any future period. Further, it is likely that in some future
quarter the Company's revenue or operating results will be below the
expectations of public market analysts and investors. In such event, the price
of the Company's Common Stock is likely to be materially adversely affected.
See "Selected Consolidated Financial Data" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
 
  Lengthy Sales Cycles; Importance of Implementation. The Company's products
are complex and generally involve significant investment decisions after
extended evaluations by prospective customers. Accordingly, the Company must
engage in a lengthy sales cycle to provide a significant level of education
regarding the use and
 
                                      15
<PAGE>
 
benefits of the Company's products. Executive level approval is often required
to license the Company's products and the agreements pursuant to which the
Company licenses its products often involve lengthy negotiation. In addition,
the implementation of the Company's software products involves a significant
commitment by customers over an extended period of time. As a result, the
Company's sales cycle is subject to a number of significant delays over which
the Company has little control.
 
  The Company believes that rapid implementation is critical to success in the
TMN market. Significant delays in implementation, whether or not such delays
are within the Company's control, could materially adversely affect its
business, operating results and financial condition. The Company from time to
time enters into fixed price arrangements for its professional services. Fixed
price arrangements could in the future result in losses primarily due to
delays in the implementation process or other complexities associated with
completion of the project. Such losses could have a material adverse effect on
the Company's business, operating results and financial condition. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Sales, Marketing and Customers."
 
  Sales and Marketing Risks. During 1998, the Company plans to increase the
number of direct sales and marketing personnel to support the further
development of TMN market opportunities. As the Company hires new sales and
marketing personnel it is anticipated that there will be a significant delay
before such personnel become effective. There can be no assurance that the
Company will be successful in attracting or retaining qualified sales and
marketing personnel, that this expansion will result in sales of its products,
that the costs of such expansion will not exceed the revenues generated, or
that the Company's sales and marketing organization will successfully compete
against the larger and better funded sales and marketing organizations of the
Company's competitors.
 
  Competition. Competition in the markets in which the Company competes is
characterized by rapidly changing technologies, evolving industry standards,
in-house or proprietary solutions, frequent new product introductions, and
rapid changes in customer requirements. To maintain and improve its
competitive position, the Company must continue to develop and introduce, in a
timely and cost-effective manner, new services, products and product features
that keep pace with competitors' offerings, technological developments and
changing industry standards. The principal competitive factors in the
Company's market are quality, performance, product features such as
scalability, interoperability, functionality, customizability and ease of use,
customer support, services, price and maintenance.
 
  The Company experiences significant competition in telecommunications
network management from TCSI, OSI, IBM, Sun Microsystems, DSET and major
telecommunication vendors such as AT&T. There can be no assurance that the
Company will be able to identify, develop, manufacture, market or support
products successfully or that the Company will be able to respond effectively
to technological changes or product announcements by its competitors. The
complexities of the Company's existing products could result in delays to
product releases or product enhancements. Delays in new product introductions
or product enhancements or the introduction of unsuccessful products could
adversely affect the Company.
 
  Many of the Company's current and potential competitors have longer
operating histories and have greater financial, technical, sales, marketing
and other resources than the Company. Moreover, the Company's current and
potential competitors may respond more quickly than the Company to new or
emerging technologies or changes in customer requirements. In addition, as the
market develops, a number of companies with significantly greater resources
than the Company could attempt to increase their presence in the market by
acquiring or forming strategic alliances with competitors of the Company
resulting in increased competition to the Company. There can be no assurance
that the Company will be able to compete successfully with such competitors.
See "Strategy and Products."
 
  Risks Associated with Complex Software-Based Products. The development,
enhancement and implementation of the Company's products entail risks of
product defects or failures. The Company has in the past discovered software
bugs in certain of its products and software solutions. Although to date the
Company
 
                                      16
<PAGE>
 
has not experienced material adverse effects resulting from any such bugs,
there can be no assurance that errors will not be found in existing or new
products or releases after commencement of commercial licensing, which may
result in delay or loss of revenue, loss of market share, failure to achieve
market acceptance, or may otherwise adversely impact the Company's business,
operating results and financial condition. Moreover, the complexities involved
in implementing and customizing the Company's software solutions entail
additional risks of performance failures. There can be no assurance that the
Company will not encounter substantial delays or other difficulties due to
such complexities. Any such occurrence could have a material adverse effect
upon the Company's business, operating results and financial condition.
 
  Fluctuations in Market Price of Common Stock. Announcement of new products
by the Company or its competitors and quarterly variations in financial
results could cause the market price of the Company's Common Stock to
fluctuate substantially. In addition, the stock market has experienced price
and volume fluctuations from time to time that have affected the market prices
of many technology-based companies and that are not necessarily related to the
operating performance of such companies. These broad market fluctuations may
adversely affect the price of the Company's Common Stock.
 
  International Sales and Operations. Sales to third party customers outside
of the United States accounted for approximately half of the Company's net
revenues for 1997, 1996 and 1995. The Company expects that international sales
will continue to be a significant portion of its business. Operating costs in
many countries, including some of those in which the Company operates, are
often higher than in the United States. International sales and operations may
also be subject to risks such as the imposition of governmental controls,
export license requirements, restrictions on the export of critical
technology, currency exchange fluctuations, political instability, trade
restrictions, changes in tariffs and difficulties in staffing and managing
international operations. In addition, sales in Europe are adversely affected
in the third quarter of each year as many customers and end-users reduce their
business activities during the summer months. These seasonal factors and
currency fluctuation risks may have an effect on the Company's quarterly
results of operations. Further, because the Company has operations in
different countries, the Company's management must address differences in
regulatory environments and cultures. Failure to address these differences
successfully could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, the Company must
obtain governmental and public telephone company approvals for certain of its
products in most countries. See "Management's Discussion and Analysis of
Financial Condition--Results of Operations" and "Sales, Marketing and
Customers."
 
  Dependence on Suppliers and Licenses. The Company licenses certain
technology included in its products; if the Company becomes unable to utilize
such technology, the Company could be adversely affected.
 
  Dependence on Key Personnel. The Company's success depends to a significant
degree upon the continued contributions of its key management, sales,
marketing, research and development and manufacturing personnel, many of whom
would be difficult to replace. If certain of these employees were to leave,
the Company could be adversely affected. The Company believes its future
success will also depend in large part upon its ability to attract and retain
highly skilled software engineers, and managerial, sales and marketing
personnel. Competition for such personnel is intense and there can be no
assurance that the Company will be successful in attracting and retaining the
necessary personnel. In addition, the Company is undertaking reorganization
and refocusing of its business. To the extent the Company is not successful in
attracting or retaining key personnel, the Company could also be adversely
affected. See "Strategy and Products", "Employees" and "Executive Officers and
Key Personnel of the Company."
 
  Currency Fluctuations. While the Company's consolidated financial statements
are prepared in United States dollars, a portion of the Company's worldwide
operations have a functional currency other than the United States dollar. In
particular, the Company maintains a professional service operation in Ireland
where the functional currency is the Irish Pound. A small portion of the
Company's revenues are also denominated in currencies other than the United
States dollar. In addition, international sales denominated in U.S. Dollars
may nonetheless be adversely affected by exchange rate fluctuations if the
relative cost of the Company's products
 
                                      17
<PAGE>
 
becomes substantially more expensive. Fluctuations in exchange rates may have
a material adverse effect on the Company's results of operations and could
also result in exchange losses. The impact of future exchange rate
fluctuations cannot be predicted adequately. To date, the Company has not
sought to hedge the risks associated with fluctuations in exchange rates, but
may undertake such transactions in the future. The Company does not have a
policy relating to hedging. There can be no assurance that any hedging
techniques implemented by the Company would be successful or that the
Company's results of operations will not be materially adversely affected by
exchange rate fluctuations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Results of Operations."
 
  Risks Associated with Intellectual Property. The Company regards its
products as proprietary and relies primarily on a combination of statutory and
common law copyright, trademark and trade secret laws, customer licensing
agreements, employee and third-party nondisclosure agreements and other
methods to protect its proprietary rights. The Company generally enters into
confidentiality and invention assignment agreements with its employees and
consultants. Additionally, the Company enters into confidentiality agreements
with certain of its customers and potential customers and limits access to,
and distribution of, its proprietary information. Despite these precautions,
it may be possible for a third party to copy or otherwise obtain and use the
Company's technologies without authorization, or to develop similar
technologies independently. Furthermore, the laws of certain countries in
which the Company does business do not protect the Company's software and
intellectual property rights to the same extent as do the laws of the United
States. The Company does not include in its software any mechanisms to prevent
or inhibit unauthorized use, but generally either requires the execution of an
agreement that restricts copying and use of the Company's products or provides
for the same in a break-the-seal license agreement. If unauthorized copying or
misuse of the Company's products were to occur to any substantial degree, the
Company's business, financial condition and results of operations could be
materially adversely affected. There can be no assurance that the Company's
means of protecting its proprietary rights will be adequate or that the
Company's competitors will not independently develop similar technology.
 
  While the Company has not received claims alleging infringement of the
proprietary rights of third parties which the Company believes would have a
material adverse effect on the Company's business, financial condition or
results of operations, nor is it aware of any similar threatened claims, there
can be no assurance that third parities will not claim that the Company's
current or future products infringe the proprietary rights of others. Any such
claim, with or without merit, could result in costly litigation or might
require the Company to enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may not be available on terms
acceptable to the Company, or at all. See "Proprietary Technology."
 
  Risks Associated With Year 2000. New releases of the Company's software have
been designed to address processing for the year 2000 to the extent it has
been required. It is the Company's intent to have all of its actively
supported software on releases which are ready for the year 2000 by the end of
1998. However, to the extent that others such as system integrators make use
of the Company's software in developing solutions for third parties, the
Company may have no knowledge as to the year 2000 readiness of those third
party products. In addition, it is possible third parties could assert claims
against the Company or its customers concerning year 2000 issues and,
regardless of their merits or lack thereof, these claims could be material.
 
  As with other organizations, the Company's internal computer systems and
programs were originally designed to recognize calendar years by their last
two digits. Calculations performed using these truncated fields would not work
properly with dates from the year 2000 and beyond. The Company has initiated
efforts to remedy this situation and expects all systems to be replaced and
tested prior to the year 2000. The incremental costs of this project have not
yet been quantified by the Company and could be material.
 
EMPLOYEES
 
  As of December 27, 1997 the Company employed 111 persons, of whom 63 were
primarily engaged in research and development activities or professional
services, 36 in sales, marketing, customer support and related activities and
12 in general management, administration and finance. The Company has no
collective bargaining
 
                                      18
<PAGE>
 
agreements with its employees. The Company believes that it maintains
competitive compensation, benefit, equity participation and workplace policies
that assist in attracting and retaining qualified employees. The Company
believes that its future success will depend, in part, on its ability to
attract and retain qualified personnel. The Company has experienced no work
stoppages and believes that its employee relations are good.
 
EXECUTIVE OFFICERS OF THE COMPANY
 
  The executive officers of the Company and their ages as of December 28, 1997
are as follows:
 
<TABLE>
<CAPTION>
      NAME                  AGE                                POSITION
      ----                  ---                                --------
   <S>                      <C> <C>
   Bruce Brown.............  47 President and Chief Executive Officer
   James Brill.............  46 Vice President, Finance and Administration and Chief Financial Officer
 
  The key divisional employees and their ages as of December 28, 1997 are as
follows:
 
   Lawrence Asten..........  51 Senior Vice President, Worldwide Sales, Vertel
   Michael Stark...........  39 Vice President, Research and Development, Vertel
   Cyrus Irani.............  39 Vice President, Marketing, Vertel
   Fred Rampey.............  43 Vice President, Professional Services, Vertel
</TABLE>
 
  Mr. Brown was elected to the position of President and Chief Executive
Officer of the Company in fiscal January 1998. Mr. Brown also serves as
President and Chief Executive Officer of Vertel, a position to which he was
elected in November 1995. Mr. Brown joined Vertel in August 1995 and has
served as a director of Vertel since October 1995. From October 1995 to
December 1996, Mr. Brown also served as Chief Financial Officer of Vertel.
Prior to joining Vertel, Mr. Brown served as President of ADC Fibermux
Corporation ("Fibermux"), a supplier of fiber optic networking products from
July 1993 until August 1995. Prior to his role at Fibermux, Mr. Brown was
Executive Vice President, Customer Operations at Ungermann-Bass Networks, Inc.
from October 1990 until July 1993. Mr. Brown holds a B.S. degree from Iowa
State University and an M.P.A. from Drake University.
 
  Mr. Brill has served as Vice President, Finance and Administration and Chief
Financial Officer of the Company since the beginning of fiscal 1998. He joined
the Company as Vice President, Finance and Administration and Chief Financial
Officer of the Company's Vertel subsidiary in December 1996. Prior to joining
the Company, Mr. Brill served for over eight years at Merisel, Inc., a
computer software and hardware distributor, from May 1988 to October 1996,
where his most recent role was Chief Financial Officer and a member of the
Board of Directors. Mr. Brill holds a B.S. degree from the U.S. Naval Academy
and an M.B.A. from the UCLA Anderson Graduate School of Management.
 
