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

                                    FORM 10-K

|X|  ANNUAL  REPORT  PURSUANT  TO  SECTION  13 OR 15(d) OF THE  SECURITIES
     EXCHANGE ACT OF 1934 
     For the fiscal year ended December 31, 1998

|_|  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: 0-23110

                            DIGITAL LINK CORPORATION
             (Exact name of registrant as specified in its charter)

           California                                       77-0067742
(State or other jurisdiction of                           (IRS Employer
 incorporation or organization)                       Identification Number)

           217 Humboldt Court                                 94089
             Sunnyvale, CA                                 (Zip Code)
(Address of principal executive offices)

Registrant's telephone number, including area code:  (408) 745-6200

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

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, 
                                                             no par value
                                                             (Title of class)

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

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

The  aggregate  market value of the voting stock held by  non-affiliates  of the
registrant as of March 26, 1999, was approximately $29,134,358.

The number of shares  outstanding of the  registrant's  Common Stock as of March
26, 1999, was 8,127,622 shares.

                      DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the definitive proxy statement (the "Definitive Proxy Statement") to
be filed with the Securities and Exchange  Commission  relative to the Company's
annual  meeting  of  shareholders  to be held June 7, 1999 are  incorporated  by
reference in Part III of this Form 10-K.

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<PAGE>


                            DIGITAL LINK CORPORATION

                           ANNUAL REPORT ON FORM 10-K

                      For the Year Ended December 31, 1998


                                TABLE OF CONTENTS


Form 10-K
 Item No.                      Name of Item                                Page
 --------                      ------------                                ----

PART I
------
 Item 1.  Business.......................................................... 3
 Item 2.  Properties........................................................ 10
 Item 3.  Legal Proceedings................................................. 11
 Item 4.  Submission of Matters to a Vote of Security Holders............... 11

PART II
-------
 Item 5.  Market for Registrant's Common Equity and Related Stockholder
               Matters...................................................... 12
 Item 6.  Selected Financial Data........................................... 12
 Item 7.  Management's Discussion and Analysis of Financial Condition and
               Results of Operations........................................ 13
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk........ 25
 Item 8.  Financial Statements and Supplementary Data....................... 26
 Item 9.  Changes in and Disagreements with Accountants on Accounting and 
          Financial Disclosure.............................................. 47

PART III
--------
 Item 10. Directors and Executive Officers of the Registrant................ 47
 Item 11. Executive Compensation............................................ 47
 Item 12. Security Ownership of Certain Beneficial Owners and Management.... 47
 Item 13. Certain Relationships and Related Transactions.................... 47

PART IV
-------
 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.. 48

               Signatures................................................... 50



<PAGE>


                                     PART I
ITEM 1.  BUSINESS

     Except  for the  historical  statements  contained  herein,  this Form 10-K
contains  forward-looking  statements  within the  meaning of Section 27A of the
Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the
Securities  Exchange  Act of  1934,  as  amended  (the  "Exchange  Act").  These
forward-looking  statements  involve a number of risks,  known and unknown,  and
uncertainties,  such as the loss of, or  difference  in actual from  anticipated
levels  of  purchases  from,  the  Company's  major  customers,  the  impact  of
competitive  products  and  pricing,  the  ability  to retain  and  attract  key
personnel  and  other  risks  which are  described  throughout  this Form  10-K,
including under the sections titled  "Products and  Technology,"  "Customers and
End  Users,"   "Research  and  Development,"   "Manufacturing,"   "Competition,"
"Intellectual  Property and Other Proprietary  Rights" and "Employees" in Item 1
hereof and within  "Management's  Discussion and Analysis of Financial Condition
and Results of  Operations,"  including  under the title "Other Factors That May
Affect  Future  Operating  Results,"  in Item 7 of this Form  10-K.  The  actual
results that the Company achieves may differ materially from any forward-looking
statements due to such risks and uncertainties.
     When  used in this  Form  10-K  words  such as  "believes,"  "anticipates,"
"expects,"   "intends,"  and  similar   expressions  are  intended  to  identify
forward-looking  statements, but are not the exclusive means of identifying such
statements.  Readers  are urged to  carefully  review and  consider  the various
disclosures  made by the  Company in this  report and in the  Company's  reports
filed  with the  Securities  and  Exchange  Commission  that  attempt  to advise
interested  parties  of the risks and  factors  that may  affect  the  Company's
business.
     Due  to  all   the   foregoing   factors,   the   Company   believes   that
period-to-period  comparisons of its results of operations  are not  necessarily
meaningful and should not be relied upon as an indication of future performance.
Similarly,  past performances are not necessarily  indicative of future results.
It is possible, in some future quarters, the Company's operating results will be
below the  expectations of stock market  analysts and investors.  In such event,
the price of the  Company's  Common Stock would likely be  materially  adversely
affected.  Consequently,  the purchase or holding of the Company's  Common Stock
involves an extremely high degree of risk.

Overview

     The Company  designs,  manufactures,  markets and supports a broad range of
digital  wide-area  network  ("WAN") access  products for global  networks.  The
Company's products are used by service providers as infrastructure equipment and
by business enterprises for connectivity to WAN services,  such as leased lines,
frame  relay,  Internet  Protocol  ("IP"),  Switched  Multimegabit  Data Service
("SMDS"),  Asynchronous  Transfer  Mode  ("ATM")  and  Digital  Subscriber  Line
("DSL").   The  Company's  products  allow  local  area  network   ("LAN")-based
internetworking  devices,  such as routers and switches, to access WANs and also
integrate  data with  digitized  voice and video traffic for more efficient line
utilization.  Digital  Link's  products  are used both in the  customer  premise
equipment  ("CPE")  environment  and in the networks of  interexchange  carriers
("IXCs"),  Internet  service  providers  ("ISPs") and telephone  companies.  The
Company believes it is a leader in the WAN access products market because of its
broad range of products and its diverse sales channels.  The Company markets and
sells its products in North  America,  Europe,  South America and Asia primarily
through its direct  sales  force,  value-added  resellers  ("VARs") and original
equipment manufacturers ("OEMs").
     The Company was incorporated in California in 1985. Its principal executive
offices are located at 217 Humboldt Court,  Sunnyvale,  California 94089 and its
web site is  http://www.dl.com.  Information  included on the Company's web site
does not constitute part of this Form 10-K.



<PAGE>


Industry Background

     The growing reliance on enterprise-wide  networks to facilitate the sharing
of information  has created an environment in which the linkage of multiple LANs
over wide area networks is critical to daily operations.  Two types of WANs have
developed to satisfy  internetworking  needs:  private WANs, which are generally
based on dedicated leased lines; and public WANs, which are based on centralized
switching networks that route data to the proper  destination.  In private WANs,
the  functions  of  switching,  routing and  multiplexing  are  performed on the
organization's premises utilizing  customer-owned  equipment and dedicated lines
leased from  telephone  companies and IXCs. As an  alternative  to private WANs,
telephone  companies,  ISPs and IXCs offer public WAN services.  Companies  that
provide  products for  connecting  LAN-based data networks to WANs could support
both private and public WANs,  including public WANs based on frame relay, SMDS,
ATM and DSL technologies.
     In order for LANs to be interconnected to WANs, an interface is required to
condition LAN-based data to a format appropriate for transmission over WANs. The
Company  believes  equipment  providers  addressing  the WAN access  market must
develop product solutions  flexible enough to respond to the changing  standards
and network requirements associated with emerging WAN technologies.

Products and Technology

     The Company's principal products offer 56/64Kbps,  T1/E1, nxT1/E1 and T3/E3
access to public and private WANs using Internet, Frame relay, SMDS, ATM and DSL
technology.  The Company's  products range from simple  desktop or  rack-mounted
units for smaller  sites to  intelligent  multi-processor  systems  that support
multiple lines and integrate data with digitized  voice and video for larger and
more complex sites.  Enterprises  use these  products to enable  internetworking
equipment  such as routers and switches to access WANs.  The Company's  products
may also be used within the  networks of telephone  companies,  ISPs and IXCs to
provide  access to their  backbone  networks.  The list prices of the  Company's
products generally range from $300 to $15,000.
     The  Company's  WAN access  products  are  classified  as  Digital  Service
Units/Channel  Service  Units  ("DSUs/CSUs"),  access  multiplexers  and inverse
multiplexers.  The Company's DSUs/CSUs generally provide the interface between a
single data port and a single WAN line, and its access  multiplexers are used to
multiplex  multiple  data,  voice or  video  ports  over one or more WAN  lines.
Digital Link's inverse  multiplexers  break down  high-speed  data from a single
source for transmission over multiple T1 WAN lines.
     The Company  introduced its first T1 access  products in 1985. In 1993, the
Company  introduced  the second  generation  of its T1/E1 access  products  with
certain  enhanced  features.  Known as the Encore  product line,  these products
provide  interfaces  to Ethernet  and Token Ring  LAN-based  data  traffic  from
internetworking  devices and connects  them to  dedicated  or Frame  relay-based
56Kbps and T1/E1 lines.  In 1998, the Company  released T1 and 56/64Kbps  access
products that include improved network  management  capabilities such as in-band
management and integrated  performance  monitoring ("IPM").  These products,  in
conjunction  with  Digital  Link  WANview  or  NetScout  Systems,  Inc.  network
management system, have allowed the Company to market a comprehensive enterprise
management solution.
     In 1993,  the  Company  introduced  the  DL3800 T1 inverse  multiplexer  in
response to marketplace demand for a method of transporting  information at data
rates faster than T1 without the expense and availability issues associated with
T3 lines.  The DL3800  accepts  data from a single  high-speed  data  device and
prepares it for  transmission  over as many as eight T1 lines. In June 1996, the
Company introduced an international  version of its inverse  multiplexer product
line.
     The Company  introduced its first T3 access products in 1990. The Company's
T3/E3 DSUs and multiplexers  include the DL3100 T3/E3 Access  Multiplexer  which
connects  networking  equipment to T3/E3 lines and is  available  with single or
multiple ports. In May 1995, the Company introduced the DL3900 multiplexer shelf
that allows customers to reduce the shelf space needed when installing  multiple
inverse  multiplexers  in the  same  location.  It  houses  both T1 and  inverse
multiplexer  modules and T3 access multiplexer  modules to provide  connectivity
between central and DL3100 or DL3800 units at remote sites.
     The Company also offers SMDS and ATM access products.  In 1991, the Company
began shipping the DL200, which is a DSU/CSU used to access public SMDS networks
that operate over T1/E1 lines.  In 1992,  the Company began shipping the DL3200,
which is a DSU used to access  public SMDS and ATM  networks  that  operate over
T3/E3 lines.
     In support of the ATM  infrastructure  and to complement the large capacity
ATM switches necessary for such an infrastructure, the Company had developed its
DL7100 product (formerly known as the W/ATM GateWay Product ) to connect non-ATM
traffic  and slower  speed ATM traffic to these  high-speed  ATM  switches.  The
DL7100 was a high-capacity  system that  multiplexes  and switches voice,  data,
video, low-speed cell and Frame relay for ATM transmissions.  In September 1997,
the  Company  acquired  certain  assets  of  Performance   Telecom   Corporation
("Performance Telecom"). Performance Telecom developed asymmetrical, symmetrical
and  rate-adaptive  DSL  products.   With  the  DSL  technology   acquired  from
Performance  Telecom,  the Company  developed a DSL interface for the DL7100. In
April 1998, the Company  entered into an Asset Sale Agreement (the  "Agreement")
with Semaphore  Communications  Corporation  ("Semaphore").  Semaphore developed
security   management  and  virtual  private   network   ("VPN")   products  for
Internet/intranet  and Frame relay applications.  In September 1998, the Company
discontinued development on the DL7100 and Semaphore product lines. The decision
to terminate these projects was in response to slower than expected  development
of the DL7100 DSL and VPN markets.
     The Company believes that network  reliability and management are among the
most important  factors  considered by users when selecting a network  equipment
supplier.  In order to  maximize  network  reliability,  the  Company  has built
monitoring  and  diagnostic  tools into all of its  products.  In addition,  the
Company offers access products with Simple Network Management Protocol ("SNMP"),
a standards-based  network management  system,  in-band management and IPM. SNMP
provides a set of processes and  procedures to manage all elements of a network,
allowing a user to manage and control  the entire  network  with one  management
system.  In-band  management  and IPM are  management  solutions used to improve
network management.
     The Company also provides an  SNMP-based  graphical  user  interface in its
WANview  technology  solutions.  WANview network management systems help service
providers  achieve  high levels of service,  increased  network  efficiency  and
reliability  for improved  operations  because they can configure,  maintain and
test the Company's products.  The Company's  Management Access Processor ("MAP")
allows  customers  to manage  Digital Link  products  via a direct  Ethernet LAN
interface.   This   cost-effective   interface   provides  a  management  access
alternative independent of routers or terminal servers.
     The  markets  for  the  Company's   products  are  characterized  by  rapid
technological advances,  product obsolescence,  changes in customer requirements
and evolving  regulatory  requirements  and industry  standards.  The  Company's
future prospects will depend in part on its ability to enhance the functionality
of its existing WAN access products in a timely manner and to identify,  develop
and achieve market  acceptance of new products that address new technologies and
meet  customer  needs in the WAN access  market.  Any  failure by the Company to
anticipate or to respond  adequately  to  competitive  solutions,  technological
developments in its industry,  changes in customer  requirements,  or changes in
regulatory  requirements or industry standards, or any significant delays in the
development, introduction or shipment of products, could have a material adverse
affect  on  the  Company's  business  and  operating  results.  There  can be no
assurance  that  the  Company's  product  development  efforts  will  result  in
commercially  successful  products  or that  product  delays  will not result in
missed  market  opportunities.   In  addition,   customers  could  refrain  from
purchasing  the  Company's  existing  products  in  anticipation  of new product
introductions by the Company or its competitors.  New products could also render
certain of the  Company's  existing  products  obsolete.  Either of these events
could materially  adversely affect the Company's business and operating results.
See "Management's  Discussion and Analysis of Financial Condition and Results of
Operations -- Other Factors That May Affect Future Operating  Results -- Company
Must Respond to Technological Change" in Item 7 of this Form 10-K.