  Mr. Asten has served as Senior Vice President, Worldwide Sales, for the
Company's Vertel subsidiary since joining Vertel in November 1995. Prior to
joining the Company, Mr. Asten served as Vice President, Sales, Marketing and
Customer Service for ADC Telecommunications, Inc., a telecommunications
equipment manufacturer, from January 1992 to October 1995. Previously, he
served as Vice President, Worldwide Sales, for Telco Systems, Inc., a
telecommunications equipment manufacturer, from July 1987 to January 1992.
 
  Mr. Stark has been with the Company's Vertel subsidiary since February 1996
where he has served as Vice President, Research and Development. Prior to
joining the Company, Mr. Stark served as Vice President, Product Development,
for BellSouth/Dataserv, a provider of data communications, from April 1992 to
January 1996. Previously, he served in various management positions at
NCR/Teradata Corporation, a database company, and Nucleus International
Corporation, a database company.
 
  Mr. Irani joined the Company's Vertel subsidiary in February 1996 and
currently serves as Vice President, Marketing. Prior to joining the Company,
Mr. Irani served as Vice President of Marketing and Sales for The Alchemy
Group, a network management software company, from August 1994 to February
1996. Previously, he was Product Line Manager for AT&T Global Information
Systems, a telecommunications service provider, from March 1993 to August
1994. From December 1989 to March 1993, he served as Director of Product
Marketing for the Company.
 
                                      19
<PAGE>
 
  Mr. Rampey has served as Vice President, Professional Services, for the
Company's Vertel subsidiary since December 1997. Prior to joining the Company,
Mr. Rampey served in various management roles, including most recently
Operations Manager, for Hewlett Packard's OpenView Telecom Division from
September 1996 to December 1997.
 
ITEM 2. PROPERTIES
 
  The Company's principal administrative, sales and marketing, research and
development and support facilities are located in Southern California. The
Company's headquarters and primary operations are located in Woodland Hills,
California, and consist of approximately 30,000 square feet under a lease that
will expire in January 2002. Annual gross rent for this facility lease
approximates $650,000. The Company's field sales and service offices
worldwide, other than its headquarters, consist of leased office space
totaling approximately 13,500 square feet with current aggregate gross rents
of approximately $82,000. In addition, the Company has various facilities
under lease, which have been subleased to tenants for which rental income
approximately offsets rental obligations. The Company believes that its
existing facilities are adequate for presently foreseeable needs.
 
ITEM 3. LEGAL PROCEEDINGS
 
  Neither the Company nor any of its subsidiaries is a party to, nor is their
property the subject of, any material pending legal proceeding. The Company
may, from time to time, become a party to various legal proceedings arising in
the normal course of its business.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  Not applicable.
 
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON AND RELATED SHAREHOLDER MATTERS
 
MARKET INFORMATION
 
  The Company's Common Stock is traded on the Nasdaq National Market
(NASDAQ:RETX). The low and high sales prices for each quarterly period in the
two fiscal years ended December 27, 1997 are as follows:
 
<TABLE>
<CAPTION>
                                                  1996 FISCAL QUARTERS ENDED
                                               ---------------------------------
                                               MARCH 30 JUNE 29 SEPT. 28 DEC. 28
                                               -------- ------- -------- -------
     <S>                                       <C>      <C>     <C>      <C>
     Low bid..................................  $1 7/8  $5       $3 3/8  $5 1/4
     High bid.................................  $5 3/8  $10 7/8  $8 5/8  $9 1/4
</TABLE>
 
<TABLE>
<CAPTION>
                                                  1997 FISCAL QUARTERS ENDED
                                               ---------------------------------
                                               MARCH 29 JUNE 28 SEPT. 27 DEC. 27
                                               -------- ------- -------- -------
     <S>                                       <C>      <C>     <C>      <C>
     Low bid.................................. $4       $3 5/8    $4     $4 1/32
     High bid................................. $7 3/16  $5 7/8    $7     $7 3/8
</TABLE>
 
  There were approximately 400 holders of record on February 26, 1998.
 
DIVIDEND POLICY
 
  The Company has never paid cash dividends on its capital stock. The Company
currently anticipates that it will retain all available funds for use in its
business and does not anticipate paying any cash dividends in the foreseeable
future.
 
                                      20
<PAGE>
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
  The following selected financial information has been derived from the
Company's Consolidated Financial Statements. The information set forth below
is not necessarily indicative of results of future operations and should be
read in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and the consolidated financial statements
and related notes thereto included elsewhere in this Form 10-K.
 
                     SELECTED CONSOLIDATED FINANCIAL DATA
                      FIVE YEARS ENDED DECEMBER 31, 1997
 
<TABLE>
<CAPTION>
                                         YEAR ENDED DECEMBER 31,
                                ----------------------------------------------
                                  1997     1996      1995      1994     1993
                                --------  -------  --------  --------  -------
                                  (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                             <C>       <C>      <C>       <C>       <C>
CONSOLIDATED STATEMENTS OF
 INCOME DATA:
Net revenues:
  License.....................  $ 12,590  $11,714  $ 10,222  $ 12,209  $15,574
  Service and other...........     5,887    4,443     5,324    11,428    7,183
                                --------  -------  --------  --------  -------
    Net revenues..............    18,477   16,157    15,546    23,637   22,757
                                --------  -------  --------  --------  -------
Cost of revenues:
  License.....................       876    1,059       943       715    1,275
  Service and other...........     3,606    1,917     2,346     7,445    4,282
                                --------  -------  --------  --------  -------
    Total cost of revenues....     4,482    2,976     3,289     8,160    5,557
                                --------  -------  --------  --------  -------
Gross profit..................    13,995   13,181    12,257    15,477   17,200
                                --------  -------  --------  --------  -------
Operating expenses:
  Research and development ...     5,600    5,461     5,156     1,730    3,643
  Sales and marketing.........     7,829    7,625     4,279     5,622    8,226
  General and administrative..     3,719    3,223     2,188     3,493    3,480
  Restructuring expense
   (benefit)..................     1,513     (197)    2,277       397      906
                                --------  -------  --------  --------  -------
    Total operating expenses..    18,661   16,112    13,900    11,242   16,255
                                --------  -------  --------  --------  -------
Operating income (loss) from
 continuing operations........    (4,666)  (2,931)   (1,643)    4,235      945
Litigation settlement and
 related costs................       --       --        --        --    (4,025)
Other income, net.............       171      591     1,046       780      540
                                --------  -------  --------  --------  -------
Income (loss) from continuing
 operations before
 provision for income taxes ..    (4,495)  (2,340)     (597)    5,015   (2,540)
Provision (benefit) for income
 taxes .......................       --       --        --      2,006   (1,016)
                                --------  -------  --------  --------  -------
Income (loss) from continuing
 operations...................    (4,495)  (2,340)     (597)    3,009   (1,524)
Loss from discontinued
 operations...................    (6,415)  (1,501)  (31,212)  (14,941)  (5,808)
                                --------  -------  --------  --------  -------
Loss before cumulative effect
 of change in accounting
 principle....................   (10,910)  (3,841)  (31,809)  (11,932)  (7,332)
                                --------  -------  --------  --------  -------
Cumulative effect of change in
 accounting
 principle....................       --       --        --        --       204
                                --------  -------  --------  --------  -------
Net income (loss).............  $(10,910) $(3,841) $(31,809) $(11,932) $(7,128)
                                ========  =======  ========  ========  =======
BASIC AND DILUTED INCOME
 (LOSS) PER COMMON SHARE:
Income (loss) from continuing
 operations...................  $  (0.21) $ (0.12) $  (0.03) $   0.08  $ (0.07)
Loss from discontinued
 operations...................     (0.30)   (0.07)    (1.75)    (0.76)   (0.36)
Cumulative effect of change in
   accounting principle.......       --       --        --        --      0.01
                                --------  -------  --------  --------  -------
  Net loss....................  $  (0.52) $ (0.19) $  (1.78) $  (0.68) $ (0.42)
                                ========  =======  ========  ========  =======
CONSOLIDATED BALANCE SHEET
 DATA:
Working capital ..............  $  6,411  $15,338  $ 12,145  $ 27,191  $35,548
Total assets..................    13,450   23,622    22,584    37,065   51,838
Long term obligations, less
 current portion..............        10      236        65       478    1,422
Shareholders' equity .........     7,733   17,602    14,360    44,928   55,282
</TABLE>
 
                                      21
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
OVERVIEW
 
  Retix was formed in 1985 and licensed its first OSI technology software in
that year. The Company entered the internetworking market in 1987 with
shipments of its first local bridge products. To broaden its internetworking
product base over the past ten years, the Company expanded to offer routing,
switching and most recently, broadband access equipment. The Company's primary
concentration was in the internetworking market until 1996 when it split the
operating divisions of the Company into three business units, each with its
own management structure. These three units focused on internetworking,
network management software (developed from its roots in OSI technology) and
wireless applications software. In 1997, the Company merged the wireless
applications software subsidiary into its network management software
subsidiary, Vertel. Additionally, in 1997, the Company's internetworking
hardware subsidiary, Sonoma Systems Inc. ("Sonoma"), announced it would focus
solely on broadband access equipment for the telecommunications marketplace.
In December 1997, it was announced that the Company would discontinue
investment in Sonoma and seek outside investors. Such financing was arranged
in early 1998 and the results of operations have been reclassified to present
the operating results of Sonoma as a discontinued operation (See Note 3 to
Financial Statements). The Company's remaining subsidiary, Vertel, was
expanded from its OSI background to begin offering network management software
for the telecommunications industry. This product line of telecommunications
network management ("TMN") software experienced increasing revenues during
1996 and 1997. Further references to the Company in Management's Discussion
and Analysis of Financial Condition refer solely to the continuing operations
of Vertel unless specifically identified otherwise.
 
  Vertel was organized as a wholly-owned subsidiary of Retix in February 1996.
In conjunction with the formation, Retix transferred to the Company the net
assets of Retix's TMN and OSI product lines, including the direct and indirect
subsidiaries through which Retix historically conducted such business. The
Company released its first TMN software products and services in 1995. By
1996, the Company no longer sold new licenses to its OSI software products,
but still receives a limited amount of related royalty and support revenue. As
a result of the product line transition in the Company's business, the
Company's results of operations prior to 1996 should not be relied upon as
indicative of future results.
 
  The Company is a leader in developing, marketing and supporting vertically
integrated, object-oriented software solutions for the management of public
telecommunications networks. The Company's solutions, which are based upon the
International Telecommunications Union's TMN standard, support seamless
network operation and management over diverse transmission media and
protocols. The Company's products are designed to reduce network management
costs by automating critical network management functions and to assist
telecommunications service providers in deriving incremental revenue by
enabling the rapid deployment of advanced services.
 
  The Company offers embedded software for network equipment, software that
allows telecommunications service providers to integrate proprietary or SNMP-
based network management systems with a TMN standards-based solution and
object-oriented software platforms that facilitate the rapid development of
network and service management applications and features such as fault
detection and automatic response, remote improvement of network configuration,
automation of accounting and billing functions, optimization of network
traffic and security. The Company provides professional services to implement
and maintain a complete TMN-based solution efficiently, including system
engineering, custom application development and technical support.
 
  The Company sells its products and services primarily through a direct sales
force in the United States and abroad and, in certain territories, utilizes
commissioned third-party agents. Additionally, the Company announced in 1997
that it had signed a joint development agreement with Hewlett Packard's
OpenView division whereby the two companies would jointly develop, market and
sell certain products. The Company's customers include telecommunications
service providers and their customers, network equipment manufacturers,
independent software developers and software platform vendors.
 
                                      22
<PAGE>
 
  The Company derives revenue primarily from software source license fees,
royalties and services, including professional services, technical support and
maintenance. Source license fees consist primarily of licenses of the
Company's TMN software products and development platforms. Source license
revenue is recognized upon transfer of the source code to the customer,
provided there are no significant remaining obligations and collectability is
deemed probable by management in accordance with Statement of Position 91-1,
Software Revenue Recognition ("SOP 91-1"). To date, substantially all source
license fees have been recognized upon transfer. Source license fees typically
have accounted for a substantial portion of total revenue in each quarter.
Source license agreements generally do not provide for a right of return.
Reserves are maintained for returns and potential credit losses, neither of
which has had a material effect on the Company's results of operations or
financial condition through December 31, 1997.
 
  Pursuant to source code license agreements, licensees may distribute binary
or embedded versions of the Company's software in the licensees' products.
Royalties become due upon shipment of products containing the binary or
embedded code and generally are recognized upon notification by the licensee
to Vertel that products have been shipped. Because of the development times
required for licensees to design and ship products containing binary or
embedded software, the Company generally does not receive royalties from
shipments of such products for at least three quarters from the date the
Company initially ships source code. Certain of the Company's source license
agreements provide for prepayment of royalties. The Company typically
recognizes guaranteed minimum prepaid royalties, which are not subject to
future obligations upon shipment of the underlying source code. Royalty
revenue that exceeds minimum guarantees, or is subject to significant vendor
obligations, or where collection cannot be assured, is recognized in the
period when earned or collection is assured.
 
  The Company separately offers professional services, including system design
and engineering, custom application development, source code portation,
conformance testing and certification and application development. Many of the
Company's customers contract for professional services. These services are
typically based on a detailed statement of work. Professional services revenue
varies according to the size, timing and complexity of the project and are
typically billed based upon the attainment of certain milestones or a per day
fee. Revenue from professional services generally is recognized using the
percentage of completion method, or on a time and materials basis. In certain
cases, the Company is reimbursed for non-recurring engineering efforts by
customers, with reclassification of such costs from research and development
to costs of revenues.
 
  Technical support services consist of product support and maintenance,
training and onsite consulting. Product support and maintenance fees have
constituted the majority of technical support and service revenue. Product
support and maintenance fees typically have ranged from 10-20% of the initial
source license fee and are recognized ratably over the term of the maintenance
agreement, which is typically one year. Other revenue from training and onsite
consulting are recognized as performed.
 
  The Company also derives revenue from the sale of its messaging products and
certain other miscellaneous products and services. The Company expects this
revenue to continue to decline as the Company focuses on its TMN-based
products and services.
 
  The Company's operating expenses have increased substantially since 1995 as
the Company has made investments related to the development and introduction
of its TMN products, expanded its sales force and established additional
general and administrative functions. The Company anticipates that operating
expenses will continue to increase for the foreseeable future as it continues
to develop its technology, increase sales and marketing efforts, establish and
expand distribution channels and institute additional general and
administrative functions.
 
  The Company's prospects are dependent on market acceptance of the TMN
standard and must be evaluated in light of the risks and uncertainties
frequently encountered by companies dependent upon such early stage standards
and products. In addition, the Company's markets are new and rapidly evolving
which heightens these risks and uncertainties. To address these risks, the
Company must, among other things, successfully implement
 
                                      23
<PAGE>
 
its marketing strategy, respond to competitive developments, continue to
develop and upgrade its products and technologies more rapidly than its
competitors and commercialize its products and services incorporating these
enhanced technologies. There can be no assurance that the Company will succeed
in addressing any or all of these risks. See "Risk Factors."
 
RESULTS OF OPERATIONS
 
  The following table sets forth certain operational data as a percentage of
net revenues:
 
<TABLE>
<CAPTION>
                                   YEAR ENDED
                                  DECEMBER 31,
                                ---------------------
                                1997    1996    1995
                                -----   -----   -----
   <S>                          <C>     <C>     <C>
   CONSOLIDATED STATEMENT OF
    INCOME DATA:
   Revenues.................... 100.0 % 100.0 % 100.0 %
   Cost of revenues............  24.3    18.4    21.2
                                -----   -----   -----
   Gross margin................  75.7    81.6    78.8
   Operating expenses:
     Research and development..  30.3    33.8    33.2
     Sales and marketing.......  42.4    47.2    27.5
     General and
      administrative...........  20.1    19.9    14.1
     Restructuring expense
      (benefit)................   8.2    (1.2)   14.6
                                -----   -----   -----
       Total operating
        expenses............... 101.0    99.7    89.4
                                -----   -----   -----
   Operating loss from
    continuing operations...... (25.3)% (18.1)% (10.6)%
                                =====   =====   =====
</TABLE>
 
  Net Revenues. Net revenues increased 14.4% to $18,477,000 in 1997 as
compared to $16,157,000 in 1996 following a 3.9% increase from 1995. The
increases experienced in net revenues over the past two years were primarily
due to growth in demand for the Company's TMN-based products through both new
product offerings and new customers. Additionally, revenues were generated
from existing customers who began to utilize TMN for new systems as well as to
interface with existing legacy systems. Sales generated by the Company consist
of network management software license, service and other revenues.
 
  License revenues consist primarily of licenses and royalties of the
Company's TMN-based software solutions and development platforms, and
typically have accounted for a substantial portion of total revenue in each
quarter. Source license fees are recognized upon transfer of the source code
to the customer, provided there are no significant remaining obligations and
collectibility is deemed probable by management in accordance with SOP 91-1.
Annual license revenues increased 7.5% to $12,590,000 during 1997 from
$11,714,000 in 1996 following a 14.6% increase from $10,222,000 in 1995. The
increase in license revenues in 1997 as compared to 1996 was primarily due to
$1,900,000 in final billings resulting from the termination of a contract to
develop wireless messaging products to a single customer. These billings will
not recur in 1998. The increase in license revenues in 1996 as compared to
1995 reflects a full year of revenues in deploying the Company's TMN-based
software and service solutions to carriers and network equipment manufacturers
for the management of public telecommunications networks.
 
  Service and other revenues consist primarily of professional services,
maintenance, technical support, non-recurring engineering projects, training
and other revenues. Service and other revenues increased 32.5% to $5,887,000
during 1997 from $4,443,000 in 1996 following a 16.5% decrease from $5,324,000
in 1995. The increase in service and other revenues in 1997 as compared to
1996 was primarily due to higher revenues from professional services,
nonrecurring engineering projects and maintenance revenues. The decrease in
service and other revenues in 1996 as compared to 1995 was primarily due to
decreases in nonrecurring engineering projects and maintenance revenues as the
Company shifted its product lines from its traditional OSI products to TMN-
based products.
 
                                      24
<PAGE>
 
  The Company intends to continue to introduce several new products to expand
its position as a leader in providing telecommunications management solutions;
however, net revenues and operating results of future periods may be adversely
affected if the Company experiences releasing new products, if such new
products are not accepted by the marketplace, or if the Company experiences
unanticipated decreases in other product revenues.
 
  Sales to customers outside of the United States comprised approximately
40.3%, 52.6% and 46.6%, respectively, of net revenues in 1997, 1996 and 1995.
The Company's high percentage of sales to customers outside of the United
States has historically been due primarily to strong international demand for
its OSI and TMN standards-based network management software which the Company
believes is due to the high degree of international investment in new
infrastructure products, whereas investment in the U.S. tends to be in
upgrading pre-existing proprietary systems. Historically, the Company's
international sales have been denominated primarily in U.S. dollars. As such,
the effects of fluctuations in foreign exchange rates, in comparison with the
U.S. dollar, have not had a significant impact on the results of the Company's
operations.
 
  Gross Margin. Cost of revenues consists primarily of professional
engineering services, primarily comprised of payroll and related costs, and
royalties paid under software licensing agreements and warranty costs. Gross
margin decreased to 75.7% of net revenues in 1997, from 81.6% in 1996 and from
78.8% in 1995 due to a shift in product mix. The decrease in gross margin for
1997 was more specifically due to a greater composition of professional
services revenue in the product mix, which tend to have lower margins versus
license revenue. Gross margins increased in 1996 as compared to 1995 due to
fewer projects with customers for non-recurring engineering efforts which
typically are generally performed at relatively low margins. The Company
anticipates that changes to pricing structures and distribution strategies may
occur, and that margins may fluctuate and could decline in future periods.
 
  Research and Development. The Company has invested heavily in research and
development to expand its expertise in TMN-based software solutions
applications technologies and to continue sustaining support of its product
offerings. The major components of research and development expenses are
engineering salaries, employee benefits and associated overhead, fees to
outside contractors, the cost of facilities and depreciation of capital
equipment, primarily computer and test equipment. Costs related to research
and development in certain cases are offset by customer reimbursement of non-
recurring engineering efforts.
 
  Total research and development expenses increased 2.5% to $5,600,000 in 1997
from $5,461,000 in 1996 and increased 5.9% in 1996 from $5,156,000 in 1995. As
a percentage of revenue, research and development expenses were relatively
constant at 30.3% in 1997, 33.8% in 1996, and 33.2% in 1995. The increase in
research and development expense in 1997 and 1996 as compared to prior years
was primarily due to an increase in expenditures for further expansion of TMN-
based software development tools, stacks and applications. The decrease in
research and development expense as a percentage of revenue in 1997 as
compared to 1996 reflects the overall increase in revenues noted for the
period.
 
  The Company expects to continue to make significant investments in the
development of new products and feature enhancements to existing product
lines, although such expenses may fluctuate from quarter to quarter both in
absolute dollars and as a percentage of revenue depending on the status of
various development projects and the level of non-recurring engineering
services.
 
  Sales and Marketing. Sales and marketing expenses consist primarily of
personnel and associated costs related to selling, support and marketing
activities, including marketing programs such as trade shows and other
promotional costs. The Company believes that substantial sales and marketing
expenditures are essential to developing the opportunities for revenue growth
and to renewing the Company's competitive position. Sales and marketing
expenses are expected to continue to comprise a significant percentage of the
Company's total expenses because of costs associated with supporting the
worldwide sales and service functions necessary to meet the needs of the
Company's customer base and respond to the opportunities in the TMN
marketplace.
 
                                      25
<PAGE>
 
  Sales and marketing expenses increased 2.7% to $7,829,000 in 1997 from
$7,625,000 in 1996 and increased 78.2% in 1996 from $4,279,000 in 1995. Sales
and marketing expenses increased slightly in 1997 as compared to 1996, but
decreased as a percentage of revenues to 42.4% in 1997 from 47.2% in 1996
primarily due to slower growth of additional sales offices in early 1997 as
revenues increased over the prior year. The increase in the absolute amount of
sales and marketing expenses and as a percentage of revenues in 1996 as
compared to 1995 reflects efforts to increase Vertel's direct sales force
including opening of offices in Germany, France, the United Kingdom, Korea and
Japan and additional marketing programs to support the launch of new TMN-based
products and entry into new markets.
 
  The Company has developed a strategy to capitalize on the emerging TMN
market through the establishment and growth of offices and sales personnel
around the world. In conjunction with this strategy, the Company intends to
expand its sales and marketing functions further to support anticipated
broader market adoption of TMN. The Company anticipates that sales and
marketing expenses will increase in absolute dollars, although such expenses
may fluctuate from quarter to quarter both in absolute dollars and as a
percentage of revenue.
 
  General and Administrative. General and administrative expenses consist
primarily of salaries and other related expenses of administrative, executive
and financial personnel as well as professional fees and insurance premiums.
General and administrative expenses increased 15.4% to $3,719,000 in 1997 as
compared to $3,223,000 in 1996, and increased 47.3% in 1996 from $2,188,000 in
1995. The increase in general and administrative costs in 1997 as compared to
1996 is primarily attributable to increases in infrastructure costs including
severance and professional fees related to the merger of the Company's
subsidiary, Wireless Solutions, into Vertel in mid-1997, and charges for
reductions in the Company's Irish offices and staffing. The increase in
general and administrative costs in 1996 as compared to 1995 is primarily
attributable to increases in infrastructure costs related to Vertel, as the
entity developed more autonomous operations during 1996. These infrastructure
costs included facilities relocation costs, professional fees and the
recruitment of staff and the expansion of an executive team.
 
  Restructuring Expense (Benefit). The Company operates in an industry that is
characterized by rapid development of new technology, which profoundly affects
product and marketing strategies of companies operating within the industry.
In December 1997, the Company announced plans to discontinue investment in its
broadband access equipment subsidiary, Sonoma. As a result, the Company's
management structure was reorganized and downsized to reflect the reduction of
the number of operating subsidiaries to one (see Notes 3 and 12 to Financial
Statements). The estimated costs of restructuring recorded in the financial
statements for the year ended December 31, 1997 was $1,816,000 and included
costs of officer severance pay, acceleration of vesting for certain officer
and director stock options, facility consolidation, professional fees and
other related charges. It is anticipated these costs will be paid during the
first half of 1998. Additionally, during the fourth quarter of 1997, the
Company recorded a reversal of certain restructuring reserves and accruals
originally recorded in 1995 totaling $303,000, resulting in a net
restructuring expense recorded for fiscal 1997 of $1,513,000.
 
  In 1995, the Company announced a major restructuring of its operations
resulting from the significant downsizing of its internetworking hardware
business unit, later known as Sonoma. The resulting restructuring charge
included costs for exiting certain leased facilities by the Company, inventory
and fixed asset write downs, severance payments for terminated employees,
foreign office closure costs and other reserves. The estimated costs of
restructuring recorded in the financial statements for the year ended December
31, 1995 was $2,277,000. Subsequently, the Company recorded the reversal of
excess restructuring reserves totalling $303,000 and $197,000 for the years
ended December 31, 1997 and 1996, respectively, primarily as a result of
favorable lease exit costs and lower than anticipated severance costs. As of
December 31, 1997, substantially all reserves related to the 1995
restructuring charge, except for $149,000 related to costs for final closures
of foreign subsidiaries, had been utilized or reversed.
 
  Loss from Continuing Operations. The Company incurred a loss from continuing
operations of $4,666,000 in 1997, $2,931,000 in 1996, and $1,643,000 in 1995.
The increase in loss from continuing operations in 1997
 
                                      26
<PAGE>
 
as compared to 1996 is primarily attributable to the restructuring reserve as
a result of the reorganization of the Company's management structure (See
Restructuring Expense (Benefit)). The loss from continuing operations in 1996
is primarily attributable to increases in operating costs as the Company
expanded infrastructure of its subsidiary, Vertel. The loss from continuing
operations in 1995 is primarily attributable to declines in net revenues
versus 1994 as the Company transitioned from its traditional OSI products to
TMN products.
 
  Other Income. Other income, net, includes interest income and expense,
foreign tax withholdings and foreign currency gains and losses. Decreases in
other income, net, to $171,000 in 1997 from $591,000 in 1996 and $1,046,000 in
1995 were primarily attributable to decreases in interest income from
decreasing cash balances during 1997 and varying interest rates earned on
investments.
 