Customers and End Users

     Digital  Link's  customers  and end users are  diverse and  represent  many
industries.  End users of private WANs that  incorporate  the  Company's  access
products, as well as telephone companies,  ISPs and IXCs that either incorporate
the Company's  products  within their public  networks or purchase the Company's
access products for resale to end users,  include major interexchange  carriers,
the  Regional  Bell   Operating   Companies   ("RBOCs"),   major   domestic  and
international  carriers,   industrial,   electronics  and  other  companies  and
governments, universities and utilities.
     The Company sells a majority of its products to a relatively limited number
of telephone  companies,  VARs,  OEMs and end users. In 1998, 1997 and 1996, net
sales to MCI represented  approximately 11%, 20% and 13%,  respectively,  of the
Company's net sales. In addition,  net sales to Cisco Systems,  Inc. during 1998
were 10% of the  Company's  net sales and net  sales to BBN  Planet  Corporation
during 1996 were 13% of the Company's net sales.  There can be no assurance that
the Company's  current  customers will continue to place orders with the Company
or that the Company will be able to obtain orders from new  customers.  The loss
of, or  difference  in actual from  anticipated  levels of purchases  from,  the
Company's  major  customers  have in the past  adversely  affected the Company's
operating  results  and could  continue to do so in the  future.  A  significant
portion of the Company's  business is derived from substantial  orders placed by
large  end  users  and  telephone  companies,  and the  timing  of such  orders,
including  the  completion  of the  build out of  carrier  and  network  service
providers'  infrastructures,  could cause material fluctuations in the Company's
business and operating results.  For example,  in the fourth quarter of 1997 and
in the second  quarter of 1998,  the Company had lower  operating  results  than
expected  due in part to a weaker than  expected  demand from  certain  domestic
carrier  customers,  including MCI. Other factors that may cause fluctuations in
the Company's  operating results include,  but are not limited to, the timing of
new product  announcements and introductions by the Company and its competitors,
market acceptance of new or enhanced versions of the Company's products, changes
in the  product  mix sold  toward  narrowband  products  that yield  lower gross
margins, seasonal capital spending patterns of large domestic customers, changes
in sales volumes through the Company's distribution  channels,  availability and
cost  of  components  from  the  Company's  suppliers  and  economic  conditions
generally or in various  geographic  areas. In addition,  the Company's  expense
levels are based in part on its  expectations  of future  revenue.  The  Company
operates with limited order backlog,  and a substantial majority of its revenues
in each quarter result from orders booked in that quarter. If revenue levels are
below  expectations,  the Company  may be unable to adjust  spending in a timely
manner which would adversely affect operating results. A significant  portion of
the Company's business is very price competitive, which has in the past and will
in the future require the Company to lower its prices, resulting in fluctuations
in the Company's  business and operating results.  See "Management's  Discussion
and  Analysis of Financial  Condition  and Results of  Operations  -- Results of
Operations -- Net Sales," " -- Quarterly Consolidated Results of Operations" and
" -- Other Factors That May Affect Future Operating Results -- Operating Results
May Fluctuate; Absence of Significant Backlog" in Item 7 of this Form 10-K.



<PAGE>


Sales and Marketing

     The Company  primarily  markets its  products  worldwide  directly to IXCs,
ISPs,  large end users and RBOCs and indirectly  primarily  through a network of
VARs and OEMs to accommodate specific markets and customer support requirements.
The  Company's  sales force focuses on (i) U.S. end users,  VARS and ISPs,  (ii)
U.S.  &  Canadian  IXCs  and   telephone   companies   ("carriers")   and  (iii)
international  customers.  Each  of  these  focus  areas  include  one  or  more
field-based  system engineers to provide  technical sales support.  In addition,
the Digital Link sales organization  receives support from various groups within
the Company such as the marketing department, which is responsible,  among other
things, for product marketing, customer service, and marketing communications.

     U.S. End Users, VAR and ISPs

     Sales to U.S. end users are  generally  made through the  Company's  direct
sales force and indirectly through VARs. Thus, the U.S. end users sales group is
primarily responsible for developing and maintaining relationships with selected
end users and for  supporting  the sales  activities of its VARs.  The Company's
agreements  with its VARs  generally  have  terms of 12 months,  are  subject to
renewal by mutual  agreement and provide for discounts  from the Company's  list
prices for products  based on the expected  annual sales volumes and require the
Company to provide sales and application  engineering support. The U.S. end user
sales group operates through the Company's headquarters in Sunnyvale, California
and seven other sales offices.

     Carriers

     Digital Link's  carrier sales force focuses on developing  and  maintaining
relationships  with  carriers in the U.S.  and Canada and on  understanding  the
network deployment  strategies of these carriers.  Products sold to carriers may
be used (i) within a carrier's  network in  conjunction  with the  provision  of
their  services,  (ii) for resale in conjunction  with a carrier's  provision of
services to an end user,  or (iii) to satisfy the needs of a carrier's  internal
management  information  systems,  where  the  carrier  is an  end  user  of the
products.  The Company has entered into agreements with certain  carriers in the
United States and Canada to purchase its products.  However, these agreements do
not  obligate the  carriers to purchase  any minimum  quantity of the  Company's
products.

     International Customers

     Sales to  international  customers  are primarily  made through  OEMs,  the
Company's direct sales force and selected VARs. International VARs authorized to
sell the  Company's  products are located in several  countries  within  Europe,
South America and Asia. Support for the Company's products sold  internationally
is provided by the Company or its  authorized  VARs.  The Company  currently has
international sales offices in the United Kingdom and Germany.

Customer Support

     The Company believes that a high level of continuing service and support is
integral to its objective of developing and maintaining long-term  relationships
with its customers. The Company's customer support personnel are responsible for
servicing the Company's  products and provide  installation,  technical training
and post-sales  support.  The Company's products generally have a warranty of at
least 2 years and some CPE products have lifetime warranties. The Company offers
free telephone  support during normal  business  hours.  The Company also offers
customers the option of entering into a  maintenance  and support  contract that
can include  telephone  support seven days a week and 24 hours a day,  emergency
replacement programs and on-site support. Internationally,  the Company provides
customer support either directly or through full service VARs.

Research and Development

     The Company's  research and  development  efforts are focused on developing
new products,  core  technologies  and  enhancements to existing  products.  The
Company's  product  development  activities are based on customer  requirements,
marketplace needs and active  participation by the Company in industry standards
groups and forums.
     In 1998, 1997 and 1996 the Company's research and development  expenditures
were $12.6 million,  $11.0 million and $10.1 million,  which represented  23.0%,
16.7% and 19.4%, respectively, of net sales. In addition, the Company incurred a
charge  for  purchased  research  and  development  of $2.3  million  in 1998 in
connection with its acquisition of Semaphore  Communications and $3.7 million in
1997 in connection  with its acquisition of Performance  Telecom.  The Company's
research and  development  efforts in 1998  primarily  focused on the  continued
development of the Company's DL7100 product,  including a DSL interface,  on the
expansion  of its Encore  product  family by  introducing  new  products and new
features, and development of the Semaphore security products. In September 1998,
the Company discontinued  development on the DL7100 and Semaphore product lines.
The  decisions  to  terminate  these  projects  were in  response to slower than
expected development in the DL7100 DSL and VPN markets. During 1999, the Company
expects that it will continue to devote  research and  development  resources to
the development of new products,  features and management systems within its WAN
access business.  The Company considers its research and development  efforts to
be vital to its future  success and  anticipates  that research and  development
expenditures,  as a percentage  of net sales,  will remain  significant  for the
foreseeable  future.  See  "Management's  Discussion  and  Analysis of Financial
Condition  and Results of  Operations  -- Results of  Operations -- Research and
Development"  and  "--Purchased   Research  and  Development  and  Restructuring
Charges" in Item 7 of this Form 10-K.
     As  referenced   above,  the  Company's  product   development   activities
frequently   address  new  WAN  services  and  applications  based  on  emerging
technologies.  The Company  believes this  strategy has often  resulted in early
market penetration for products based on these technologies.  However,  industry
standards and requirements  are more likely to change in new markets,  which can
adversely  impact  the  Company's  business  and  operating  results.  Moreover,
technology and implementation approaches selected by the Company may be rendered
obsolete  by such  changes,  and a new  market may not  become  widespread.  See
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations -- Other Factors That May Affect Future Operating  Results -- Company
Must Respond to Technological Change" in Item 7 of this Form 10-K.
     The Company's  success will depend upon its ability to develop new products
that achieve market acceptance and to provide  enhancements to existing products
as required by the Company's  customers and the communications  marketplace.  In
order to meet the challenges of rapidly  changing  technologies and services and
new industry  standards  that can render  obsolete the Company's  products,  the
Company has invested and expects to continue to invest substantial  resources in
the development of new products and technologies.  The Company may in the future
develop products with which the Company has only limited  experience and/or that
are targeted at emerging  market  segments.  There can be no assurance  that the
Company's  product  development  efforts will result in commercially  successful
products or that product delays will not result in missed market opportunities.
    
     As of December 31, 1998,  the  Company's  research  and  development  staff
consisted  of 56  employees,  of  whom  53  were  engineers,  and  approximately
one-third of such  engineers  were engaged  principally  in the  development  of
software  content.  The  Company  believes  its  ability to  attract  and retain
qualified  development  personnel is essential to the success of its development
programs. The market for such personnel is highly competitive, and the Company's
development   activities   could  be  adversely   affected  if  the  Company  is
unsuccessful in attracting and retaining skilled technical personnel.

Manufacturing

     The  Company's  manufacturing  operations  consist  primarily  of component
procurement and final assembly,  test and quality control of  subassemblies  and
systems.  The Company  uses local third party  contractors  to  manufacture  and
assemble printed circuit boards.  The manufacturing  process enables the Company
to configure the hardware and software in combinations to meet a wide variety of
customer requirements.  The Company performs "burn-in" procedures and functional
tests,  as  well  as  comprehensive   inspections  to  assure  the  quality  and
reliability of its products.
     The Company's  product designs are  proprietary  but generally  incorporate
industry standard hardware components.  However,  certain  semiconductor devices
and  components  and  subassemblies  are  presently  available  only from single
sources.  Certain other components are presently available or acquired only from
a limited  number  of  sources.  To date,  the  Company  has been able to obtain
adequate supplies of these components, as well as subassemblies from third party
contractors,  in a timely manner from existing sources or, when necessary,  from
alternative  sources,  or to redesign its products to accommodate an alternative
component.  The inability to obtain sufficient sole or limited source components
or subassemblies as required in the future, or to develop alternative sources or
redesign its  products if and as required in the future,  could result in delays
or  reductions  in  product  shipments.  Any such  occurrence  could  materially
adversely affect the Company's business and operating results or damage customer
relationships.