  Provision for Income Taxes. The Company recorded no provision for income
taxes on pre-tax losses from continuing operations of $4,495,000, $2,340,000,
and $597,000 in 1997, 1996 and 1995 respectively. Deferred tax assets and
liabilities are recognized based on differences between financial statement
and tax bases of assets and liabilities using presently enacted rates. A
valuation allowance equal to the total amount of the Company's net deferred
tax assets of $25,344,000 at December 31, 1997, has been established. The net
deferred tax assets will be realized to the extent that the Company operates
profitably in the future during the respective carryforward periods.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  The Company has incurred net losses of $ 10,910,000, $3,841,000 and
$31,809,000 and operating losses from continuing operations of $4,666,000,
$2,931,000 and $1,643,000 for the years ended December 31, 1997, 1996 and
1995, respectively. As a result, the Company's principal sources of liquidity,
consisting of cash and cash equivalents and short-term investments, have
decreased to $2,253,000 and $3,999,000, respectively, at December 31, 1997. In
response to these factors, as more fully discussed at Note 3 to the Financial
Statements, in December 1997, the Company's board of directors adopted a plan
to discontinue further investment in the Company's broadband access equipment
subsidiary, Sonoma. The plan, which was substantially completed in January
1998, reduces the Company's level of investment in Sonoma to that of a passive
investor and, as a result, the Company will no longer contribute to the future
working capital requirements of Sonoma. Net cash used by Sonoma was
$6,313,000, $6,057,000 and $11,591,000 in 1997, 1996 and 1995, respectively.
In response to the losses at the Company's remaining operating subsidiary,
Vertel, the Company reduced ongoing operating expenses in the second half of
1997 to align with anticipated sales levels. Additionally, the Company has
streamlined its management structure through the restructuring activities
announced in December 1997 (see Note 11).
 
  The Company believes the effects of the disposition of Sonoma and reductions
in ongoing operating expenses in the second half of 1997 will result in cash
flows in 1998 which, when combined with the Company's cash and short term
investment balances, will be sufficient to meet the Company's liquidity
requirements for the next 12 months.
 
  The Company has experienced operating losses from continuing operations
before provision for income taxes totaling $4,495,000, $2,340,000 and $597,000
in 1997, 1996 and 1995, respectively. Operating activities required the use of
cash of $4,277,000 during 1997 primarily as a result of the operating loss in
that year. Additionally, the Company experienced overall decreases in payables
and accruals in 1997 as compared to the prior year. Offsetting the loss in
1996 were cash flow increases primarily due to increases in accounts payable
and accrued liabilities compared to the prior year.
 
  The Company has received net cash of $256,000, $3,321,000, and $1,120,000
from the exercise of stock options and stock sales under the employee stock
purchase plans in 1997, 1996 and 1995, respectively. In 1997, the Company also
received cash of $510,000 as a result of the repayment of certain notes
receivable originally issued from the exercise of certain stock options.
Additionally, in 1996, the Company received cash of $4,090,000 as a result of
the private placement of its common stock in that year.
 
                                      27
<PAGE>
 
  At December 31, 1997 the Company's long-term liquidity needs consisted
principally of operating lease commitments related to facilities and office
equipment.
 
  The Company's capital expenditures approximated $480,000 for 1997, $340,000
for 1996 and $858,000 for 1995. The Company currently anticipates that capital
expenditures for the next twelve months will be utilized for the acquisition
of computer, test and office equipment as well as tenant improvements in
connection with the expansion of facilities. From time to time, the Company
may also consider the acquisition of, or evaluate investments in, certain
products and businesses complimentary to the Company's business. Any such
acquisition or investment may require additional capital resources.
 
  New releases of the Company's software have been designed to address
processing for the year 2000 to the extent it has been required. It is the
Company's intent to have all of its actively supported software on releases
which are ready for the year 2000 by the end of 1998. However, to the extent
that others such as system integrators make use of the Company's software in
developing solutions for third parties, the Company may have no knowledge as
to the year 2000 readiness of those third party products. In addition, it is
possible third parties could assert claims against the Company or its
customers concerning year 2000 issues and, regardless of their merits or lack
thereof, these claims could be material.
 
  As with other organizations, the Company's internal computer systems and
programs were originally designed to recognize calendar years by their last
two digits. Calculations performed using these truncated fields would not work
properly with dates from the year 2000 and beyond. The Company has initiated
efforts to remedy this situation and expects all systems to be replaced and
tested prior to the year 2000. The incremental costs of this project have not
yet been quantified by the Company and could be material.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  None.
 
                                      28
<PAGE>
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                                     RETIX
 
                          CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                            ------------------
                                                              1997      1996
                                                            --------  --------
<S>                                                         <C>       <C>
                          ASSETS
Current assets:
  Cash and cash equivalents................................ $  2,253  $  8,219
  Short-term investments ..................................    3,999     7,748
  Trade accounts receivable (net of allowances of $452 and
   $368 for 1997 and 1996, respectively)...................    4,941     4,315
  Prepaid expenses and other current assets................      925       840
                                                            --------  --------
    Total current assets...................................   12,118    21,122
Property and equipment, net................................      766       913
Other assets...............................................      566     1,587
                                                            --------  --------
                                                            $ 13,450  $ 23,622
                                                            ========  ========
           LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable......................................... $    733  $  1,064
  Accrued wages and related liabilities ...................      660       903
  Accrued restructuring expenses ..........................    1,487       491
  Other accrued liabilities ...............................    2,100     2,493
  Deferred revenue.........................................      531       739
  Net liabilities of discontinued operations...............      196        94
                                                            --------  --------
    Total current liabilities .............................    5,707     5,784
Deferred rent..............................................       10       236
                                                            --------  --------
    Total liabilities......................................    5,717     6,020
                                                            --------  --------
Shareholders' equity:
  Preferred stock, par value $.01, 2,000,000 shares
   authorized; none issued and outstanding.................
  Common stock, par value $.01, 50,000,000 shares
   authorized; shares issued and outstanding 1997,
   24,146,518; 1996, 22,597,427............................      227       226
  Additional paid-in capital ..............................   78,661    78,089
  Accumulated deficit .....................................  (64,760)  (53,850)
  Cumulative translation adjustment .......................   (2,003)   (1,961)
                                                            --------  --------
                                                              12,125    22,504
  Less notes receivable from issuance of common stock .....   (4,392)   (4,902)
                                                            --------  --------
    Total shareholders' equity ............................    7,733    17,602
                                                            --------  --------
                                                            $ 13,450  $ 23,622
                                                            ========  ========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
 
                                       29
<PAGE>
 
                                     RETIX
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                   ---------------------------
                                                     1997     1996      1995
                                                   --------  -------  --------
<S>                                                <C>       <C>      <C>
Net revenues:
  License......................................... $ 12,590  $11,714  $ 10,222
  Service and other...............................    5,887    4,443     5,324
                                                   --------  -------  --------
    Net revenues..................................   18,477   16,157    15,546
                                                   --------  -------  --------
Cost of revenues:
  License.........................................      876    1,059       943
  Service and other...............................    3,606    1,917     2,346
                                                   --------  -------  --------
    Total cost of revenues .......................    4,482    2,976     3,289
                                                   --------  -------  --------
Gross profit .....................................   13,995   13,181    12,257
                                                   --------  -------  --------
Operating expenses:
  Research and development........................    5,600    5,461     5,156
  Sales and marketing.............................    7,829    7,625     4,279
  General and administrative .....................    3,719    3,223     2,188
  Restructuring expense (benefit).................    1,513     (197)    2,277
                                                   --------  -------  --------
    Total.........................................   18,661   16,112    13,900
                                                   --------  -------  --------
Operating loss from continuing operations ........   (4,666)  (2,931)   (1,643)
Other income, net ................................      171      591     1,046
                                                   --------  -------  --------
Loss from continuing operations before provision
 for income taxes.................................   (4,495)  (2,340)     (597)
Provision for income taxes........................      --       --        --
                                                   --------  -------  --------
Loss from continuing operations...................   (4,495)  (2,340)     (597)
Loss from discontinued operations (including
 provision for operating losses of $100 during
 phase out period)................................   (6,415)  (1,501)  (31,212)
                                                   --------  -------  --------
Net loss.......................................... $(10,910) $(3,841) $(31,809)
                                                   ========  =======  ========
Basic and diluted loss per common share:
Loss from continuing operations .................. $  (0.21) $ (0.12) $  (0.03)
Loss from discontinued operations ................ $  (0.30) $ (0.07) $  (1.75)
                                                   --------  -------  --------
Net loss.......................................... $  (0.52) $ (0.19) $  (1.78)
                                                   ========  =======  ========
Common shares used in computing per share amounts
 .................................................   21,120   20,322    17,886
</TABLE>
 
          See accompanying notes to consolidated financial statements.
 
                                       30
<PAGE>
 
                                     RETIX
 
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                           COMMON STOCK    ADDITIONAL             CUMULATIVE
                         -----------------  PAID-IN   ACCUMULATED TRANSLATION   NOTES
                           SHARES   AMOUNT  CAPITAL     DEFICIT   ADJUSTMENT  RECEIVABLE  TOTAL
                         ---------- ------ ---------- ----------- ----------- ---------- --------
<S>                      <C>        <C>    <C>        <C>         <C>         <C>        <C>
Balance at January 1,
 1995................... 17,569,068  $176   $64,706    $(18,200)    $(1,754)   $   --    $ 44,928
 Issuance of common
  stock upon exercise of
  options ..............    381,230     4       875                                           879
 Issuance of common
  stock under employee
  stock purchase plan ..    102,284     1       240                                           241
 Cumulative translation
  adjustment............                                                121                   121
 Net loss...............                                (31,809)                          (31,809)
                         ----------  ----   -------    --------     -------    -------   --------
Balance at December 31,
 1995................... 18,052,582   181    65,821     (50,009)     (1,633)               14,360
 Issuance of common
  stock upon exercise of
  options...............  2,458,999    25     7,938                             (4,902)     3,061
 Issuance of common
  stock upon private
  placement ............  2,000,000    20     4,070                                         4,090
 Issuance of common
  stock under employee
  stock purchase plan...     85,846             260                                           260
 Cumulative translation
  adjustment ...........                                               (328)                 (328)
 Net loss...............                                 (3,841)                           (3,841)
                         ----------  ----   -------    --------     -------    -------   --------
Balance at December 31,
 1996................... 22,597,427   226    78,089     (53,850)     (1,961)    (4,902)    17,602
 Issuance of common
  stock upon exercise of
  warrants .............  1,457,627
 Issuance of common
  stock upon exercise of
  options...............     35,985              41                                            41
 Payment of notes
  receivable from
  issuance of common
  stock.................                                                           510        510
 Compensation expense
  from acceleration of
  stock options.........                        317                                           317
 Issuance of common
  stock under employee
  stock purchase plan...     55,479     1       214                                           215
 Cumulative translation
  adjustment............                                                (42)                  (42)
 Net loss ..............                                (10,910)                          (10,910)
                         ----------  ----   -------    --------     -------    -------   --------
 Balance at December 31,
  1997.................. 24,146,518  $227   $78,661    $(64,760)    $(2,003)   $(4,392)  $  7,733
                         ==========  ====   =======    ========     =======    =======   ========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
 
                                       31
<PAGE>
 
                                     RETIX
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                    --------------------------
                                                     1997     1996      1995
                                                    -------  -------  --------
<S>                                                 <C>      <C>      <C>
Cash flows from operating activities:
  Net loss from continuing operations.............. $(4,495) $(2,340) $   (597)
  Adjustments to reconcile net loss to net cash
   (used for) provided by operating activities:
    Depreciation and amortization .................   1,017    1,003     2,300
    Reserve for returns and bad debts..............      84      277        91
    Restructuring expense (benefit) ...............   1,513     (197)    2,277
    Deferred rent..................................    (226)     171      (413)
    Changes in operating assets and liabilities
     (Note 10).....................................  (2,170)   2,300    (1,976)
                                                    -------  -------  --------
    Net cash (used for) provided by operating
     activities ...................................  (4,277)   1,214     1,682
                                                    -------  -------  --------
Cash flows from investing activities:
  Net sales of short-term investments .............   3,749    1,684     2,827
  Additions to property and equipment .............    (480)    (340)     (858)
  Change in other assets...........................     631     (883)     (478)
                                                    -------  -------  --------
    Net cash provided by investing activities......   3,900      461     1,491
                                                    -------  -------  --------
Cash flows from financing activities:
  Proceeds from issuance of common stock ..........     766    7,411     1,120
                                                    -------  -------  --------
    Net cash provided by financing activities......     766    7,411     1,120
                                                    -------  -------  --------
Net cash used by discontinued operations...........  (6,313)  (6,057)  (11,591)
                                                    -------  -------  --------
Effect of exchange rate changes on cash............     (42)    (328)      121
                                                    -------  -------  --------
Net (decrease) increase in cash and cash
 equivalents.......................................  (5,966)   2,701    (7,177)
Cash and cash equivalents, beginning of year ......   8,219    5,518    12,695
                                                    -------  -------  --------
Cash and cash equivalents, end of year............. $ 2,253  $ 8,219  $  5,518
                                                    =======  =======  ========
</TABLE>
 
 
          See accompanying notes to consolidated financial statements.
 