Competition

     The market for the Company's  products is highly  competitive.  Many of the
Company's  customers  purchase  products from both the Company and the Company's
competitors.   The  Company  currently  competes  primarily  with  Adtran,  Inc.
("Adtran"),  Kentrox Industries,  Inc., a subsidiary of ADC  Telecommunications,
Inc. ("Kentrox"),  Larscom Inc. ("Larscom"),  Paradyne Corporation ("Paradyne"),
Verilink Corporation ("Verilink") and Visual Networks, Inc. ("Visual Networks").
Many of the Company's current and potential  competitors have greater financial,
research and development,  intellectual property,  marketing and other resources
than those of the Company and have  broader  product  lines and longer  standing
relationships with customers than the Company.  The Company expects  competition
to increase in the future from  existing  competitors  and from other  companies
that may enter the  Company's  existing  or future  markets.  In  addition,  the
Company faces competition from suppliers of internetworking  equipment,  such as
routers, and telephone equipment, such as switches, which are including a direct
WAN interface in certain of their products.  An increased  reliance by customers
on such suppliers for WAN access would reduce demand for the Company's products.
Any such reduced  demand would have a material  adverse  effect on the Company's
business and operating results.  As discussed above,  increased  competition has
also placed increasing pressures on the pricing of the Company's products, which
has  resulted in lower  operating  results.  The Company  anticipates  that this
pricing  pressure will continue for the foreseeable  future.  See  "Management's
Discussion  and Analysis of Financial  Condition  and Results of  Operations  --
Results of Operations -- Net Sales" and "-- Gross Profit" in Item 7 of this Form
10-K. The Company believes that its ability to compete successfully depends on a
number of factors  both within and outside of its  control,  including,  but not
limited to,  price;  announcements  by the Company  and its  competitors;  rapid
development  of new  products and  features;  product  quality and  performance;
experienced sales,  marketing and service  organizations;  and evolving industry
standards.  There can be no assurance  that the Company will be able to continue
to compete successfully with its existing competitors or that it will be able to
compete successfully with new competitors.

Intellectual Property and Other Proprietary Rights

     The  telecommunications  industry is  characterized  by the  existence of a
large number of patents and frequent  litigation  based on allegations of patent
infringement.  For  example,  the Company  has been  contacted  by two  separate
parties who have expressed  their belief that certain of the Company's  products
may infringe upon patents held by it. The third  parties have  suggested on such
occasions that the Company acquire a license to such patents.  See "Management's
Discussion  and Analysis of Financial  Condition  and Results of  Operations  --
Other  Factors That May Affect Future  Operating  Results -- Risk of Third Party
Claims of Infringement," in Item 7 of this Form 10-K.
     The Company  treats its software and hardware  designs as  proprietary  and
relies  primarily on a  combination  of  copyrights,  trademark and trade secret
laws,  and employee  and third party  nondisclosure  agreements,  to protect its
proprietary  information.  There  can  be  no  assurance  that  the  contractual
obligations to maintain the  confidentiality  of the Company's  trade secrets or
proprietary information will not be breached by employees, consultants, advisors
or others,  or that the Company's  trade secrets or proprietary  technology will
not otherwise  become known or be  independently  developed by competitors.  The
Company has one patent with the U.S. Patent and Trademark office for certain ATM
technology  that expires in September 2011.  However,  there can be no assurance
that such patent will prove to be important in the Company's product development
efforts.  Certain  technologies used in the Company's products are licensed from
third parties on a non-exclusive basis.

Employees

     As of December 31,  1998,  the Company had 208  employees,  of whom 56 were
primarily  engaged in  research  and  development,  83 in sales,  marketing  and
administration, 8 in customer support and 61 in manufacturing. In addition, from
time to time,  Digital Link employs contract labor to assist with its short-term
personnel  needs.  The Company  believes that its future  success will depend in
large part upon the continued  contributions  of members of the Company's senior
management and other key  personnel,  and upon its ability to attract and retain
highly  skilled  managerial,   engineering,   sales,  marketing  and  operations
personnel,  the  competition  for whom is intense.  Certain of the Company's key
management  personnel  have  only  recently  joined  the  Company,  and  certain
personnel have only limited experience in the Company's  industry.  For example,
in March 1998,  Kent Bossange,  was promoted to Vice  President,  Marketing,  in
December 1998,  Lana Vaysburd was hired as Vice  President,  Engineering  and in
March 1999, Sherman Silverman was hired as Vice President,  Sales and Marketing,
Worldwide.  In  addition,  in March 1998  Vinita  Gupta was  reappointed  as the
Company's  interim  President and Chief  Executive  Officer,  which position she
accepted on a full-time  basis in January  1999.  The  current  availability  of
qualified  sales and  engineering  personnel is quite limited,  and  competition
among  companies  for such  personnel  is  intense.  The  Company  is  currently
attempting  to  hire a  number  of  sales  and  engineering  personnel  and  has
experienced delays in filling such positions. There can be no assurance that the
Company will be successful in attracting and retaining skilled personnel to hold
these important positions.  The Company expects to continue to experience growth
in the number of its employees,  resulting in increased responsibilities for the
Company's  management.  The  Company's  employees  are  not  represented  by any
collective bargaining organization, and the Company has never experienced a work
stoppage. The Company believes that its employee relations are good.

ITEM 2.  PROPERTIES

     The Company  leases its 60,030  square foot  principal  facility,  which is
located in  Sunnyvale,  California,  pursuant to a lease that expires in October
2003.  Digital Link also leases 11,500  square feet of space in  Rochester,  New
York,  as a research  and  development  facility.  The Company  maintains  sales
operations in North America in Oak Brook,  Illinois;  Ann Arbor,  Michigan;  St.
Charles,  Missouri;  Carrollton,  Texas;  Houston,  Texas;  Irving,  Texas;  and
Toronto,  Ontario.  In Europe,  the Company  leases a facility  near  Stuttgart,
Germany.  The Company believes that its existing facilities are adequate to meet
its current needs and that  suitable  additional  or  alternative  space will be
available in the future on commercially reasonable terms. See Note 3 of Notes to
Consolidated Financial Statements.

ITEM 3.  LEGAL PROCEEDINGS

     In April 1996, a class action  complaint  was filed against the Company and
certain of its officers and directors in Santa Clara Superior Court of the State
of  California,  alleging  violations of the  California  Corporations  Code and
California  Civil Code. In October 1996, a similar parallel lawsuit was filed in
the  United  States  District  Court for the  Northern  District  of  California
alleging violations of federal securities laws. See "Management's Discussion and
Analysis of Financial  Condition and Results of Operations -- Other Factors That
May Affect Future  Operating  Results -- Legal  Proceedings,"  in Item 7 of this
Form 10-K.

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

     Not Applicable.



<PAGE>



                                     PART II

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

     The Common  Stock of the  Company  began  trading  in the  over-the-counter
market on the  Nasdaq  National  Market on  February  1, 1994  under the  symbol
"DLNK." The following  table sets forth the high and low closing  prices for the
Company's  Common  Stock as  reported  on the  Nasdaq  National  Market for each
quarterly  period  since  January 1, 1997.  These  prices  reflect  inter-dealer
prices, without retail mark-up, markdown or commission,  and may not necessarily
represent actual transactions.

                             1998                       1997
                       High        Low           High        Low
                       ----        ---           ----        ---
1st Quarter.......    $12.50      $9.50         $24.25      $12.50
2nd Quarter.......    $11.13      $6.75         $21.75      $13.75
3rd Quarter.......     $7.75      $3.75         $27.38      $18.88
4th Quarter.......     $5.69      $3.22         $26.25       $9.41

     As of December  31, 1998 there were 146 holders of record of the  Company's
Common Stock and approximately 1,200 beneficial owners.
     The Company has never  declared or paid any cash  dividends  on its capital
stock.  The Company  currently  intends to retain any future earnings for use in
its business and,  therefore,  does not anticipate  paying any cash dividends in
the foreseeable future.

ITEM 6.  SELECTED FINANCIAL DATA

     The  following  selected  consolidated  financial  data  should  be read in
conjunction  with the  consolidated  financial  statements and the notes thereto
included elsewhere herein. The consolidated statement of operations data for the
years ended December 31, 1998, 1997 and 1996, and the consolidated balance sheet
data at December  31,  1998 and 1997 are  derived  from,  and are  qualified  by
reference to, the audited  consolidated  financial statements included elsewhere
in this report and should be read in conjunction with those financial statements
and the notes thereto.  The  consolidated  statement of operations  data for the
years ended December 31, 1995 and 1994 and the  consolidated  balance sheet data
at  December  31,  1996,  1995 and  1994  are  derived  from  audited  financial
statements not included in this report.



<PAGE>


<TABLE>

<CAPTION>





                                                                  Year Ended December 31,
                                                                  -----------------------
                                                   
(in thousands, except per share data)              1998        1997       1996       1995       1994
                                                 --------    --------   --------   --------   --------

Statement of Operations Data:
<S>                                              <C>         <C>        <C>        <C>        <C>     
Net sales ....................................   $ 54,627    $ 66,008   $ 52,078   $ 44,344   $ 35,222
Cost of sales ................................     31,442      29,078     21,457     16,769     11,927
                                                 --------    --------   --------   --------   --------
        Gross profit .........................     23,185      36,930     30,621     27,575     23,295
                                                 --------    --------   --------   --------   --------

Expenses:
     Research and development ................     12,580      11,005     10,120      8,922      7,300
     Selling, general and administrative .....     18,716      22,019     16,150     13,958     10,514
     Purchased research & development 
     and restructuring charges(1)
                                                    4,805       3,651       --         --         --
                                                 --------    --------   --------   --------   --------
        Total expenses .......................     36,101      36,675     26,270     22,880     17,814
                                                 --------    --------   --------   --------   --------
        Operating income (loss) ..............    (12,916)        255      4,351      4,695      5,481
Other income .................................      2,196       2,524      2,495      2,281      1,098
                                                 --------    --------   --------   --------   --------
        Income (loss)  before provision
        (benefit) for income taxes ...........    (10,720)      2,779      6,846      6,976      6,579
Provision (benefit) for income taxes .........     (4,248)        847      2,149      2,162      2,171
                                                 --------    --------   --------   --------   --------
        Net income (loss) ....................   $ (6,472)   $  1,932   $  4,697   $  4,814   $  4,408
                                                 ========    ========   ========   ========   ========
Earnings per share (basic)
--------------------------
Net income (loss) per share ..................   $  (0.71)   $   0.21   $   0.52   $   0.55   $   0.55
                                                 ========    ========   ========   ========   ========
Shares used in computing per share  amounts
                                                    9,176       9,249      9,107      8,783      7,976
                                                 ========    ========   ========   ========   ========
Earnings per share (diluted)
----------------------------
Net income (loss) per share ..................   $  (0.71)   $   0.20   $   0.50   $   0.51   $   0.48
                                                 ========    ========   ========   ========   ========
Shares used in computing per share  amounts
                                                    9,176       9,600      9,478      9,467      9,113
                                                 ========    ========   ========   ========   ========

</TABLE>



<PAGE>
<TABLE>

<CAPTION>


                                                       Year Ended December 31,
                                ----------------------------------------------------------------------
(in thousands)                      1998          1997          1996          1995           1994
                                    ----          ----          ----          ----           ----
<S>                               <C>           <C>           <C>           <C>             <C>  
Balance Sheet Data:
Cash, cash equivalents and
    marketable securities......   $34,730       $42,429       $44,048       $37,609         $31,688
Working capital................    22,135        28,901        28,523        27,483          23,352
Total assets...................    54,906        66,056        62,733        54,755          46,829
Total shareholders' equity.....    45,366        57,334        53,802        47,773          40,211

</TABLE>

     (1) See Notes 8 and 9 of Notes to Consolidated  Financial Statements for an
explanation of these changes.


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

     Except  for the  historical  statements  contained  herein,  this Form 10-K
contains  forward-looking  statements  within the  meaning of Section 27A of the
Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the
Securities  Exchange  Act of  1934,  as  amended  (the  "Exchange  Act").  These
forward-looking  statements  involve a number of risks,  known and unknown,  and
uncertainties,  such as the loss of, or  difference  in actual from  anticipated
levels  of  purchases  from,  the  Company's  major  customers,  the  impact  of
competitive  products  and  pricing,  the  ability  to retain  and  attract  key
personnel  and  other  risks  which are  described  throughout  this Form  10-K,
including under the sections titled  "Products and  Technology,"  "Customers and
End  Users,"   "Research  and  Development,"   "Manufacturing,"   "Competition,"
"Intellectual  Property and Other Proprietary  Rights" and "Employees" in Item 1
hereof and within  "Management's  Discussion and Analysis of Financial Condition
and Results of  Operations,"  including  under the title "Other Factors That May
Affect  Future  Operating  Results,"  in Item 7 of this Form  10-K.  The  actual
results that the Company achieves may differ materially from any forward-looking
statements due to such risks and uncertainties.
     When  used in this  Form  10-K  words  such as  "believes,"  "anticipates,"
"expects,"   "intends,"  and  similar   expressions  are  intended  to  identify
forward-looking  statements, but are not the exclusive means of identifying such
statements.  Readers  are urged to  carefully  review and  consider  the various
disclosures  made by the  Company in this  report and in the  Company's  reports
filed  with the  Securities  and  Exchange  Commission  that  attempt  to advise
interested  parties  of the risks and  factors  that may  affect  the  Company's
business.
     Due  to  all   the   foregoing   factors,   the   Company   believes   that
period-to-period  comparisons of its results of operations  are not  necessarily
meaningful and should not be relied upon as an indication of future performance.
Similarly,  past performances are not necessarily  indicative of future results.
It is possible, in some future quarters, the Company's operating results will be
below the  expectations of stock market  analysts and investors.  In such event,
the price of the  Company's  Common Stock would likely be  materially  adversely
affected.  Consequently,  the purchase or holding of the Company's  Common Stock
involves an extremely high degree of risk.