                                       32
<PAGE>
 
                                     RETIX
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. GENERAL
 
  The consolidated financial statements include the accounts of Retix and its
subsidiaries (the "Company"). All significant intercompany balances and
transactions have been eliminated in consolidation. As discussed more
thoroughly in Note 3, the Company's broadband access equipment subsidiary,
Sonoma Systems, Inc. ("Sonoma"), is presented as a discontinued operation for
all periods presented.
 
  The Company was founded in 1985 and develops and markets software for the
management and operations of telecommunications networks. The Company provides
advanced telecommunications management solutions ("TMN") including
communications infrastructure products, network management platforms and
applications software for telecommunication carrier networks worldwide. In
addition, the Company serves telecommunications equipment manufacturers,
computer systems original equipment manufacturers ("OEMs") and Internet access
providers. Trading of the Company's common stock on the Nasdaq National Market
(symbol: RETX) commenced following the Company's initial public offering in
December 1991. In conjunction with its annual shareholders' meeting to be held
in March 1998, the Company has announced plans to change the name of the
Company to Vertel. The Company expects to change its ticker symbol to VRTL,
assuming the symbol is available after the name change is approved.
 
  Revenues are generated primarily from software licenses, royalty agreements,
professional services and maintenance contracts. Sales to one customer
comprised approximately 10.2% of net revenues in 1997.
 
  The Company has incurred net losses of $ 10,910,000, $3,841,000 and
$31,809,000 and operating losses from continuing operations of $4,666,000,
$2,931,000 and $1,643,000 for the years ended December 31, 1997, 1996 and
1995, respectively. As a result, the Company's principal sources of liquidity
consisting of cash and cash equivalents and short-term investments, have
decreased to $2,253,000 and $3,999,000, respectively, at December 31, 1997. In
response to these factors, as more fully discussed in Note 3, in December
1997, the Company's board of directors adopted a plan to discontinue further
investment in the Company's broadband access equipment subsidiary, Sonoma
Systems, Inc. ("Sonoma"). The plan, which was substantially completed in
January 1998, reduces the Company's level of investment in Sonoma to that of a
passive investor and, as a result, the Company will no longer contribute to
the future working capital requirements of Sonoma. Net cash used by Sonoma was
$6,313,000, $6,057,000 and $11,591,000 in 1997, 1996 and 1995, respectively.
In response to the losses at the Company's remaining operating subsidiary,
Vertel, the Company has reduced ongoing operating expenses in the second half
of 1997 to align with anticipated sales levels. Additionally, the Company has
streamlined its management structure through the restructuring activities
announced in December 1997 (see Note 11).
 
  The Company believes the effects of the disposition of Sonoma and reductions
in ongoing operating expenses in the second half of 1997 will result in cash
flows in 1998 which, when combined with the Company's cash, cash equivalents
and short term investments as of December 31, 1997, will be sufficient to meet
the Company's liquidity requirements for the next 12 months.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Cash Equivalents & Short-term Investments
 
  Cash equivalents consist of short-term investments purchased with original
maturities of three months or less. Short-term investments consist primarily
of highly liquid municipal bonds and commercial paper purchased with original
maturities greater than three months. Such investments are recorded at cost
which approximates their fair market values.
 
                                      33
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Property and Depreciation
 
  Property and equipment are stated at cost. Depreciation is provided using
the straight-line method over the estimated useful lives of one to two years
for machinery and computer equipment, three years for furniture and fixtures
and the term of the lease for leasehold improvements
 
 Software Development Costs
 
  Development costs incurred in the research and development of software
products are expensed as incurred until the technological feasibility of the
products has been established. After technological feasibility is established,
certain additional costs of coding and testing are capitalized. Unamortized
software development costs of $250,000 and $885,000 were included in other
assets at December 31, 1997 and 1996, respectively. Amortization of
capitalized software development costs for the years ended December 31, 1997,
1996 and 1995 totaled $390,000, $484,000 and $458,000, respectively.
 
 Deferred Rent
 
  The Company recognizes rent expense on operating leases with scheduled rent
increases on a straight-line basis over the term of the lease. Deferred rent
consists of timing differences between the recognition of rent expense and
cash payments for rent.
 
 Revenue Recognition
 
  The Company derives revenue primarily from software license and royalty
fees, maintenance and customer support and, to a lesser extent, professional
services and custom engineering consulting contracts. Revenues from software
licenses and applications, for which there is a signed contract, collection is
probable and customer acceptance is not dependent on fulfillment of other
significant vendor obligations, is generally recognized upon transfer of the
product to the customer in accordance with Statement of Position 91-1,
Software Revenue Recognition ("SOP 91-1"). Costs associated with insignificant
vendor obligations are accrued. Software license royalty revenue is recognized
upon notification by the licensee that products incorporating the Company's
software have been shipped by the licensee or, for products for which the
Company has sufficient historical information, upon estimated amounts which
the Company expects the customer to report. Revenues from maintenance and
support contracts are recognized on a straight-line basis over the term of the
contract. Revenues from professional services and custom engineering contracts
are generally recognized using the percentage of completion method of
accounting or on a time and materials basis.
 
  Deferred revenues include unearned amounts received under maintenance and
support contracts and amounts billed to customers but not recognized as
revenue. An allowance for sales returns and price protection is accrued
concurrently with the recognition of revenue.
 
 Income Taxes
 
  Deferred tax assets and liabilities are recognized based on differences
between financial statement and tax bases of assets and liabilities using
presently enacted rates. A valuation allowance equal to the total amount of
the Company's net deferred tax assets of $25,344,000 at December 31, 1997 has
been established. The net deferred tax assets will be realized to the extent
that the Company operates profitably in the future during the respective
carryforward periods.
 
                                      34
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Earnings Per Share
 
  In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 128, Earnings per Share. The
Company has reflected the provisions of SFAS 128 in the accompanying financial
statements for all periods presented. SFAS 128 replaces the presentation of
primary Earnings Per Share ("EPS") with a presentation of basic EPS, which
excludes dilution and is computed by dividing income available to common
shareholders by the weighted average number of common shares outstanding for
the period. The Statement also requires the dual presentation of basic and
diluted EPS on the face of the income statement for all entities with complex
capital structures. Diluted EPS is computed similarly to fully diluted EPS
pursuant to Accounting Principles Board Opinion No. 15. Due to the losses
reported by the Company in each of the last three years, any potential common
shares to be included in diluted earnings per share as a result of common
stock options and warrants are anti-dilutive and thus diluted earnings per
share and basic earnings per share are equal. Potentially dilutive securities
not included in the computation of basic earnings per share consisted solely
of stock options outstanding as of December 31, 1997 (See Note 7).
 
 International Currency Translation
 
  Assets and liabilities of international subsidiaries are translated into
United States dollars at the exchange rate in effect at the close of the
period, and revenues and expenses of these subsidiaries are translated at the
weighted average exchange rate during the period. The aggregate effect of
translating the financial statements of international subsidiaries is included
as a separate component of shareholders' equity. Substantially all of the
Company's sales are denominated in U.S. dollars.
 
 Concentration of Credit Risk
 
  Financial instruments which potentially subject the Company to concentration
of credit risk consist principally of cash, cash equivalents, short-term
investments and accounts receivable. The Company places its cash, cash
equivalents and short-term investments with high credit-quality institutions
and limits the amount of credit exposure to any one institution. The Company's
accounts receivable arise from sales directly to customers and indirectly
through resellers, systems integrators and OEMs. The Company performs ongoing
credit evaluations of its customers before granting uncollateralized credit
and to date has not experienced any material credit related losses.
 
 Impairment of Long-lived Assets
 
  The Company evaluates long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying value of an asset may not
be recoverable. If the estimated future cash flows (undiscounted and without
interest charges) from the use of an asset are less than the carrying value, a
write-down would be recorded to reduce the related asset to its estimated fair
value.
 
 Fair Market Value of Financial Instruments
 
  The recorded values of the Company's financial instruments approximate their
fair values.
 
 Use of Estimates in the Preparation of the Financial Statements
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect amounts reported therein. Due to the inherent
uncertainty involved in making estimates, actual results reported in future
periods may differ from these estimates.
 
                                      35
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Fiscal Year
 
  The Company's fiscal year is the 52 or 53-week period ending on the Saturday
nearest to December 31. For simplicity of presentation, the Company has
described the 52 weeks ended December 27, 1997 as December 31, 1997, the 52
weeks ended December 28, 1996 as December 31, 1996, and the 52 weeks ended
December 30, 1995 as December 31, 1995.
 
 Recent Accounting Pronouncements
 
  In October 1997, the American Institute of Certified Public Accountants
("AICPA") released Statement of Position 97-2, "Software Revenue Recognition"
("SOP 97-2"). Among other things, SOP 97-2 eliminates the distinction between
significant and insignificant vendor obligations promulgated by SOP 91-1 and
requires each element of a software arrangement to meet certain criteria in
order to recognize revenue allocated to that element. Additionally, SOP 97-2
requires that total fees under an arrangement be allocated to each element in
the arrangement based upon vendor specific objective evidence, as defined. SOP
97-2 is effective for software transactions entered into by the Company in
fiscal 1998 and subsequent periods.
 
  As a result of certain issues raised in applying SOP 97-2, on February 11,
1998, the AICPA issued an exposure draft of a Statement of Position which will
delay for one year the effective date of certain provisions of SOP 97-2 with
respect to what constitutes vendor-specific objective evidence of fair value
of the delivered software element in certain multiple-element arrangements
that include service elements entered into by entities that never sell the
software elements separately. The proposed SOP will be effective on issuance
which is expected to occur before March 15, 1998. The Company does not
anticipate that the adoption of SOP 97-2 and the proposed SOP, when issued,
will have a material effect on the Company's results of operations. However,
the ultimate resolution of the implementation issues referred to above, or
additional issues not yet raised or addressed by the AICPA, could change the
Company's expectation.
 
3. DISCONTINUED OPERATIONS
 
  In December 1997, in order to focus exclusively on the telecommunications
network management software business, the Company's Board of Directors adopted
a formal plan to reduce the Company's investment in its broadband access
equipment subsidiary, Sonoma Systems, Inc., ("Sonoma") through direct
investment in Sonoma by certain venture capital firms. The plan, as adopted by
the Board of Directors, calls for the Company to reduce its ownership interest
in Sonoma to that of a passive investor with no significant influence over the
former subsidiary's operations. In January 1998, Sonoma closed the first round
of such investment and expects to complete the second and final round of
financing in the first quarter of 1998. When completed, the financing will
result in Sonoma raising approximately $9 million through the issuance of
preferred stock and will reduce the Company's voting ownership in Sonoma to
19.9%. Subsequent to the financing, the Company will account for its
investment in Sonoma using the cost method and expects to record an increase
in its net investment in Sonoma of $1.9 million with a corresponding credit to
additional paid-in-capital in the first quarter of 1998 to reflect the
increase in its share of Sonoma's net assets.
 
  As a result of the foregoing, the Company's financial statements and related
Notes to financial statements reflect the results of operations and net
liabilities of Sonoma as a discontinued operation for all periods presented.
 
                                      36
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Operating results from discontinued operations have been segregated from the
previously reported consolidated statements of operations and are as follows:
 
<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                    --------------------------
                                                     1997     1996      1995
                                                    -------  -------  --------
   <S>                                              <C>      <C>      <C>
   Net revenues.................................... $ 6,342  $14,958  $ 23,241
   Cost of revenues................................   3,094    7,148    13,677
   Operating expenses..............................   9,311    9,380    40,241
                                                    -------  -------  --------
   Operating loss..................................  (6,063)  (1,570)  (30,677)
   Other income (expense)..........................    (252)      69      (535)
   Provision for estimated losses during phase-out
    period.........................................    (100)     --        --
                                                    -------  -------  --------
   Net loss........................................ $(6,415) $(1,501) $(31,212)
                                                    =======  =======  ========
</TABLE>
 
  Summarized balance sheet information for the discontinued operations is as
follows:
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                              ----------------
                                                               1997     1996
                                                              -------  -------
   <S>                                                        <C>      <C>
   Current assets............................................ $ 1,366  $ 4,045
   Total assets..............................................   1,908    4,451
   Current liabilities.......................................  (2,104)  (4,505)
   Total liabilities.........................................  (2,104)  (4,545)
   Net liabilities of discontinued operations................ $  (196) $   (94)
</TABLE>
 
4. PROPERTY AND EQUIPMENT
 
  Property and equipment consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                                  -------------
                                                                   1997   1996
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Machinery and equipment....................................... $3,454 $2,895
   Furniture and fixtures........................................    325    424
   Leasehold improvements........................................    147    127
                                                                  ------ ------
                                                                   3,926  3,446
   Less accumulated depreciation and amortization................  3,160  2,533
                                                                  ------ ------
   Property and equipment, net................................... $  766 $  913
                                                                  ====== ======
</TABLE>
 
5. INCOME TAXES
 
  The components of loss from continuing operations before income taxes
consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                      -------------------------
                                                       1997     1996     1995
                                                      -------  -------  -------
   <S>                                                <C>      <C>      <C>
   Domestic.......................................... $(5,429) $(2,835) $ 1,217
   Foreign...........................................     934      495   (1,814)
                                                      -------  -------  -------
     Total........................................... $(4,495) $(2,340) $  (597)
                                                      =======  =======  =======
</TABLE>
 
                                      37
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The provision (benefit) for income taxes consists of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                      -------------------------
                                                       1997     1996     1995
                                                      -------  -------  -------
   <S>                                                <C>      <C>      <C>
   Current:
     Federal......................................... $   --   $   --   $   --
     State...........................................     --       --       --
     Foreign.........................................     --       --       --
                                                      -------  -------  -------
       Total current.................................     --       --       --
   Deferred..........................................    (699)  (5,700)  (6,648)
   Valuation allowance...............................     699    5,700    6,648
                                                      -------  -------  -------
       Total......................................... $   --   $   --   $   --
                                                      =======  =======  =======
</TABLE>
 
  The Company's effective income tax rate differs from the federal statutory
income tax rate applied to loss from continuing operations before provision for
income taxes due to the following:
 
<TABLE>
<CAPTION>
                                   DECEMBER 31,
                                 ---------------------
                                 1997    1996    1995
                                 -----   -----   -----
   <S>                           <C>     <C>     <C>
   Federal statutory income tax
    rate.......................  (34.0)% (34.0)% (34.0)%
   Increases (reductions) in
    taxes resulting from:
     Effects of foreign
      operations...............   (7.3)   (7.4)  106.4
     State taxes, net of
      federal benefit..........    0.1     0.1     0.2
     Research and development
      tax credit...............   (3.4)   (4.5)  (53.1)
     Tax exempt interest
      income...................     --      --     2.5
     Dividends received
      deduction................     --      --    15.5
     Expiration of foreign tax
      credits..................    7.2      --      --
       Other...................   (0.2)    1.6      --
       Valuation allowance.....   37.6    44.2   (37.5)
                                 -----   -----   -----
   Effective tax rate..........     -- %    -- %    -- %
                                 =====   =====   =====
</TABLE>
 
                                       38
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Current and noncurrent deferred tax assets (liabilities) consist of the
following (in thousands):
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                             ------------------
                                                               1997      1996
                                                             --------  --------
   <S>                                                       <C>       <C>
   Deferred tax assets:
     Expenses accrued....................................... $  1,514  $  1,328
     Credit for research and development expenses...........    6,046     4,756
     Credit for foreign taxes withheld......................      484       809
     Depreciation...........................................      323       243
     Foreign deferred tax assets............................      233       --
   Net operating loss carryforwards.........................   16,853    17,773
                                                             --------  --------
                                                               25,453    24,909
   Deferred tax liabilities:
     Capitalized software...................................     (109)     (264)
   Valuation allowance......................................  (25,344)  (24,645)
                                                             --------  --------
     Net deferred tax assets................................ $    --   $    --
                                                             ========  ========
</TABLE>
 
  The Company's credits for research and development expenses, which may be
carried forward fifteen years, expire in 2004 through 2012; credits for
foreign taxes withheld, which may be carried forward five years, expire in
1998 and 1999. The Company has net operating loss carryforwards for federal
income tax purposes of approximately $43,363,000, which expire in 2007 through
2012. The Company also has net operating loss carryforwards for state purposes
of approximately $17,500,000 which expire in 1998 through 2002.
 
  Tax benefits arising from the disposition of certain shares issued upon
exercise of stock options within two years of the date of grant or within one
year of the date of exercise by the option holder provide the Company a tax
deduction equal to the difference between the exercise price and the fair
market value of the stock on the date of exercise. The tax effect of the
deduction, when realized, will be excluded from the provision (benefit) for
income taxes and credited directly to additional paid-in capital. At December
31, 1997, deferred tax assets creditable directly to shareholders' equity upon
realization totaled $4,540,000.
 
6. COMMITMENTS AND CONTINGENCIES
 
  The Company leases its facilities and certain equipment under noncancellable
operating leases. At December 31, 1997, future minimum rental payments, net of
applicable sublease income, under leases that have initial or remaining
noncancellable lease terms in excess of one year are as follows (in
thousands):
 
<TABLE>
   <S>                                                                  <C>
     1998.............................................................. $ 1,847
     1999..............................................................   1,794
     2000..............................................................   1,134
     2001..............................................................     643
                                                                        -------
       Total operating lease commitments...............................   5,418
     Less: sublease income.............................................  (2,044)
                                                                        -------
       Total........................................................... $ 3,374
                                                                        =======
</TABLE>
 
  Rent expense under operating leases for the years ended December 31, 1997,
1996 and 1995 was $1,126,000, $1,725,000 and $2,899,000, respectively.
 
                                      39
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The Company is subject to certain legal proceedings and claims which arise
in the conduct of its business. Additionally, the Company is contingently
liable for the repayment of certain employment, training and capital grants
from the government of Ireland. In the opinion of management, the amount of
any liability with respect to these actions will not have a material effect on
the financial condition or results of operations of the Company.
 
7. SHAREHOLDERS' EQUITY
 
 Common Stock
 
  Effective January 30, 1996, Sierra Ventures VLP ("Sierra"), a venture
capital firm, purchased 2,000,000 shares of the Company's Common Stock in a
private placement at $2.00 per share. Additionally, Sierra was granted a
warrant to purchase an additional 2,000,000 shares of the Company's Common
Stock at prices ranging from $2.00 to $5.00 per share over the three year term
of the warrant. Sierra's equity investment totaled $4.2 million and was
recorded in common stock and additional paid-in capital in 1996. During 1997,
the warrant was exercised with respect to 1,457,627 shares of Common Stock for
no cash consideration with the balance of the warrant being cancelled and the
difference between the then market price of the Company's Common Stock and the
exercise price of the warrant serving as the consideration for the exercise of
the balance of the warrant.
 
  Notes receivable from issuance of Common Stock arose from the exercise of
stock options. During 1996, the Board of Directors approved the exercise of
stock options held and outstanding by certain key employees in exchange for
promissory notes with a repayment date equal to the original termination date
of the option exercise. The 1,793,250 shares of Common Stock issued upon such
exercise of options were subject to repurchase by the Company based upon
continuation of employment, with vesting and release from the Company's
repurchase right on a cumulative basis from original date of option grant at a
rate of 25% one year after the vesting commencement date and 1/48th of the
shares subject to the original option in equal monthly installments
thereafter. As a result, the Common Stock subject to the notes receivable vest
in a manner identical to the original with respect to options. In connection
with the Company's 1997 restructuring (see Note 11), the vesting and release
from the Company's repurchase right with respect to shares issued upon the
exercise of stock options subject to notes receivable held by certain officers
were accelerated, resulting in full vesting of 76,063 shares to the employees.
Additionally, vesting of 50,000 options to purchase the Company's common stock
issued to a non-continuing director were also accelerated in 1997. The Company
has recorded a compensation charge of $317,000 related to the accelerated
stock and options held by the officers and the director. For purposes of
computing earnings per share, the Common Stock issued subject to notes
receivable are treated as options and are excluded from the calculation of
earnings per share because they are considered antidilutive.
 
  In April 1997, the Company's Board of Directors adopted a shareholders'
rights plan and distributed a dividend of one right (the "Right") to purchase
one one-thousandth of a share of Series A participating Preferred Stock
("Preferred Shares") for each outstanding share of common stock of the
Company. The rights become exercisable per share at an exercise price of
$25.00 ten days after a person or group announces acquisition of 20% or more
of Retix's outstanding common stock or the commencement of a tender offer
which would result in ownership by the person or group of 20% or more of the
outstanding common stock. The Preferred Shares have been approved by the Board
but are not made part of the Company's charter until needed; as a result, the
Preferred Shares have not been formally authorized. The Company will be
entitled to redeem the Rights at $0.01 per right at any time on or before the
tenth day following acquisition by a person or group of 20% or more of the
Company's common stock.
 
  If a person or group acquires 20% or more of the Company's common stock
prior to redemption of the Rights, the Rights will entitle shareholders other
than the potential acquirer to purchase, at the then current exercise price,
that number of shares of the Company's common stock (or, in certain
circumstances as
 
                                      40
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
determined by the board, cash, other property or other securities) having a
market value at that time of twice the exercise price. If, after the tenth day
following acquisition by a person or group of 20% or more of the Company's
common stock, the Company sells more than 50% of its assets or earning power
or is acquired in a merger or other business combination transaction, the
acquirer must assume the obligations under the Rights, and the Rights will
become exercisable to acquire common stock of the acquirer at the discounted
price. Under certain circumstances the Company's board of directors may also
exchange the Rights (other than those owned by the acquirer or its affiliates)
for its common stock at an exchange ratio of one share of common stock per
Right. The Rights expire on April 29, 2007.
 
 Stock Purchase and Stock Option Plans
 
  Under the Company's stock purchase and stock option plans in effect at
December 31, 1997, approximately 7,787,000 shares of Common Stock may be
issued to employees directly or upon exercise of stock options issued to
employees and in certain cases to consultants. The Company has six stock and
option plans that were in effect at December 31, 1997: the 1988 Stock Option
Plan, the 1990 Stock Option Plan for Irish Employees, the 1991 Employee Stock
Purchase Plan, the 1991 Directors' Stock Option Plan, the 1995 Executive Stock
Option Plan and the 1996 Directors' Stock Option Plan. Under the foregoing
option plans, options may be granted at an exercise price not less than the
fair market value of the shares on the date of grant. Options under the 1990
Stock Option Plan for Irish Employees become exercisable at a rate of 25%
after one year from the date of grant and 25% each year thereafter. Options
granted under the 1988 Stock Option Plan and the 1995 Executive Stock Option
Plan generally become exercisable 25% after one year from date of grant, then
ratably 1/48 per month over the remaining thirty-six months based on
continuous employment from the date of grant. The initial options granted to a
director under the 1991 and 1996 Directors' Stock Option Plan become
exercisable 25% on each of the first four anniversaries of the date of grant.
Each subsequent option grant under the Directors' Stock Option Plans becomes
exercisable in whole on the fourth anniversary of the date of grant. All
options expire ten years from the date of grant.
 
  The following summarizes activity in the option plans for the three years
ended December 31, 1997:
 
<TABLE>
<CAPTION>
                                                                WEIGHTED AVERAGE
                                                    NUMBER OF    EXERCISE PRICE
                                                     OPTIONS       PER SHARE
                                                    ----------  ----------------
   <S>                                              <C>         <C>
   Outstanding, January 1, 1995....................  2,727,082       $4.68
     Granted.......................................  2,259,925        2.50
     Exercised.....................................   (371,491)       2.37
     Canceled...................................... (1,291,150)       4.73
                                                    ----------
   Outstanding, December 31, 1995..................  3,324,366        3.43
     Granted.......................................    625,500        3.40
     Exercised..................................... (2,461,241)       4.03
     Canceled...................................... (1,103,241)       3.40
                                                    ----------
   Outstanding, December 31, 1996..................    385,384        4.73
     Granted.......................................     40,000        6.75
     Exercised.....................................    (35,985)       4.40
     Canceled......................................    (92,098)       5.10
                                                    ----------
   Outstanding, December 31, 1997..................    297,301       $4.92
                                                    ==========
</TABLE>
 
  As of December 31, 1997, 1996 and 1995 options to purchase 102,301 shares,
175,384 shares and 709,551 shares, respectively, were exercisable under all
Retix stock option plans. At December 31, 1997, 1,819,779 shares were
available for future grants under all option plans.
 
                                      41
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Additional information regarding options outstanding as of December 31, 1997
is as follows:
 
<TABLE>
<CAPTION>
                                    OPTIONS OUTSTANDING                       OPTIONS EXERCISABLE
                  ------------------------------------------------------- ----------------------------
    RANGE OF        NUMBER    WEIGHTED AVERAGE REMAINING WEIGHTED AVERAGE   NUMBER    WEIGHTED AVERAGE
 EXERCISE PRICES  OUTSTANDING  CONTRACTUAL LIFE (YEARS)   EXERCISE PRICE  EXERCISABLE  EXERCISE PRICE
 ---------------  ----------- -------------------------- ---------------- ----------- ----------------
 <S>              <C>         <C>                        <C>              <C>         <C>
 $2.00-2.13         175,000              8.1                    2.10         40,000          2.09
    4.00             15,000              7.0                    4.00            --            --
  5.00-5.25           2,301              6.8                    5.15          2,301          5.15
    6.75             40,000              9.0                    6.75            --            --
    9.88             45,000              6.0                    9.88         40,000          9.88
    15.50            20,000              5.2                   15.50         20,000         15.50
                    -------                                                 -------
 $2.00-15.50        297,301              7.6                  $ 4.92        102,301        $ 7.83
                    =======                                                 =======
</TABLE>
 
  The 1991 Employee Stock Purchase Plan allows eligible employees (including
officers and employee directors) to purchase Common Stock of the Company
through payroll deductions. Employees are eligible to participate if employed
by the Company for at least twenty hours per week and more than five months
per year. The purchase price per share is the lower of 85% of the fair market
value of the Common Stock at either the beginning or end of the relevant six-
month offering period. The Board of Directors may alter the duration of the
offering periods without shareholder approval.
 