Overview

     The Company  designs,  manufactures,  markets and supports a broad range of
digital  wide-area  network  ("WAN") access  products for global  networks.  The
Company's products are used by service providers as infrastructure equipment and
by business enterprises for connectivity to WAN services,  such as leased lines,
frame relay,  IP, SMDS,  ATM and DSL. The  Company's  products  allow  LAN-based
internetworking  devices,  such as routers and switches, to access WANs and also
integrate  data with  digitized  voice and video traffic for more efficient line
utilization. Digital Link's products are used both in the CPE environment and in
the networks of IXCs, ISPs and telephone companies. The Company believes it is a
leader in the WAN access  products market because of its broad range of products
and its diverse sales  channels.  The Company  markets and sells its products in
North America, Europe, South America and Asia primarily through its direct sales
force, VARs and OEMs.



<PAGE>


Results of Operations

     The following table sets forth statement of operations data as a percentage
of net sales for the years ended December 31, 1998, 1997 and 1996:

<TABLE>

<CAPTION>

                                                              Year Ended December 31,
                                                    ---------------------------------------------
                                                         1998           1997            1996
                                                         ----           ----            ----
<S>                                                      <C>             <C>            <C>   
Net sales..........................................      100.0%          100.0%         100.0%
Cost of sales......................................       57.6            44.1           41.2
                                                    ----------      ----------     ----------
        Gross profit...............................       42.4            55.9           58.8
                                                    ----------      ----------     ----------

Expenses:
     Research and development......................       23.0            16.7           19.4
     Selling, general and administrative...........       34.2            33.3           31.0
     Purchased research and development 
     and restructuring charges ....................        8.8             5.5              0
                                                    ----------      ----------     ----------
        Total expenses.............................       66.0            55.5           50.4
                                                    ----------      ----------     ----------
        Operating income (loss) ...................      (23.6)            0.4            8.4
Other income.......................................        4.0             3.8            4.8
                                                    ----------      ----------     ----------
        Income (loss) before provision (benefit)
        for income taxes...........................      (19.6)            4.2           13.2
Provision (benefit) for income taxes...............       (7.8)            1.3            4.1
                                                    -----------     ----------     ----------
        Net income (loss) .........................      (11.8)%           2.9%           9.1%
                                                    ============    ==========     ==========
</TABLE>

     Net Sales

     Net sales  decreased  17% to $54.6  million in 1998 from  $66.0  million in
1997.  This  decrease in net sales was primarily  attributable  to a decrease in
unit sales of broadband (i.e.,  transmission rates in excess of T1/E1) products,
as a result of lower sales to certain domestic carrier customers, including MCI,
and a decrease in the average selling prices on certain broadband  products as a
result of price  reductions  made in 1998 and 1997.  Net sales  increased 27% to
$66.0  million in 1997 from  $52.1  million in 1996.  The  increase  in 1997 was
primarily attributable to an increase in unit sales of broadband products and to
a lesser  extent,  an increase in unit sales of narrowband  (i.e.,  transmission
rates up to T1/E1)  products.  This  increase  was  offset in part by  decreased
average selling prices on certain  narrowband and broadband products as a result
of price reductions made in the first half of 1997.
     In 1998, narrowband sales in absolute dollars decreased by 6% and increased
as a percentage of net sales to 63% as compared to 60% in 1997.  Broadband sales
decreased in absolute  dollars by 31% and decreased as a percentage of net sales
to 37% in 1998 as compared to 40% in 1997.  The changes in narrowband  sales and
broadband  sales as a percentage of net sales were  primarily due to lower sales
of broadband products to certain domestic carrier  customers,  including MCI. In
1997,  narrowband sales in absolute dollars  increased by 15% and decreased as a
percentage  of net  sales to 55% as  compared  to 61% in 1996.  Broadband  sales
increased in absolute  dollars by 45% and increased as a percentage of net sales
to 45% in 1997 as compared to 39% in 1996.  The changes in narrowband  sales and
broadband  sales as a percentage  of net sales from 1996 to 1997 was primarily a
result of higher broadband sales to certain domestic carrier customers and ISPs.
     International sales (including sales in Canada)  represented  approximately
22%, 17% and 17% of net sales in 1998, 1997 and 1996, respectively. The increase
in 1998 as  compared  to 1997  was due to  sales of the  products  developed  by
Semaphore  Communications  Corporation  ("Semaphore") acquired by the Company in
connection  with the acquisition of Semaphore in April 1998. The increase in net
sales relating to the Semaphore product will not continue in 1999 as the Company
has  discontinued  sales of the  Semaphore  products.  International  sales  are
subject to inherent risks,  including  difficulties in homologating  products in
other  countries,  difficulties  in staffing  and managing  foreign  operations,
greater  difficulty in accounts  receivable  collection,  unexpected  changes in
regulatory  requirements and tariffs,  and potentially adverse tax consequences,
which may in the future contribute to fluctuations in the Company's business and
operating results.
     In 1998, 1997 and 1996, net sales to MCI represented approximately 11%, 20%
and 13%,  respectively,  of the Company's net sales.  In addition,  net sales to
Cisco  Systems,  Inc.  during 1998 were 10% of the  Company's  net sales and net
sales to BBN Planet Corporation during 1996 were 13% of the Company's net sales.
A  significant  portion of the  Company's  business is derived from  substantial
orders placed by large end users and telephone companies.  Therefore,  the level
of demand  from,  and the timing of orders  from,  such  customers  could  cause
material  fluctuations  in the  Company's  business and operating  results.  For
example,  in the fourth  quarter of 1997 and in the second  quarter of 1998, the
Company  experienced  a shortfall  in revenues as compared to its  expectations,
which was due  primarily to lower than expected  revenues from certain  domestic
carriers, including MCI.

     Gross Profit

        Gross  profit  decreased  by 37% in 1998 to  $23.2  million  from  $36.9
million  for  1997.  Gross  margin  decreased  to 42.4% of net  sales in 1998 as
compared to 55.9% in 1997.  These  decreases are primarily a result of decreased
sales volume,  and to a lesser extent, to a result of the restructuring  charges
related to the  termination  of the Company's  DL7100 and VPN product lines that
were  included  as a  component  of cost of sales.  These  charges  amounted  to
approximately  $3.2  million  in the third  quarter of 1998 as  discussed  under
"Purchased  Research and Development  and  Restructuring  Charges" below.  These
charges were  primarily  related to the  write-down  of  inventory  and warranty
reserves due to the discontinuation or de-emphasis of certain product lines.
     Gross profit  increased  21% to $36.9 million in 1997 from $30.6 million in
1996.  Gross margin decreased to 55.9% of net sales in 1997 as compared to 58.8%
in 1996. This decrease in gross margin was primarily due to the above referenced
price  reductions,  which were somewhat offset by a shift in the mix of products
sold to include  more  broadband  products,  which  generally  have higher gross
margins than narrowband products.
     Gross profits may vary  significantly  from quarter to quarter depending on
many factors including  competitive  pricing pressures and changes in the mix of
products  sold. A significant  portion of the  Company's  business is very price
competitive, which has in the past and will in the future require the Company to
lower its prices,  resulting  in  fluctuations  in the  Company's  business  and
operating  results.  The Company  anticipates  that this pricing  pressure  will
continue for the foreseeable  future. In addition,  the mix of products sold may
change to include a higher  percentage of narrowband  products  which  generally
have lower gross  margins and would  therefore  adversely  affect the  Company's
overall gross profits.

     Research and Development

     The primary types of expenses included in research and development  ("R&D")
expenses  are  personnel,   consulting,  prototype  materials  and  professional
services. R&D expenses increased 14% to $12.6 million in 1998 from $11.0 million
in  1997.  The  absolute  dollar  increase  in 1998 is  attributable  to  higher
personnel-related  expenses including  personnel-related expense associated with
the  acquisition  of Semaphore in the second quarter of 1998. As a percentage of
net sales,  R&D  expenses  were 23.0% in 1998 as compared to 16.7% in 1997.  The
increase in R&D expenses as a percentage  of net sales is due primarily to lower
sales volumes  during 1998.  R&D expenses  increased 9% to $11.0 million in 1997
from  $10.1  million  in 1996.  This  increase  was  primarily  attributable  to
personnel  related  expenses  offset by a decrease in consulting fees related to
the Company's  DL7100 product.  As a percentage of net sales,  R&D expenses were
16.7% in 1997 as compared to 19.4% in 1996.  The decrease as a percentage of net
sales was  primarily  the result of  operating  efficiencies  from higher  sales
volume during the period. The Company anticipates that its R&D expenses for 1999
will  decrease  in absolute  dollars  from the levels  experienced  in 1998 as a
result of the Company's  restructuring  related to the termination of the DL7100
and VPN  developments.  However,  actual  results  could vary from the foregoing
forward-looking statement due to, among other factors set forth or referenced in
"Other Factors That May Affect Future  Operating  Results" below,  the Company's
ability to develop and achieve  market  acceptance  of new products and hire new
personnel during 1999.
     All of the  Company's  R&D  expenditures  to date  have  been  expensed  as
incurred.  In the future, the Company may be required to capitalize a portion of
its software  development  costs  pursuant to Statement of Financial  Accounting
Standards No. 86,  "Accounting for Costs of Computer Software to be Sold, Leased
or Otherwise Marketed."

     Selling, General and Administrative

     The   primary   types  of  expenses   included  in  selling,   general  and
administrative ("SG&A") expenses are personnel,  advertising, other promotional,
and travel  and  entertainment.  SG&A  expenses  decreased  15% in 1998 to $18.7
million from $22.0 million in 1997.  This decrease is primarily  attributable to
lower personnel related expenses and consulting  expenses in 1998. SG&A expenses
increased 36% in 1997 to $22.0 million from $16.2 million in 1996. This increase
was primarily  attributable to higher personnel  related expenses and consulting
expenses.  As a percentage of net sales,  SG&A  expenses  increased to 34.3% for
1998 as  compared  to 33.4%  for  1997.  This  increase  in SG&A  expenses  as a
percentage  of net sales was  primarily a result of lower sales  volumes  during
1998. As a percentage of net sales, SG&A expenses increased to 33.4% for 1997 as
compared to 31.0% for the prior year. This increase as a percentage of net sales
was primarily a result of a higher rate of growth in personnel  related expenses
compared  to the rate of growth in net sales over the same  period.  The Company
has in the past hired more of its SG&A personnel and incurred increased expenses
related to trade shows and other promotional activities during the first half of
the year. Accordingly,  SG&A expenses as a percentage of net sales are generally
higher during the first half of the year. However, any decrease in such expenses
as a  percentage  of net sales in the second  half of the year are  subject  to,
among other  factors  set forth or  referenced  in "Net Sales"  above and "Other
Factors That May Affect Future Operating  Results" below, the Company's  ability
to accelerate or defer operating expenses and achieve revenue levels during such
periods.