 Subsidiary Stock Option Plans
 
  During 1996, the Company transferred the net assets and employees of its
principal business divisions into wholly owned subsidiaries, and received
Preferred Stock in amounts equivalent to the then-current fair value of the
respective entities. In addition, separate stock option plans were created
whereby options to purchase Common Stock of the respective subsidiaries were
issued to the employees and directors of these subsidiaries. Vesting under the
subsidiary option plans generally reflects the vesting schedule as described
above for the Retix employee and director stock option plans. All options were
issued with an exercise price approximating the fair market value of the
respective subsidiaries' common stock and expire ten years from the date of
grant.
 
  During 1997, the Company's wireless subsidiary was merged into its network
management software subsidiary, Vertel Corporation ("Vertel"). In connection
with this merger, vested options to purchase 416,829 shares of the Company's
wireless subsidiary at $0.25 per share were purchased by Vertel at $0.40 per
share and unvested options were cancelled. The difference between the grant
price and the purchase price per share was recognized as compensation expense
during 1997. During 1996, options to purchase 3,045,547 shares of Vertel were
issued at a weighted average exercise price of $2.56 per share, 53,277 of such
options were canceled at a weighted average exercise price of $1.00 and no
options were exercised. During 1997, options to purchase 1,156,648 Vertel
shares with a weighted average exercise price of $3.12 were issued, 203,565
options with an exercise price of $1.00 were exercised and 597,326 options
with a weighted average exercise price of $2.30 were canceled. Also during
1997, options to purchase 221,500 Vertel shares with an original exercise
price of $6.00 were repriced to $2.50. At December 31, 1997, options to
purchase 1,213,688 shares with a weighted average exercise price of $1.88 were
exercisable under the Vertel option plans. Subject to shareholder approval at
its 1998 shareholders' meeting, the Company intends to exchange each option to
purchase shares of Vertel common stock for options to purchase shares of the
Company's common stock at a ratio of 1.26 shares of the Company's common stock
per share of Vertel common stock originally subject to the option. The
exercise price of such exchanged options is not expected to be less than the
original exercise price per share of Vertel common stock divided by the
exchange ratio.
 
                                      42
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Fair Value Information
 
  In October 1995, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based
Compensation," which was effective for the Company beginning January 1, 1996.
SFAS No. 123 requires expanded disclosures of stock-based compensation
arrangements with employees and encourages (but does not require) compensation
cost to be measured based on the fair value of the equity instrument awarded.
Under SFAS No. 123, the fair value of stock-based awards to employees is
calculated through the use of option pricing models, even though such models
were developed to estimate the fair value of freely tradable, fully
transferable options without vesting restrictions, which significantly differ
from the Company's stock option awards. These models also require subjective
assumptions, including future stock price volatility and expected time to
exercise, which greatly affect the calculated values. Companies are permitted;
however, to continue to apply APB Opinion No. 25, which recognizes
compensation cost based on the intrinsic value of the equity instrument
awarded. The Company has elected to continue to apply APB Opinion No. 25 in
accounting for its stock-based compensation arrangements.
 
  The Company has adopted the disclosure-only provisions of SFAS No. 123. Had
the Company elected to measure compensation cost based on the fair value of
stock options awarded in 1997, 1996 and 1995, the loss from continuing
operations and loss per share would have been $6,964,000 and $0.33,
respectively, for the year ended December 31, 1997, $3,624,000 and $0.18,
respectively, for the year ended December 31, 1996 and $809,000 and $0.05,
respectively, for the year ended December 31, 1995. The weighted average fair
value of options granted during the twelve months ended December 31, 1997,
1996 and 1995 was $4.59, $2.32 and $1.69 per share, respectively. Stock
options issued during 1997, 1996 and 1995 were assumed to be valued using the
Black-Scholes model using a risk-free interest rate of 5.4% in 1997 and 6.0%
in 1996 and 1995, an expected life of 36 months, expected volatility of 107%
and expected dividends of zero. However, because options vest over several
years and grants prior to 1995 are excluded from these calculations, these
amounts may not be representative of the impact on future years earnings,
assuming grants are made in those years.
 
8. EMPLOYEE BENEFIT PLANS
 
  Qualified employees are eligible to participate in the Company's 401(k) tax
deferred savings plan. Individual participants may contribute up to 15% of
their compensation, subject to certain limitations, and the Company may make
discretionary contributions. To date, the Company has made no contributions to
the plan. The Company does not provide any other post retirement benefits to
its employees.
 
                                      43
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
9. OPERATIONS BY GEOGRAPHIC AREA
 
  The Company operates in one industry segment. The following presents a
summary of operations by geographic area (in thousands):
 
<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                     -------------------------
                                                      1997     1996     1995
                                                     -------  -------  -------
   <S>                                               <C>      <C>      <C>
   Net revenues
     U.S. operations................................ $17,722  $14,500  $15,046
     Foreign operations.............................     755    1,657      500
                                                     -------  -------  -------
     Consolidated................................... $18,477  $16,157  $15,546
                                                     =======  =======  =======
     Transfers between operations................... $   715  $   619  $ 1,102
                                                     =======  =======  =======
   Income (loss) from continuing operations
     U.S. operations................................ $(5,429) $(2,835) $ 1,217
     Foreign operations.............................     934      495   (1,814)
                                                     -------  -------  -------
     Consolidated................................... $(4,495) $(2,340) $  (597)
                                                     =======  =======  =======
   Identifiable assets at end of period
     U.S. operations................................ $13,224  $23,370  $21,983
     Foreign operations.............................     226      252      601
                                                     -------  -------  -------
     Consolidated................................... $13,450  $23,622  $22,584
                                                     =======  =======  =======
</TABLE>
 
  Included in U.S. operations are export sales of $6,687,000, $6,837,000 and
$6,743,000 for the years ended 1997, 1996 and 1995, respectively.
 
10. STATEMENT OF CASH FLOWS
 
  Increases (decreases) in operating cash flows arising from changes in assets
and liabilities consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                      ------------------------
                                                       1997     1996    1995
                                                      -------  ------  -------
   <S>                                                <C>      <C>     <C>
   Trade accounts receivable......................... $  (710) $ (472) $ 1,002
   Prepaid expenses and other current assets.........     (85)    396      353
   Accounts payable..................................    (331)    753     (457)
   Accrued wages and related liabilities.............    (243)    523     (217)
   Cash payments for restructuring expenses..........    (200)   (112)  (1,477)
   Other accrued liabilities.........................    (393)  1,180     (973)
   Deferred revenue..................................    (208)     32     (207)
                                                      -------  ------  -------
                                                      $(2,170) $2,300  $(1,976)
                                                      =======  ======  =======
</TABLE>
 
  Cash paid (received) during the years for interest and income taxes is as
follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                                ----------------
                                                                1997 1996   1995
                                                                ---- -----  ----
   <S>                                                          <C>  <C>    <C>
   Interest.................................................... $--  $ --   $474
   Income taxes................................................ $18  $(240) $ 30
</TABLE>
 
                                      44
<PAGE>
 
                                     RETIX
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
11. RESTRUCTURING EXPENSES
 
  As discussed in Note 3, Discontinued Operations, in December 1997, the
Company announced plans to discontinue investment in its broadband access
equipment subsidiary, Sonoma. As a result, the Company's management structure
was consolidated to reflect the reduction of the number of operating
subsidiaries to one. The estimated costs of restructuring recorded in the
financial statements for the year ended December 31, 1997 was $1,816,000 and
included costs of severance pay for three of the Company's officers,
acceleration of vesting for certain officer and director stock options (see
Note 7), facility and asset consolidation, professional fees and other related
charges. It is anticipated these costs will be paid during the first half of
1998. Additionally, during the fourth quarter of 1997, the Company recorded a
reversal of certain 1995 restructuring reserves and accruals totaling
$303,000, resulting in a net restructuring expense recorded for fiscal 1997 of
$1,513,000.
 
  In 1995, the Company announced a major restructuring of its operations,
resulting from the significant downsizing of its internetworking hardware
business unit, later known as Sonoma. The resulting restructuring charge
included costs for exiting certain leased facilities, inventory and fixed
asset write downs, severance payments for terminated employees, foreign office
closure costs and other reserves. The estimated costs of restructuring
recorded in the financial statements for the year ended December 31, 1995 were
$2,277,000. Subsequently, the Company recorded the reversal of excess
restructuring reserves totaling $303,000 and $197,000 recorded in the
financial statements for the years ended December 31, 1997 and 1996,
respectively, primarily as a result of favorable lease exit costs and lower
than anticipated severance costs.
 
  Restructuring expenses and benefit for 1997, 1996 and 1995 are summarized as
follows (in thousands):
 
<TABLE>
<CAPTION>
                                          RESTRUCTURING EXPENSES (BENEFIT)
                                         ------------------------------------
                                            1997         1996        1995
                                         -----------  ----------  -----------
   <S>                                   <C>          <C>         <C>
   Write down of assets to be sold,
    vacated or disposed of
    (in thousands):
     Inventory.......................... $       --   $      --   $       120
     Fixed assets.......................         --          (25)         181
     Facilities.........................         --          (98)         920
   Severance and related costs..........       1,025         (59)         594
   Stock option acceleration............         317         --           --
   Professional fees....................         176         --           --
   Foreign subsidiary closings..........         --          --           200
   Other................................          (5)        (15)         262
                                         -----------  ----------  -----------
                                              $1,513       $(197)      $2,277
                                         ===========  ==========  ===========
</TABLE>
 
  With respect to the 1997 restructuring charge, substantially all of the
reserves remaining as of December 31, 1997, are expected to be utilized in
1998, requiring the disbursement of approximately $1,499,000 in cash. As of
December 31, 1997, substantially all reserves related to the 1995
restructuring charge, except for $149,000 related to costs for final closures
of certain non-operating foreign subsidiaries, had been utilized or reversed.
 
                                      45
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT
 
TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF RETIX:
 
  We have audited the accompanying consolidated balance sheets of Retix and
its subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of operations, shareholders' equity, and cash flows
for each of the three years in the period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Retix and its subsidiaries at
December 31, 1997 and 1996, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1997 in
conformity with generally accepted accounting principles.
 
Deloitte & Touche LLP
 
Los Angeles, California
January 23, 1998, except for the last paragraph of Note 2,
 as to which the date is February 11, 1998
 
                                      46
<PAGE>
 
RESULTS OF OPERATIONS--UNAUDITED QUARTERLY FINANCIAL INFORMATION
 
  The following tables present unaudited quarterly financial information for
the two years ended December 27, 1997. In the opinion of management, this
information contains all adjustments, consisting only of normal, recurring
adjustments, necessary for a fair presentation thereof. The operating results
are not necessarily indicative of results for any future periods.
 
<TABLE>
<CAPTION>
                                                   1997 QUARTERS ENDED
                                              ---------------------------------
                                                         JUNE   SEPT.
                                              MARCH 29    28      27    DEC. 27
                                              --------  ------  ------  -------
                                                (IN THOUSANDS, EXCEPT PER
                                                       SHARE DATA)
<S>                                           <C>       <C>     <C>     <C>
Quarterly results of continuing operations:
  Net revenues............................... $ 3,774   $5,870  $3,694  $ 5,140
  Gross profit...............................   2,672    4,884   2,594    3,848
  Restructuring expense......................     --       --      --     1,513
  Operating income (loss) from continuing
   operations................................  (2,630)     326    (866)  (1,494)
  Net income (loss) from continuing
   operations................................  (2,667)     399    (826)  (1,401)
  Net income (loss) from continuing
   operations per common and common
   equivalent share.......................... $ (0.13)  $ 0.02  $(0.04) $ (0.06)
                                              =======   ======  ======  =======
<CAPTION>
                                                   1996 QUARTERS ENDED
                                              ---------------------------------
                                                         JUNE   SEPT.
                                              MARCH 30    29      28    DEC. 28
                                              --------  ------  ------  -------
                                                (IN THOUSANDS, EXCEPT PER
                                                       SHARE DATA)
<S>                                           <C>       <C>     <C>     <C>
Quarterly results of continuing operations:
  Net revenues............................... $ 3,778   $3,752  $4,803  $ 3,824
  Gross profit...............................   2,981    3,084   4,098    3,018
  Restructuring benefit......................     --       --      --      (197)
  Operating loss from continuing operations..    (428)    (788)     (4)  (1,711)
  Net income (loss) from continuing
   operations................................    (254)    (626)    352   (1,812)
  Net income (loss) from continuing
   operations per common and common
   equivalent share.......................... $ (0.01)  $(0.03) $ 0.02  $ (0.09)
                                              =======   ======  ======  =======
</TABLE>
 
  The Company's future revenues and operating results may be subject to
quarterly fluctuations as a result of factors such as the timing of
significant licenses of, or orders for, the Company's products, shifts in
product mix, changes in distribution channels, the introduction of new
products by the Company or its competitors, competitive pricing, changes in
product demand resulting from fluctuations in foreign currency exchange rates,
decreased European business activity during the summer months and changes in
operating and material costs. Accordingly, quarter-to-quarter comparisons
should not be relied upon as indicators of future performance. See "Business--
Risk Factors."
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
  None.
 