     Purchased Research and Development and Restructuring Charges

     The  Company  incurred  an expense  of $2.3  million  related to  purchased
research  and  development  for  which  technological  feasibility  had not been
achieved in the second quarter of 1998 related to the  acquisition of Semaphore.
Such in-process technology was valued, along with other acquired assets, using a
discounted  cash flow analysis with separate cash flow  projections for existing
and  in-process  technology.  The  value  of  in-process  technology  for  which
technological  feasibility  had not been  established and for which there was no
alternative  use was expensed  upon  acquisition  in accordance  with  Financial
Accounting  Standards  ("FAS") No. 2,  "Accounting  for Research and Development
Costs." See Note 7 of Notes to Financial Statements.
     The  Company  incurred  an expense  of $3.7  million  related to  purchased
research  and  development  for  which  technological  feasibility  had not been
achieved in the third  quarter of 1997 in  connection  with its  acquisition  of
certain assets and in-process technology for $5 million in cash from Performance
Telecom.  Such  in-process  technology  was  valued,  along with other  acquired
assets,   using  a  discounted  cash  flow  analysis  with  separate  cash  flow
projections  for existing and  in-process  technology.  The value of  in-process
technology for which technological  feasibility had not been established and for
which there was no alternative  use was expensed upon  acquisition in accordance
with FAS No. 2. This technology was designed to enable network service providers
to offer  applications  such as Internet  access,  interactive  video  services,
remote  data  access and  multimedia  applications  at  multi-megabit-per-second
speeds over standard voice-grade copper lines.
     The  Company  incurred an expense of $2.5  million in the third  quarter of
1998 related to the  termination of its DL7100 and VPN product lines,  including
termination of 25 project employees and abandonment of a leased facility.  Since
the products included use of, or planned  integration of, technologies and other
assets acquired through the Company's  acquisitions of Semaphore and Performance
Telecom,  the  Company  also  evaluated  those  acquired  assets,  which  had no
alternative  future use, for  realizability.  The restructuring  expense of $2.5
million  consisted  primarily  of severance  costs of $500,000,  legal and lease
commitment  costs of $500,000 and the  write-off of goodwill and fixed assets of
$1.5 million related to the  aforementioned  acquisitions.  In addition to these
costs the Company reflected $3.2 million of restructuring  related costs in cost
of sales for inventory write-downs and warranty reserves.
     All 25 project  employees  were  notified  of their  termination  severance
benefits by September  30, 1998 and 84% of these  benefits were actually paid by
the end of December 1998. The Company's  leased facility was exited in the first
quarter  of 1999.  Remaining  accrued  restructuring  charges  amounted  to $1.2
million as of December 31, 1998, primarily for legal product claims and warranty
expenses associated with the termination of the aforementioned product lines.

     Other Income

     Other income includes primarily interest income. Other income decreased 13%
to $2.2 million in 1998 from $2.5 million in 1997.  This  decrease was primarily
due to lower interest  income as a result of lower interest rates and lower cash
balances.  Other  income  remained  flat at $2.5  million in 1997 as compared to
1996.

     Provision (Benefit) for Income Taxes

     The Company's effective rate increased to 40% for 1998 compared to 30.5% in
1997.  This  increase is due primarily to the higher rate  available  assuming a
carry-back of current year losses  compared to the effective tax rate applicable
if the Company were  profitable.  The Company's  effective tax rate decreased to
30.5% in 1997  compared  to 31.4% in 1996.  This  decrease is due  primarily  to
increases in foreign sales  corporation  tax benefits and  nontaxable  municipal
interest. The Company has not provided a valuation allowance on the deferred tax
assets as those  amounts can be realized  through  carryback to prior years when
the  Company  paid  income  taxes or are  expected  to be  realized  from future
operations based upon the Company's history of profitable operations.

Quarterly Consolidated Results of Operations

     The  following  table  sets forth  certain  unaudited  quarterly  financial
information for each of the Company's last eight quarters.  The Company believes
this information  reflects all adjustments,  consisting only of normal recurring
adjustments,  that  the  Company's  management  considers  necessary  for a fair
representation  of  this  information  in  accordance  with  generally  accepted
accounting  principles.  Quarterly  results are not  necessarily  indicative  of
future results of operations.


<PAGE>

<TABLE>

<CAPTION>



                                                                               Quarter Ended
                                    ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
                                    Mar. 31,   June 30,   Sept. 30,  Dec. 31,   Mar. 31,   June 30,   Sept. 30,  Dec. 31,
                                      1997       1997        1997      1997       1998       1998       1998       1998 
(in thousands, except per share     ---------  ---------  ---------  ---------  ---------  ---------  ---------  ----------
data)                                                 
<S>                                 <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>    
Net sales......................     $ 16,038   $ 17,033   $ 18,529   $14,408    $ 14,519   $ 12,797   $ 13,271   $14,040
Cost of sales..................        6,816      6,856      7,948     7,458       7,204      6,830     10,168     7,240
                                    --------   --------   --------   -------    --------   --------   --------   -------
     Gross profit..............        9,222     10,177     10,581     6,950       7,315      5,967      3,103     6,800
                                    --------   --------   --------   -------    --------   --------   --------   -------
Expenses:
   Research and development....        3,032      2,594      2,603     2,776       2,822      3,567      3,856     2,335
   Selling, general and                
    administrative.................    4,916      5,768      5,858     5,477       5,023      4,965      4,413     4,315
   Purchased research & development                        
    and restructuring charges......        0          0      3,651         0           0      2,299      2,506         0
                                    --------    -------   --------   --------   --------    -------   --------    ------ 
      Total expenses............       7,948      8,362     12,112     8,253       7,845     10,831     10,775     6,650
                                    --------    -------    --------  --------   --------    -------    -------   -------
      Operating income..........       1,274      1,815     (1,531)   (1,303)       (530)    (4,864)    (7,672)      150
                                                                                
Other income...................          641        638        646       599         601        466        551       578
                                    --------    --------   -------- ----------  --------    --------   --------  -------
     Income before provision
     (benefit) for income taxes.       1,915      2,453       (885)     (704)         71     (4,398)    (7,121)      728
      
Provision (benefit) for income taxes     583        748       (270)     (214)         22     (1,712)    (2,848)      290
                                    --------   --------   ------------------------------   ---------- ---------- -------
     Net income (loss).........     $  1,332    $ 1,705   $   (615)  $  (490)   $     49   $ (2,686)  $ (4,273)  $   438
                                    =========   =======   =========  ========== ========   =========  =========  ========
Earnings per share (basic)
--------------------------
Net income (loss) per share....      $  0.14    $  0.19   $  (0.07)  $ (0.05)   $  (0.01)  $  (0.29)  $  (0.47)  $  0.05
                                     =======    =======   ========== ========== ========   =========  =========  =======
Shares used in computing per share
   amounts.....................        9,190      9,188      9,240     9,375       9,383      9,422      9,129     8,776
                                     =======    =======    =======   =======    ========    =======    =======   =======
Earnings per share (diluted)
----------------------------
Net income (loss) per share....      $  0.14    $  0.18   $  (0.07)  $ (0.05)   $  (0.01)  $  (0.29)  $  (0.47)  $  0.05
                                     =======    =======   ========== ========   ========   ========   ========== ========
Shares used in computing per share
   amounts.....................        9,577      9,506      9,240     9,375       9,436      9,422      9,129     8,937
                                     =======    =======    =======   =======     =======    =======    =======   =======

</TABLE>

     The Company  acquired  certain assets of  Performance  Telecom in September
1997,  incurring a one-time  charge of $3.7 million for  purchased  research and
development. This created a net loss in the third quarter of 1997.
     A significant portion of the Company's business is derived from substantial
orders placed by large  end-users and  telephone  companies.  The timing of such
orders can, in general,  cause material  fluctuations in the Company's operating
results and was of particular  significance in the fourth quarter of 1997 and in
the second  quarter of 1998 where  weaker  than  expected  demand  from  certain
domestic carrier customers together with expense levels geared in expectation of
higher revenue levels combined to unfavorably impact the Company's net income.
     The Company acquired certain assets of Semaphore Corporation in April 1998,
incurring  a  one-time  charge  of  $2.3  million  for  purchased  research  and
development.  This charge,  in conjunction with weaker than expected demand from
certain  carrier  customers  referenced  above,  resulted  in a net loss for the
second quarter of 1998.
     The Company  incurred  costs of $5.7  million in the third  quarter of 1998
related to the  termination  of its DL7100 and VPN product  lines,  of which (i)
$2.5 million was included as operating expense under  restructuring  charges for
severance  costs,  costs associated with the write-off of fixed assets and legal
and lease  commitment  costs and (ii) $3.2 million was included in cost of sales
for inventory  write-downs and warranty  reserves for the  discontinued  product
lines.
     The  Company  has in the past  hired more of its SG&A  personnel  primarily
within the sales and marketing  organizations,  and incurred  increased expenses
related to trade shows and other promotional  activities,  during the first half
of the year.
     A significant  portion of the Company's business is very price competitive,
which has in the past and will in the future  require  the  Company to lower its
prices,  resulting in  fluctuations  in the  Company's  business  and  operating
results. For example,  periodically  throughout 1996, 1997 and 1998, the Company
reduced the prices on some of its access products to address competitive pricing
pressures,  which  adversely  affected the Company's  gross margins during those
periods.  The Company  anticipates  that this  increased  pricing  pressure will
continue for the foreseeable  future. In addition,  the mix of products sold may
continue to change to include a higher  percentage of  narrowband  products that
generally have lower gross margins.  This would  adversely  affect the Company's
overall  gross  margins.  Other  factors  that  may  cause  fluctuations  in the
Company's operating results include the timing of new product  announcements and
introductions  by the Company and its competitors,  market  acceptance of new or
enhanced  versions of the  Company's  products,  changes in the product mix sold
toward  narrowband  products that yield lower gross  margins,  seasonal  capital
spending patterns of large domestic customers,  changes in sales volumes through
the Company's  distribution  channels,  availability and cost of components from
the  Company's  suppliers  and  economic  conditions  generally  or  in  various
geographic areas. In addition,  the Company's expense levels are based, in part,
on its  expectations  of future  revenue.  The Company  typically  operates with
limited  order  backlog,  and a  substantial  majority  of its  revenues in each
quarter  result from orders booked in that quarter.  If revenue levels are below
expectations,  the Company may be unable to adjust  spending in a timely manner,
which would adversely affect operating results.

Liquidity and Capital Resources

     The Company's  working  capital  decreased to $22.1 million at December 31,
1998 from $28.9  million at December 31, 1997 and $28.5  million at December 31,
1996. The Company's  cash, cash  equivalents and long and short-term  marketable
securities decreased to $34.7 million at December 31, 1998 from $42.4 million at
December 31, 1997 and $44.0  million at December 31, 1996.  The decline in cash,
cash  equivalents  and long and short-term  marketable  securities at the end of
1998 is  primarily  due to the  Company's  net loss in 1998  and to  significant
repurchases  of Company  shares when  compared  with 1997.  The Company  paid $5
million for certain assets of Performance  Telecom in the third quarter of 1997,
accounting  for much of the  decline  in  cash,  cash  equivalents  and long and
short-term  marketable  securities at the end of 1997 when compared with the end
of 1996.
     Net cash provided by operating  activities  was $2.9 million,  $5.8 million
and $6.4 million in 1998, 1997 and 1996,  respectively.  The decline in net cash
provided by operating  activities  from 1997 to 1998 was due to the net loss and
to the income tax refunds  receivable  in 1998 but not  collectible  until 1999,
offset  partially by a decrease in  inventories.  In 1997,  net cash provided by
operating  activities  was  primarily a result of net income and a reduction  in
receivables  offset by  increased  inventories.  In 1996,  net cash  provided by
operating  activities  was  primarily  a result of net  income,  a  decrease  in
accounts  receivable and an increase in accounts payable and accrued payroll and
other accrued expenses, offset to some extent by increased inventories. To date,
the Company has not experienced any material inventory  obsolescence as a result
of new product  development,  but there can be no assurance  that future product
development efforts will not render Company products obsolete.
     Net cash provided by investing  activities was $3.6 million in 1998, versus
net cash used in investing  activities  of $5.3 million and $7.8 million in 1997
and 1996, respectively. 1998 was $8.9 million more positive than 1997 due in the
main to net proceeds from  marketable  securities in 1998 versus 1997 and to the
acquisition  of  Performance  Telecom  assets  for cash in  1997.  1997 was $2.5
million more positive than 1996 despite the  acquisition of Performance  Telecom
assets and the increase in purchases of capital  equipment,  due to a net inflow
from  marketable  securities  in 1997  versus a net  outflow in 1996.  Leasehold
improvements  and capital  equipment  additions were $2.1 million in 1998,  $2.3
million in 1997 and $1.3 million in 1996.
     Net cash used in financing  activities  amounted to $8.7 million in 1998 as
compared to $10,000 in 1997 and to net cash provided by financing  activities of
$812,000 in 1996.  The use of cash in financing  activities in 1998 and 1997 was
due  primarily to the  Company's  repurchase  of $9.4 million and $2.4  million,
respectively,  of its Common Stock,  offset by the proceeds from the exercise of
stock options and employee stock purchases.
     In  October  1996,   the  Company's   Board  of  Directors   announced  the
authorization for the Company to repurchase up to 500,000 shares of common stock
for  cash  from  time  to time at  market  prices  and as  market  and  business
conditions warrant, in open market,  negotiated or block transactions,  at which
time the stock will be retired. The Board authorized  additional  repurchases of
up to 1,000,000  shares in May 1998 and 500,000 shares in December 1998. No time
limit was set for completion of the repurchase  programs.  The Company purchased
1,372,000  shares of common stock in 1998 and 142,000  shares in 1997 under this
program at a cost of $9,364,000 and $2,422,000 for 1998 and 1997, respectively.
     The Company believes that existing cash and cash flows from operations will
be sufficient to meet its anticipated cash  requirements for working capital and
capital expenditures for at least the next 12 months.

IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS

     In March 1998,  the  American  Institute of  Certified  Public  Accountants
("AICPA")  issued  Statement of Position 98-1 ("SOP 98-1"),  "Accounting for the
Costs of  Computer  Software  Developed  or  Obtained  for  Internal  Use." This
standard  requires  companies to capitalize  qualifying  computer software costs
which are incurred  during the application  development  stage and amortize them
over the  software's  estimated  useful life.  SOP 98-1 is effective  for fiscal
years beginning after December 15, 1998. The Company is currently evaluating the
impact of SOP 98-1 on its financial statements and related disclosures.
     In April 1998,  the AICPA issued  Statement of Position  98-5 ("SOP 98-5"),
"Reporting  on  the  Costs  of  Start-Up  Activities."  This  standard  requires
companies to expense the costs of start-up  activities and organization costs as
incurred.  In general,  SOP 98-5 is effective for fiscal years  beginning  after
December 15, 1998. The Company believes the adoption of SOP 98-5 will not have a
material impact on its results of operations.
     In June 1998, the Financial  Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"),  "Accounting for Derivative
Instruments  and Hedging  Activities."  SFAS 133  establishes  new  standards of
accounting and reporting for derivative instruments and hedging activities. SFAS
133 requires that all  derivatives  be recognized at fair value in the statement
of financial  position,  and that the corresponding  gains or losses be reported
either in the statement of operations or as a component of comprehensive income,
depending  on the type of hedging  relationship  that  exists.  SFAS 133 will be
effective for fiscal years  beginning  after June 15, 1999. The Company does not
currently hold derivative instruments or engage in hedging activities.

OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

     In addition to the factors set forth above in this "Management's Discussion
and  Analysis of Financial  Condition  and Results of  Operations,"  there are a
number of other factors that may affect the Company's future operating  results.
Most of the following  discussion  consists of  forward-looking  statements  and
accompanying risks.

Operating Results May Fluctuate; Absence of Significant Backlog

     The loss of, or difference in actual from  anticipated  levels of purchases
from, the Company's  major  customers  have in the past  adversely  affected the
Company  and  could  in  the  future  adversely  affect  operating   results.  A
significant portion of the Company's business is derived from substantial orders
placed by large end users and  telephone  companies.  The timing of such orders,
including  the  completion  of the  build out of  carrier  and  network  service
providers'  infrastructures,  could cause material fluctuations in the Company's
business and operating results.  For example,  in the fourth quarter of 1997 and
in the second  quarter of 1998,  the Company had lower  operating  results  than
expected  due in part to a weaker than  expected  demand from  certain  domestic
carrier customers,  including MCI. In addition,  none of the Company's customers
are  contractually  obligated  to  purchase  any  quantity  of  products  in any
particular  period, and product sales to major customers have varied widely from
quarter  to  quarter  and  year to  year.  There  can be no  assurance  that the
Company's current customers will continue to place orders with the Company, that
orders from existing  customers will continue at the levels of previous  periods
or that the  Company  will be able to obtain  orders from new  customers.  Other
factors that may cause fluctuations in the Company's  operating results include,
but  are  not  limited  to,  the  timing  of  new  product   announcements   and
introductions  by the Company and its competitors,  market  acceptance of new or
enhanced  versions of the  Company's  products,  changes in the product mix sold
toward  narrowband  products that yield lower gross  margins,  seasonal  capital
spending patterns of large domestic customers,  changes in sales volumes through
the Company's  distribution  channels,  availability and cost of components from
the  Company's  suppliers  and  economic  conditions  generally  or  in  various
geographic areas. In addition, the Company's expense levels are based in part on
its  expectations  of future  revenue.  The Company  operates with limited order
backlog,  and a substantial majority of its revenues in each quarter result from
orders booked in that quarter.  If revenue  levels are below  expectations,  the
Company  may be  unable  to  adjust  spending  in a timely  manner  which  would
adversely affect operating results.

Market for the Company's Products is Highly Competitive

     The market for the Company's  products is highly  competitive.  The Company
expects competition to increase in the future from existing competitors and from
other  companies  that may enter the Company's  existing or future  markets.  In
addition,  the Company  faces  competition  from  suppliers  of  internetworking
equipment, such as routers, and telephone equipment, such as switches, which are
including a direct WAN  interface  in certain of their  products.  An  increased
reliance by customers on such  suppliers  for WAN access would reduce demand for
the  Company's  products.  This  would  have a  material  adverse  affect on the
Company's  business  and  operating  results.  As  discussed  above,   increased
competition has also placed increasing pressures on the pricing of the Company's
products, which has resulted in lower operating results. The Company anticipates
that this pricing pressure will continue for the foreseeable future.

Company Must Respond to Technological Change

     The  Company's  future  prospects  will  depend in part on its  ability  to
enhance  the  functionality  of its  existing  WAN access  products  in a timely
manner.  It will also depend on the Company's  ability to identify,  develop and
achieve market acceptance of new products that address new technologies and meet
customer  needs  in the  WAN  access  market.  Any  failure  by the  Company  to
anticipate or to respond  adequately  to  competitive  solutions,  technological
developments in its industry,  changes in customer  requirements,  or changes in
regulatory  requirements or industry standards, or any significant delays in the
development, introduction or shipment of products, could have a material adverse
effect  on  the  Company's  business  and  operating  results.  There  can be no
assurance  that  the  Company's  product  development  efforts  will  result  in
commercially  successful  products  or that  product  delays  will not result in
missed  market  opportunities.   In  addition,   customers  could  refrain  from
purchasing  the  Company's  existing  products  in  anticipation  of new product
introductions by the Company or its competitors.  New products could also render
certain of the  Company's  existing  products  obsolete.  Either of these events
could materially adversely affect the Company's business and operating results.



<PAGE>


Company Depends on Key Personnel

     The Company believes that its future success will depend in large part upon
the continued  contributions of members of the Company's  senior  management and
other key  personnel,  and upon its ability to attract and retain highly skilled
managerial,   engineering,   sales,  marketing  and  operations  personnel,  the
competition  for  whom is  intense.  Certain  of the  Company's  key  management
personnel have only recently joined the Company and certain  personnel have only
limited experience in the Company's  industry.  For example, in March 1998, Kent
Bossange,  was promoted to Vice  President,  Marketing,  in December 1998,  Lana
Vaysburd was hired as Vice  President,  Engineering  and in March 1999,  Sherman
Silverman  was hired as Vice  President,  Sales  and  Marketing,  Worldwide.  In
addition,  in March 1998 Vinita Gupta was  reappointed as the Company's  interim
President  and  Chief  Executive  Officer,  which  position  she  accepted  on a
full-time basis in January 1999. The current availability of qualified sales and
engineering personnel is quite limited, and competition among companies for such
personnel is intense.  The Company is currently  attempting  to hire a number of
sales and  engineering  personnel  and has  experienced  delays in filling  such
positions.  There can be no  assurance  that the Company will be  successful  in
attracting and retaining skilled personnel to hold these important positions.

Year 2000 Compliance

     The Company utilizes management information systems and software technology
that may be affected by Year 2000 issues throughout its businesses. During 1998,
the  Company  began to  implement  plans for certain of its  internal  operating
systems to ensure  these  systems  continue to meet its  internal  and  external
requirements.  The Year 2000 compliance efforts will encompass: 
                    All Digital Link  products.  The cost of this effort will be
               approximately  $250,000  and  will be  financed  through  working
               capital and the use of internal engineering resources.
                    All Digital Link major  operational  systems  (including ASK
               MANMAN, databases,  spreadsheets,  word processing, and CAD). The
               cost of these  initiatives  will be approximately  $150,000.  The
               Company has  contracted  with a third party to perform the MANMAN
               compliance  work and will use a combination  of  consultants  and
               internal  resources to address the  compliance  issues with other
               internal operational systems.
     The remaining  initiatives  to address  vendor and customer  compliance are
estimated to be complete by the end of June 1999.  In addition,  the Company has
developed  questionnaires  and contacted  key suppliers and customers  regarding
their  Year 2000  compliance  to  determine  any  impact on its  operations.  In
general,  the Company's  suppliers and customers  have advised it that they have
developed or are in the process of developing plans to address Year 2000 issues.
The Company will  continue to monitor and evaluate the progress of its suppliers
and  customers  on this  critical  matter.  The  Company is also  reviewing  its
non-information  technology  systems to determine the extent of any changes that
may be necessary and believes that there will be minimal  changes  necessary for
compliance.
     To date,  the  Company  has  incurred  approximately  $250,000  in expenses
related to Year 2000 compliance of its products and internal  operating systems.
The Company has achieved  approximately 95% of its products Year 2000 compliance
and plans to have the remaining products compliant by April 1999. Currently,  in
excess of 50% of the internal  operating  systems are Year 2000  compliant.  The
Company plans to implement Year 2000 compliance to the remaining portion by July
1999.
     Based on the  progress  the  Company has made in  addressing  its Year 2000
issues and the Company's plan and timeline to complete its  compliance  program,
the Company does not foresee  significant  risks  associated  with its Year 2000
compliance  at this time. As the  Company's  plan is to address its  significant
Year  2000  issues  prior to being  affected  by them,  it has not  developed  a
comprehensive  contingency plan. However, if the Company identifies  significant
risks  related to its Year 2000  compliance  or its progress  deviates  from the
anticipated  timeline,  the Company  will  develop  contingency  plans as deemed
necessary at that time.

Legal Proceedings

     In April 1996, a class action  complaint  was filed against the Company and
certain of its officers and directors in the Santa Clara  Superior  Court of the
State of California, alleging violations of the California Corporations Code and
California  Civil Code. In October 1996, a similar  parallel lawsuit against the
Company and the same  individuals  was filed in the United States District Court
for the  Northern  District of  California  alleging  violations  of the federal
securities  laws. The class period in both of these lawsuits runs from September
12,  1994  through  December  29,  1995,  and both  complaints  allege  that the
defendants  concealed and/or  misrepresented  material adverse information about
the  Company and that the  individual  defendants  sold shares of the  Company's
stock based upon material nonpublic information. The complaints seek unspecified
monetary damages.
     In the state court action, the court granted three prior motions to dismiss
filed by the Company and the individuals,  in each case granting plaintiff leave
to amend his complaint.  The court denied the motion to dismiss the most recent,
third amended  complaint.  Discovery to date has been limited in the state court
action, and the Superior Court has not set a trial date.
     In the  parallel  Federal  proceedings,  the Court on  September  11,  1997
granted the  Company's  motion to dismiss the  federal  complaint  with leave to
amend,  and plaintiff has filed an amended  complaint.  The Company has moved to
dismiss the amended  complaint,  the hearing on which is scheduled to take place
in April or May of 1999. There has been no discovery in the federal action,  and
no trial date has been set.
     The Company  believes  that both  actions are without  merit and intends to
defend  both  actions  vigorously.  However,  litigation  is subject to inherent
uncertainties  and, thus,  there can be no assurance that these lawsuits will be
resolved  favorably to the Company or that they will not have a material adverse
affect on the  Company's  financial  condition  and  results of  operations.  No
provision for any liability that may result upon  adjudication  has been made in
the accompanying financial statements.

Risk of Third Party Claims of Infringement

     The  telecommunications  industry is  characterized  by the  existence of a
large number of patents and frequent  litigation  based on allegations of patent
infringement.  For example, a third party has, on several  occasions,  expressed
its belief that certain of the Company's products,  including its DSU/CSUs,  may
infringe  upon  patents  held by it.  The  third  party  has  suggested  on such
occasions  that the  Company  acquire a license  to such  patents.  The  Company
believes that a license, to the extent required, will be available;  however, no
assurance can be given that the terms of any offered  license would be favorable
to the Company.  Should a license be unavailable,  the Company could be required
to discontinue the sale of or to redesign certain of its products.  In addition,
Larscom,  a competitor of the Company,  has continued to express its belief that
the Company's inverse  multiplexer  products may infringe a patent jointly owned
by  Larscom  and a third  party and has  suggested  that the  Company  acquire a
license to the  patent.  The  Company  does not  believe  that there is merit to
Larscom's  claim.  Management,  after  review  and  consultation  with  counsel,
believes that the ultimate resolution of both these allegations is uncertain and
there can be no assurance that these  assertions will be resolved without costly
litigation or in a manner that is not adverse to the Company.  While the Company
has accrued certain amounts deemed probable for these matters in prior years, it
is  currently  unable to estimate  the ultimate  range of loss  regarding  these
matters.  Therefore,  it is reasonably  possible that the ultimate resolution of
these matters  could result in payments in excess of, or less than,  the amounts
accrued in the accompanying financial statements and require royalty payments in
the future which could adversely  impact gross margins and results of operations
in any one period.
     There  can be no  assurance  that  other  third  parties  will  not  assert
infringement claims against the Company in the future, that any such claims will
not result in costly  litigation  or that the Company  will  prevail in any such
litigation  or be able to license  any valid and  infringed  patents  from third
parties on commercially reasonable terms.

Possible Adverse Changes in Future Market Price

     The risks  outlined  herein are difficult for the Company to forecast,  and
these or other factors can materially affect the Company's operating results and
stock price for one quarter or a series of  quarters.  Further,  in recent years
the stock market has experienced extreme price and volume fluctuations that have
particularly  affected the market prices of  securities of many high  technology
companies,  for reasons frequently unrelated to the operating performance of the
specific companies. These fluctuations,  as well as general economic,  political
and market conditions,  may materially  adversely affect the market price of the
Company's common stock.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company  has limited  exposure to  financial  market  risks,  including
changes  in  interest  rates.  The  Company  does not use  derivative  financial
instruments in its investment  portfolio.  The Company's investment portfolio is
generally comprised of municipal government  securities that mature within three
years.  The Company  places  investments  in  instruments  that meet high credit
quality standards. These securities are subject to interest rate risk, and could
decline  in  value  if  interest  rates  increase.   Due  to  the  duration  and
conservative nature of the Company's investment portfolio,  the Company does not
expect any material loss with respect to its investment  portfolio.  The Company
does not have any  significant  foreign  operations  and thus is not  materially
exposed to foreign currency  fluctuations.  The Company does not currently hedge
against foreign currency rate fluctuations.


<PAGE>


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The  quarterly   supplementary   data  is  included  as  part  of  Item  7,
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations." The financial statements required by this item are set forth below.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
                                                                           Page

Report of Independent Accountants ........................................   27

Consolidated Financial Statements:

     Consolidated Balance Sheets as of December 31, 1998 and 1997 .........  28

     Consolidated Statements of Operations and Comprehensive Income (Loss)
     for each of the three years in the period ended December 31, 1998.....  29

     Consolidated Statements of Shareholders' Equity for each of the three
     years in the period ended December 31, 1998 ..........................  30

     Consolidated Statements of Cash Flows for each of the three years in
     the period ended December 31, 1998 ..................................   31

     Notes to Consolidated Financial Statements ..........................   32



<PAGE>









                        REPORT OF INDEPENDENT ACCOUNTANTS


To the Board of Directors and Shareholders
Digital Link Corporation and Subsidiaries:

In our  opinion,  the  consolidated  financial  statements  listed  in the index
appearing under Item 8 present fairly, in all material  respects,  the financial
position of Digital Link  Corporation and its  Subsidiaries at December 31, 1998
and 1997,  and the results of their  operations and their cash flows for each of
the three years in the period  ended  December  31,  1998,  in  conformity  with
generally  accepted  accounting  principles.  In addition,  in our opinion,  the
financial statement schedule listed in the index appearing under Item 14(a) (2),
presents  fairly,  in all material  respects,  the information set forth therein
when  read in  conjunction  with  the  related  consolidated  statements.  These
financial statements and the financial statement schedule are the responsibility
of Company's  management;  our  responsibility is to express an opinion on these
financial  statements and the financial  statement schedule based on our audits.
We  conducted  our  audits of these  statements  in  accordance  with  generally
accepted auditing  standards which 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,  assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall  financial  statement  presentation.  We believe that our
audits provide a reasonable basis for the opinion expressed above.



/s/ PricewaterhouseCoopers LLP

San Jose, California
January 19, 1999




<PAGE>

<TABLE>

<CAPTION>

                    DIGITAL LINK CORPORATION AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                        (in thousands, except share data)


                                     ASSETS

                                                                               December 31,
                                                                               ------------
                                                                             1998       1997
                                                                             ----       ----
                                                                             

Current assets:
<S>                                                                         <C>       <C>    
         Cash and cash equivalents ......................................   $   296   $ 2,504
         Short-term marketable securities ...............................    15,738    18,026
         Accounts receivable, less allowance for doubtful accounts of 
         $540 in 1998 and $517 in 1997 ..................................     4,767     5,193
         Inventories, net ...............................................     4,306     8,163
         Prepaid and other current assets ...............................       998     1,433
         Income taxes receivable ........................................     2,501      --
         Deferred income taxes ..........................................     3,069     2,304
                                                                            -------   -------
                  Total current assets ..................................    31,675    37,623

Property and equipment, net .............................................     2,582     3,325
Long-term marketable securities .........................................    18,696    21,899
Deferred income taxes ...................................................     1,560     2,062
Other assets ............................................................       393     1,147
                                                                            -------   -------
                           Total assets .................................   $54,906   $66,056
                                                                            =======   =======


                      LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
         Accounts payable ...............................................   $ 2,365   $ 2,407
         Accrued payroll and related expense ............................     2,168     2,344
         Other accrued expenses .........................................     4,764     3,785
         Income taxes payable ...........................................       243       186
                                                                            -------   -------
                  Total current liabilities .............................     9,540     8,722

Commitments and contingencies (Note 3)
Shareholders' equity:
         Preferred stock, no par value:
              Authorized:  5,000,000 shares;
              Issued and outstanding:  none in 1998 and 1997
         Common stock, no par value:
              Authorized:  25,000,000 shares;
              Issued and outstanding:  8,490,472 shares in 1998 and
              9,427,306 shares in 1997 ..................................    33,311    34,609
         Accumulated other comprehensive income .........................        52       107
         Retained earnings ..............................................    12,003    22,618
                                                                            -------   -------
                  Total shareholders' equity ............................    45,366    57,334
                                                                            -------   -------

                           Total liabilities and shareholders' equity ...   $54,906   $66,056
                                                                            =======   =======
</TABLE>
                                                                            
                                                                             







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


<PAGE>

<TABLE>

<CAPTION>


                    DIGITAL LINK CORPORATION AND SUBSIDIARIES
      CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
                      (in thousands, except per share data)


                                                           Year Ended December 31,
                                                           -----------------------
                                                        1998         1997       1996
                                                        ----         ----       ----

<S>                                                   <C>         <C>         <C>     
Net sales .........................................   $ 54,627    $ 66,008    $ 52,078
Cost of sales .....................................     31,442      29,078      21,457
                                                      --------    --------    --------
       Gross profit ...............................     23,185      36,930      30,621
                                                      --------    --------    --------

Expenses:
    Research and development ......................     12,580      11,005      10,120
    Selling, general and administrative ...........     18,716      22,019      16,150
    Purchased research and development and ........      4,805       3,651        --
                                                      --------    --------    --------
restructuring charges
       Total expenses .............................     36,101      36,675      26,270
                                                      --------    --------    --------
       Operating income (loss) ....................    (12,916)        255       4,351
Other income ......................................      2,196       2,524       2,495
                                                      --------    --------    --------
       Income (loss) before provision (benefit) for    (10,720)      2,779       6,846
income taxes
Provision (benefit) for income taxes ..............     (4,248)        847       2,149
                                                      --------    --------    --------
       Net income (loss) ..........................     (6,472)      1,932       4,697
Other comprehensive income (loss) net of tax:
    Unrealized losses on securities ...............        (55)       (150)       (298)
                                                      --------    --------    --------
       Comprehensive income (loss) ................   $ (6,527)   $  1,782    $  4,399
                                                      ========    ========    ========
Earnings per share (basic)
--------------------------
Net income (loss) per share .......................   $  (0.71)   $   0.21    $   0.52
                                                      ========    ========    ========
Shares used in computing per share amounts ........      9,176       9,249       9,107
                                                      ========    ========    ========
Earnings per share (diluted)
----------------------------
Net income (loss) per share .......................   $  (0.71)   $   0.20    $   0.50
                                                      ========    ========    ========
Shares used in computing per share amounts ........      9,176       9,600       9,478
                                                      ========    ========    ========
</TABLE>












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


<PAGE>

<TABLE>

<CAPTION>

                    DIGITAL LINK CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                                 (in thousands)





                                                                         Accumulated
                                                                            Other
                                                   Common Stock         Comprehensive   Retained
                                                Shares     Amounts          Income       Earnings       Total
                                                -------------------------------------------------------------
<S>                                             <C>      <C>            <C>            <C>           <C>     
Balances, December 31, 1995 .................    9,000    $ 29,283       $    555       $ 17,935      $ 47,773
    Issuance of common stock in
      connection with:
      Stock option plan .....................      199         546             --             --           546
      Stock purchase plan ...................       19         266             --             --           266   
    Tax benefit related to disqualifying
      dispositions from exercise of stock
      options ...............................      --          818             --             --           818             
    Unrealized loss on marketable
      securities ............................      --           --           (298)            --          (298)
    Net income ..............................      --           --             --          4,697         4,697
                                              --------     --------       --------       --------       --------
Balances, December 31, 1996 .................    9,218      30,913            257         22,632        53,802
    Issuance of common stock in
      connection with:
      Stock option plan .....................      311       1,885             --             --         1,885
      Stock purchase plan ...................       40         527             --             --           527
    Repurchase of common stock ..............     (142)       (476)            --         (1,946)       (2,422)
    Tax benefit related to disqualifying
      dispositions from exercise of stock
      options ...............................       --       1,760             --             --         1,760
    Unrealized loss on marketable
      securities ............................       --          --           (150)            --          (150)
    Net income ..............................       --          --             --          1,932         1,932
                                               --------    --------       --------       --------      --------
Balances, December 31, 1997 .................    9,427      34,609            107         22,618        57,334
    Issuance of common stock in
      connection with:
      Stock option plan .....................       21          48             --             --            48
      Stock purchase plan ...................      123         661             --             --           661
    Repurchase of common stock ..............   (1,372)     (5,221)            --         (4,143)       (9,364)
    Tax benefit related to disqualifying
      dispositions from exercise of stock
      options ...............................       --          14             --             --            14
    Acquisition of Semaphore Corp. ..........      291       3,200             --             --         3,200
    Unrealized loss on marketable
      securities ............................       --          --            (55)            --           (55)
    Net loss ................................       --          --             --         (6,472)       (6,472)
                                               --------    --------       --------       --------      --------
Balances, December 31, 1998 .................    8,490    $ 33,311       $     52       $ 12,003      $ 45,366
                                               ========    ========       ========       ========      ========


</TABLE>





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


<PAGE>

<TABLE>

<CAPTION>

                    DIGITAL LINK CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

                                                                              Year Ended December 31,
                                                                            1998        1997       1996
                                                                            ----        ----       ----
Cash flows from operating activities:
<S>                                                                      <C>         <C>         <C>     
   Net income (loss) .................................................   $ (6,472)   $  1,932    $  4,697
   Adjustments to reconcile net income (loss) to net cash flows
          provided by operating activities:
      Depreciation and amortization ..................................      3,359       1,224         752
      Restructuring charges ..........................................      1,240          --          --
      Amortization of goodwill .......................................        664          28          --
      Provision (reduction in allowance) for doubtful accounts .......         27          66        (383)
      Provision (reduction in allowance) for excess and obsolete
          inventories ................................................      3,045         555         457
      R&D write-off on acquisition ...................................      2,299       3,651          --
      Deferred income taxes ..........................................       (263)     (1,663)       (482)
      Changes in assets and liabilities:
         Accounts receivable .........................................        600       1,686       1,583
         Inventories .................................................      1,260      (2,315)     (1,774)
         Prepaid and other current assets ............................        700        (284)       (402)
         Accounts payable ............................................        (42)        107       1,136
         Accrued payroll and related expenses and other accrued ......     (1,057)        421         700
         expenses
         Income taxes (receivable) payable ...........................     (2,430)        405         114
                                                                         --------    --------    --------
             Net cash flows provided by operating activities .........      2,930       5,813       6,398
                                                                         --------    --------    --------

Cash flows from investing activities:
   Purchases of marketable securities ................................    (47,434)    (22,740)    (34,915)
   Maturities of marketable securities ...............................     52,870      24,670      24,391
   Sales of marketable securities ....................................         --          --       4,008
   Acquisition of Performance Telecom Corporation assets .............         --      (5,000)         --
   Acquisition of Semaphore Corporation assets .......................        182          --          --
   Acquisition of property and equipment .............................     (2,101)     (2,272)     (1,290)
                                                                         --------    --------    --------
             Net cash flows provided by (used in) investing activities      3,517      (5,342)     (7,806)
                                                                         --------    --------    --------

Cash flows from financing activities:
   Proceeds from exercise of stock options and employee stock
          purchases ..................................................        709       2,412         812
   Repurchase of common stock ........................................     (9,364)     (2,422)         --
                                                                         --------    --------    --------
             Net cash flows provided by (used in) financing activities     (8,655)        (10)        812
                                                                         --------    --------    --------
                  Net increase (decrease) in cash and cash
                  equivalents ........................................     (2,208)        461        (596)

Cash and cash equivalents at beginning of year .......................      2,504       2,043       2,639
                                                                         --------    --------    --------

Cash and cash equivalents at end of year .............................   $    296    $  2,504    $  2,043
                                                                         ========    ========    ========

Supplemental disclosure of cash flow information:
   Cash paid during the year for income taxes ........................   $    168    $  2,377    $  1,727
                                                                         --------    --------    --------
   Cash received during the year for income taxes ....................   $  1,911    $     85    $     27
                                                                         ========    ========    ========

Supplemental schedule of noncash investing and financing activities:
   Unrealized gain (loss) on securities carried at market ............   $     55    $   (150)   $   (298)
                                                                         ========    ========    ========
   Tax benefit related to disqualifying dispositions from exercise of
          stock options ..............................................   $     14    $  1,760    $    818
                                                                         ========    ========    ========
   Acquisition of Semaphore Corporation assets for stock .............   $  3,200    $     --    $     --
                                                                         ========    ========    ========

</TABLE>


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


<PAGE>



                    DIGITAL LINK CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.   Business and Summary of Significant Accounting Policies:

     Basis of Consolidation:

     The consolidated  financial statements include the accounts of Digital Link
Corporation and its wholly owned  subsidiaries (the "Company").  All significant
intercompany balances and transactions have been eliminated.