                                      47
<PAGE>
 
                                   PART III
 
  Certain information required by Part III is omitted from this report because
the Registrant will file a definitive proxy statement (within 120 days after
the end of its fiscal year) pursuant to Regulation 14(A) as promulgated by the
U.S. Securities and Exchange Commission (the "Proxy Statement") for its annual
meeting of shareholders to be held March 31, 1998, and the information
included therein is incorporated herein by reference to the extent detailed
below.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  Information with respect to directors of Retix is incorporated by reference
from the information under the caption "Election of Directors--Nominees" in
the Registrant's Proxy Statement.
 
  Information with respect to executive officers of Retix is set forth in Part
I in this Annual Report on Form 10-K under "Item I--Business--Executive
Officers of the Company."
 
ITEM 11. COMPENSATION OF EXECUTIVE OFFICERS
 
  Incorporated by reference from the information under the captions "Report of
the Compensation Committee--Chief Executive Officer Compensation" and
"Transactions with Management and Others" in the Registrant's Proxy Statement.
 
ITEM 12. COMMON STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  Incorporated by reference from the information under the caption "Common
Stock Ownership of Certain Beneficial Owners and Management" in the
Registrant's Proxy Statement.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  Incorporated by reference from the information under the captions "Report of
the Compensation Committee--Executive Officer Compensation" and "Transactions
with Management and Others" in the Registrant's Proxy Statement.
 
                                      48
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a)1. The financial statements and supplementary financial information
listed below are filed as part of this annual report.
 
<TABLE>
<CAPTION>
                                                                             PAGE
                                                                             ----
<S>                                                                          <C>
Consolidated Balance Sheets at December 31, 1996 and December 31, 1997.....   29
Consolidated Statements of Operations for each of the three years in the
 period ended December 31, 1997............................................   30
Consolidated Statements of Shareholders' Equity for each of the three years
 in the period ended December 31, 1997.....................................   31
Consolidated Statements of Cash Flows for each of the three years in the
 period ended December 31, 1997............................................   32
Notes to Consolidated Financial Statements.................................   33
Independent Auditors' Report...............................................   46
 
  2. The supplementary financial information listed below are filed as part of
this annual report.
 
Unaudited Quarterly Financial Information..................................   47
Schedule filed as part of Form 10-K:
  Schedule II--Valuation and Qualifying Accounts...........................  S-1
  Independent Auditors' Report on Supplemental Schedule....................  S-2
</TABLE>
 
  Schedules have been omitted since the required information is not present in
amounts sufficient to require submission of the schedules, or because the
information required is included in the consolidated financial statements.
 
  3. Exhibits included herein, numbered in accordance with Item 601 of
   Regulation S-K.
 
<TABLE>
<CAPTION>
 NUMBER                               DESCRIPTION
 ------                               -----------
 <C>    <S>
  3.3   Amended and Restated Articles of Incorporation of the Registrant.(5)
  3.4   Bylaws of the Registrant, as amended to date.(13)
 10.2   1988 Stock Option Plan and forms of option agreements thereunder.(6)
        1990 Stock Option Plan for Irish Employees and form of option agreement
 10.3   thereunder.(1)
 10.4   1991 Directors' Stock Option Plan and forms of option agreements
        thereunder, as amended to date.(8)
        1991 Employee Stock Purchase Plan and form of subscription agreement
 10.5   thereunder.(3)
 10.6   Form of Indemnification Agreement.(2)
 10.22  Lease Agreement between the Registrant and Moorpark Associates, a
         California Limited Partnership, dated February 5, 1993.(4)
 10.27  Lease Agreement between the Registrant and OMA El Segundo Properties, a
         California general partnership, dated May 23, 1995.(7)
 10.28  Employment Agreement between M.Y. Stephan and Retix, dated September
        27, 1995.(7)
 10.29  Employment Agreement between Philip Mantle and Retix, dated November 1,
        1995.(7)
 10.30  Common Stock and Warrant Purchase Agreement by and between Retix and
         Sierra Ventures V.LP., dated January 30, 1996.(7)
 10.31  Master Agreement dated February 28, 1996 for Spin-Off of Open Systems
         Interconnection Technology between Telaware Corporation and Retix.(7)
 10.32  1996 Directors' Stock Option Plan and forms of option agreement
        thereunder.(13)
 10.33  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and M.Y. Stephan, dated January 30, 1996.(8)
</TABLE>
 
 
                                      49
<PAGE>
 
<TABLE>
<CAPTION>
 NUMBER                               DESCRIPTION
 ------                               -----------
 <C>    <S>
 10.34  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and M.Y. Stephan, dated March 18, 1996.(8)
 10.35  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and M.Y. Stephan, dated March 18, 1996.(8)
 10.36  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Philip Mantle, dated January 30, 1996.(8)
 10.37  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Philip Mantle, dated March 18, 1996.(8)
 10.38  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated March 18, 1996.(8)
 10.39  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated January 30, 1996.(8)
 10.40  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated February 21, 1996.(8)
 10.41  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated March 26, 1996.(8)
 10.42  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated March 26, 1996.(8)
 10.43  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated March 26, 1996.(8)
 10.44  Form of Exercise Notice and Stock Purchase Agreement between the
         Company and Steven M. Waszak, dated March 26, 1996.(8)
 10.45  Sublease Agreement dated May, 1996 between Value Behavioral Health and
        Retix.(9)
 10.46  Master Agreement between Retix and Internetworking Solutions dated May
        31, 1996.(9)
 10.47  Master Agreement between Retix and Wireless Solutions dated May 31,
        1996.(9)
 10.48  Lease Agreement between the Registrant and Nomura-Warner Center
         Associates, L.P., dated November 26, 1996.(10)
 10.49  Stock Transfer Agreement between Retix, Vertel Corporation and Wireless
         Solutions dated June 10, 1997.(11)
 10.50  Surrender of Lease between Cofton Irish Investments and Retix B.V.,
        dated August 21, 1997.(12)
 10.51  Sub-Sublease Agreement between TSN, L.L.C., and Retix, dated August 22,
        1997.(12)
 10.52  Executive Separation Agreement between Retix and M.Y. Stephan dated
        December 27, 1997. (13)
 10.53  Executive Separation Agreement between Retix and Philip Mantle dated
        December 27, 1997. (13)
 10.54  Executive Separation Agreement between Retix and Steve Waszak dated
        December 27, 1997. (13)
 10.55  Amended and Restated Articles of Incorporation of Sonoma Systems, Inc.,
         and related documents dated January 7, 1998.(13)
 10.56  Sub-sublease between Retix and Sonoma Systems, Inc., dated December 28,
        1997.(13)
 21.1   Subsidiaries of the Registrant.(13)
 24.1   Independent Auditors' Consent.(13)
 25.1   Power of Attorney (see page 52).(13)
 27.1   Financial Data Schedule.(13)
</TABLE>
--------
 (1) Incorporated by reference to identically numbered exhibits filed in
     response to Item 14(a)(3), "Exhibits," of the Registrant's Annual Report
     on Form 10-K for the fiscal year ended December 28, 1991.
 
                                      50
<PAGE>
 
 (2) Incorporated by reference to identically numbered exhibits filed in
     response to Item 16(a), "Exhibits," of the Registrants Registration
     Statement on Form S-1 and Amendment No. 1 thereto (File No. 33-43544)
     which became effective on December 9, 1991.
 
 (3) Incorporated by reference to identically numbered exhibits filed in
     response to Item 6(a), "Exhibits," of the Registrant's Quarterly Report
     on Form 10-Q for the fiscal quarter ended September 26, 1992.
 
 (4) Incorporated by reference to identically numbered exhibits filed in
     response to Item 14(a)(3), "Exhibits," of the Registrant's Annual Report
     on Form 10-K for the fiscal year ended January 2, 1993.
 
 (5) Incorporated by reference to identically numbered exhibit filed in
     response to Item 6(a), "Exhibits," of the Registrant's Quarterly Report
     on Form 10-Q for the fiscal quarter ended October 1, 1994.
 
 (6) Incorporated by reference from Registrant's Registration Statement on
     Form S-8 (No. 33-82154) filed on July 28, 1994.
 
 (7) Incorporated by reference to identically numbered exhibits filed in
     response to Item 14(a)(3), "Exhibits," of the Registrant's Annual Report
     on Form 10-K for the fiscal year ended December 31, 1995.
 
 (8) Incorporated by reference to identically numbered exhibit filed in
     response to Item 6(a), "Exhibits," of the Registrant's Quarterly Report
     on Form 10-Q for the fiscal quarter ended March 30, 1996.
 
 (9) Incorporated by reference to identically numbered exhibit filed in
     response to Item 6(a), "Exhibits," of the Registrant's Quarterly Report
     on Form 10-Q for the fiscal quarter ended June 30, 1996.
 
(10) Incorporated by reference to identically numbered exhibits filed in
     response to Item 14(a)(3), "Exhibits," of the Registrant's Annual Report
     on Form 10-K for the fiscal year ended December 28, 1996.
 
(11) Incorporated by reference to identically numbered exhibit filed in
     response to Item 6(a), "Exhibits," of the Registrant's Quarterly Report
     on Form 10-Q for the fiscal quarter ended June 28, 1997.
 
(12) Incorporated by reference to identically numbered exhibit filed in
     response to Item 6(a), "Exhibits," of the Registrant's Quarterly Report
     on Form 10-Q for the fiscal quarter ended September 27, 1997.
 
(13) Filed herewith.
 
  (b) Reports on Form 8-K
 
  The Company filed a Current Report on Form 8-K on November 11, 1997 with
regard to the exercise by Sierra Ventures V, L.P., of its warrant to purchase
the Company's Common Stock.
 
                                      51
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report on Form 10-K to be signed on its behalf
by the undersigned, thereunto duly authorized.
 
                                          RETIX
 
                                                    /s/ James Brill
Date: February 26, 1998                   By: _________________________________
                                                        James Brill
                                                Vice President, Finance &
                                                      Administration
                                               and Chief Financial Officer
 
  KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Bruce W. Brown and James Brill, jointly and
severally, his attorneys-in-fact, each with the power of substitution, for him
in any and all capacities, to sign any amendments to this Report on Form 10-K,
and to file the same, with exhibits thereto and other documents in connection
therewith with the Securities and Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his substitute or
substitutes may do or cause to be done by virtue hereof.
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report on Form 10-K has been signed by the following persons in the capacities
and on the date indicated.
 
<TABLE>
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----
<S>                                  <C>                           <C>
       /s/ Bruce W. Brown            President, Chief Executive    February 26, 1998
____________________________________  Officer and Director
          Bruce W. Brown              (Principal Executive
                                      Officer)
        /s/ James Brill              Vice President of Finance     February 26, 1998
____________________________________  and Administration and
            James Brill               Chief Financial Officer
                                      (Principal Financial and
                                      Accounting Officer)
     /s/ Jeffrey M. Drazan           Director                      February 26, 1998
____________________________________
         Jeffrey M. Drazan
       /s/ Neil J. Hynes             Director                      February 26, 1998
____________________________________
           Neil J. Hynes
     /s/ Craig W. Johnson            Director                      February 26, 1998
____________________________________
         Craig W. Johnson
        /s/ Joe Stephan              Director                      February 26, 1998
____________________________________
            Joe Stephan
   /s/ Gilbert P. Williamson         Director                      February 26, 1998
____________________________________
       Gilbert P. Williamson
</TABLE>
 
                                      52
<PAGE>
 
                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
 
                  YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
 
<TABLE>
<CAPTION>
                                         ADDITIONS
                          BALANCE  ---------------------
                            AT                  CHARGES
                         BEGINNING  CHARGED TO     TO
                            OF       COSTS &     OTHER                 BALANCE AT
      DESCRIPTION         PERIOD   EXPENDITURES ACCOUNTS DEDUCTIONS   END OF PERIOD
      -----------        --------- ------------ -------- ----------   -------------
<S>                      <C>       <C>          <C>      <C>          <C>
Allowance for doubtful
 accounts and sales
 returns:
  Year ended December
   31, 1997............. $368,000    $249,000             $165,000(a)   $452,000
  Year ended December
   31, 1996............. $ 91,000    $371,000             $ 94,000(a)   $368,000
  Year ended December
   31, 1995............. $    --     $ 91,000             $    --       $ 91,000
</TABLE>
--------
(a) Write-off of uncollectible accounts, net of recoveries.
 
                                      S-1
<PAGE>
 
             INDEPENDENT AUDITORS' REPORT ON SUPPLEMENTAL SCHEDULE
 
TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF RETIX:
 
  We have audited the consolidated financial statements of Retix and
subsidiaries as of December 31, 1997 and 1996, and for each of the three years
in the period ended December 31, 1997, and have issued our report thereon
dated January 23, 1998, except for the last paragraph of Note 2, as to which
the date is February 11, 1998; such report is included elsewhere in this Form
10-K. Our audits also included the financial statement schedule of Retix and
subsidiaries, listed in Item 14. This financial statement schedule is the
responsibility of Retix's management. Our responsibility is to express an
opinion based on our audits. In our opinion, such financial statement
schedule, when considered in relation to the basic financial statements taken
as a whole, presents fairly in all material respects the information set forth
therein.
 
Deloitte & Touche LLP
 
Los Angeles, California
January 23, 1998
 
                                      S-2