     Cash, Cash Equivalents and Marketable Securities:

     The Company  considers all highly  liquid  investments  with  maturities of
three  months or less at the time of purchase  and money market funds to be cash
equivalents.  The Company has  deposited  its cash and money market funds at one
major bank and two investment  firms.  Cash  equivalents are stated at cost plus
accrued interest, which approximates market.
     All marketable securities are deemed by management to be available for sale
and are reported at fair value with net unrealized gains or losses reported as a
separate  component in  shareholders'  equity.  Realized gains and losses on the
sale of marketable securities are computed on the specific identification basis.
Available for sale marketable securities with maturities less than one year from
the  balance  sheet date are  classified  as current  and those with  maturities
greater than one year from the balance sheet date are classified as long-term.

     Revenue Recognition:

     Product  revenues are recognized  upon shipment of the product if remaining
obligations are  insignificant  and  collections of the resulting  receivable is
probable.  The Company records  estimated product returns and accrues for future
warranty costs,  anticipated  retroactive  price  adjustments and  insignificant
vendor  obligations  at the time of  product  shipment.  Warranty  costs to date
generally have not been significant. Maintenance and support revenues, which are
not significant, are recognized over the terms of the related agreements.

     Inventories:

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

     Property and Equipment:

     Property and equipment is stated at cost.  Effective  January 1, 1996,  the
Company adopted the  straight-line  method of depreciation  for all property and
equipment  placed in service after that date.  Property and equipment  placed in
service  prior  to  January  1,  1996  continues  to be  depreciated  using  the
double-declining  balance method.  Furniture and fixtures are  depreciated  over
five years,  leasehold  improvements  over the lesser of five years or the lease
term and all other assets over three years.  When  property  and  equipment  are
retired or otherwise disposed of, the cost and related accumulated  depreciation
are removed  from the  accounts  and the  resulting  gain or loss is included in
income.
     The  Company   periodically   assesses  the  recoverability  of  assets  by
determining  whether the  amortization  of the asset  balance over its remaining
life can be recovered  through  undiscounted  future  operating cash flows.  The
amount of  impairment,  if any,  is measured as the amount by which the net book
value exceeds the fair value of the asset.

     Fair Value:

     The fair value of cash  equivalents and marketable  securities is disclosed
in  relevant  notes  to  the  financial  statements.  For  all  other  financial
instruments, the carrying amount approximates fair value.

     Concentration of Credit Risk:

     Financial   instruments   which   potentially   subject   the   Company  to
concentration  of credit risk consist  principally  of investments in marketable
securities and accounts receivable.
     The  Company  currently  places its  investments  with  three  high  credit
qualified  financial  institutions.  With  respect to accounts  receivable,  the
Company's  customer base is dispersed  across many different  geographic  areas.
While its customers are dispersed across many industries,  a substantial portion
of its sales are to  Internet  service  providers  and  domestic  carriers.  The
Company performs ongoing credit evaluations of its customers, generally does not
require  collateral and maintains an allowance for potential  credit losses.  At
December 31, 1998, there were six customers with balances individually in excess
of 5% of total accounts  receivable versus three customers at December 31, 1997.
Jointly,  these  customers  accounted  for 58% of total  accounts  receivable at
December 31, 1998 versus 23% at December 31, 1997.

     Use of Estimates:

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

     Comprehensive Income (Loss):

     The Company  adopted  Statement of Financial  Accounting  Standards No. 130
("SFAS 130"),  "Accounting  for  Comprehensive  Income,"  during the fiscal year
ended 1998.  This statement  establishes  standards for reporting and display of
comprehensive income and its components (including revenues, expenses, gains and
losses) in a full set of  general-purpose  financial  statements.  The Company's
unrealized  losses on investments  represent the only component of comprehensive
income (loss) which is excluded from net income (loss) for 1998 and prior years.
The Company's comprehensive income (loss) has been presented in the consolidated
financial  statements.  The tax effects  allocated to the  unrealized  losses on
investments are as follows:


<PAGE>



                     Before-Tax    Tax Benefit   Net of Tax
                       Amount      -----------     Amount          
                       ------                      ------
                                 (in thousands)
1998
Unrealized losses on
securities .........   $ (91)        $  36        $ (55)
                       -----         -----         -----
1997
Unrealized losses on
securities .........   $(216)        $  66        $(150)
                       -----         -----        -----
1996
Unrealized losses on
securities .........   $(433)        $ 135        $(298)
                       -----         -----        -----

     Computation of Net Income per Share:

     Basic and diluted  earnings  per share is computed in  accordance  with the
Statement  of  Financial  Accounting  Standards  No. 128 ("SFAS No.  128").  The
weighted  average shares used in the  computations for 1998, 1997 and 1996, were
9,176,000, 9,249,000 and 9,107,000, respectively.

                                                   1998       1997        1996
                                                   ----       ----        ----
Basic
-----
Weighted-average common shares outstanding
     for the period ............................   9,176      9,249     9,107
                                                 -------    -------     -----
Shares used in computing per share amounts .....   9,176      9,249     9,107
                                                 -------    -------   -------   
Net income (loss) .............................. ($6,472)   $ 1,932   $ 4,697
                                                 =======    =======   =======

Net income (loss) per share .................... ($ 0.71)   $  0.21   $  0.52
                                                 =======    =======   =======


                                                  1998       1997     1996
                                                  ----       ----     ----
Diluted
-------
Weighted-average common shares outstanding
     for the period ............................  9,176      9,249     9,107
Common equivalent shares from conversion of
     stock options under treasury stock method .     --        351       371
                                                -------    -------   -------   
Shares used in computing per share amounts .....  9,176      9,600     9,478
                                                -------    -------   -------   
Net income (loss) ..............................($6,472)   $ 1,932   $ 4,697
                                                =======    =======   =======

Net income (loss) per share ....................($ 0.71)   $  0.20   $  0.50
                                                =======    =======   =======

     A total of 1,587,000 common  equivalent  shares have been excluded from the
calculation in 1998, as their effect would have been anti-dilutive.

     Advertising Costs:

     Costs  related to  advertising  and  promotion  of  products  is charged to
advertising expense as incurred. Advertising expense was $1,193,000,  $1,750,000
and $1,408,000 for 1998, 1997 and 1996, respectively.

     Research and Development Costs:

     Costs related to research,  design and  development of products are charged
to research and development expenses as incurred. Software development costs are
capitalized  beginning  when a  product's  technological  feasibility  has  been
established  and  ending  when a product is  available  for  general  release to
customers  provided that  research and  development  activities  for the related
hardware  portion of the product have been completed.  Generally,  the Company's
products   include   hardware  and  software   components   that  are  developed
concurrently.  As a  result,  the  Company  has  not  capitalized  any  software
development costs since such costs have not been significant.

     Foreign Currency Translation:

     The Company's  foreign  subsidiaries  use the United States dollar as their
functional currency.  Resulting foreign transaction gains and losses, which have
been insignificant, are included in the results of operations.

     Accounting for Income Taxes:

     The  Company's  provision  for income taxes  comprises  its  estimated  tax
liability  currently  payable  and the  change  in its  deferred  income  taxes.
Deferred tax assets and liabilities are determined based on differences  between
financial  reporting  and tax bases of assets and  liabilities  and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse.


     Stock-Based Compensation:

     The Company  accounts for employee  stock options under APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and provides pro forma disclosure in
Note 4 to the financial statements as if the measurement  provisions of SFAS No.
123 ("SFAS 123") "Accounting for Stock-Based Compensation," had been adopted.

     Recent Pronouncements:

     In March 1998,  the  American  Institute of  Certified  Public  Accountants
("AICPA")  issued  Statement of Position 98-1 ("SOP 98-1"),  "Accounting for the
Costs of  Computer  Software  Developed  or  Obtained  for  Internal  Use." This
standard  requires  companies to capitalize  qualifying  computer software costs
which are incurred  during the application  development  stage and amortize them
over the  software's  estimated  useful life.  SOP 98-1 is effective  for fiscal
years beginning after December 15, 1998. The Company is currently evaluating the
impact of SOP 98-1 on its financial statements and related disclosures.
     In April 1998,  the AICPA issued  Statement of Position  98-5 ("SOP 98-5"),
"Reporting  on  the  Costs  of  Start-Up  Activities."  This  standard  requires
companies to expense the costs of start-up  activities and organization costs as
incurred.  In general,  SOP 98-5 is effective for fiscal years  beginning  after
December 15, 1998. The Company believes the adoption of SOP 98-5 will not have a
material impact on its results of operations.
     In June 1998, the Financial  Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"),  "Accounting for Derivative
Instruments  and Hedging  Activities."  SFAS 133  establishes  new  standards of
accounting and reporting for derivative instruments and hedging activities. SFAS
133 requires that all  derivatives  be recognized at fair value in the statement
of financial  position,  and that the corresponding  gains or losses be reported
either in the statement of operations or as a component of comprehensive income,
depending  on the type of hedging  relationship  that  exists.  SFAS 133 will be
effective for fiscal years  beginning  after June 15, 1999. The Company does not
currently hold derivative instruments or engage in hedging activities.



<PAGE>


     2.  Balance Sheet Detail:


     Marketable Securities:

                                                      December 31,
                                               1998                  1997
                                               ----                  ----
                                                      (in thousands)

                                                    Market              Market 
                                           Cost     Value       Cost    Value
                                           ----     -----       ----    -----
Debt securities:
     U.S. government corporations and
          agencies ...................... $24,766   $24,763   $24,689   $24,679
     Commercial paper ...................   5,556     5,555        --        --
     State and municipal securities .....   4,060     4,116    15,129    15,246
                                          -------   -------   -------   ------- 
                                          $34,382   $34,434   $39,818   $39,925
                                          =======   =======   =======   =======

     Gross unrealized gains and unrealized losses for marketable securities were
$63,000 and $11,000, respectively at December 31, 1998 and $136,000 and $29,000,
respectively, at December 31, 1997.
     At December 31, 1998, scheduled maturities of marketable  securities within
one year were $15,738,000 (cost $15,688,000) and for one year to five years were
$18,696,000 (cost $18,694,000).

     Inventories, net:

                                         December 31,
                                         ------------
                                        1998    1997
                                        ----    ----
                                       (in thousands)

Raw materials .....................   $1,349   $2,952
Work in progress ..................    1,456    2,275
Finished goods ....................    1,501    2,936
                                      ------   ------
                                      $4,306   $8,163
                                      ======   ======

     The  Company's  products  are  concentrated  in a  single  segment  in  the
telecommunications  industry that is highly  competitive  and rapidly  changing.
Significant technological changes in the industry segment could affect operating
results adversely.  The Company's  inventories include high technology parts and
components  that may be specialized in nature or subject to rapid  technological
obsolescence.   While  the  Company  has   programs  to  minimize  the  required
inventories on hand and considers  technological  obsolescence in estimating the
required  allowance to reduce recorded amounts to market values,  such estimates
could  change in the future.  In  addition,  certain  semiconductor  devices and
components and subassemblies  are presently  available only from single sources,
and certain other  components  are  presently  available or acquired only from a
limited number of sources.



<PAGE>


     Property and Equipment, net:

                                                       December 31,
                                                       ------------
                                                   1998         1997
                                                   ----         ----
                                                     (in thousands)

Manufacturing and development equipment .........$ 10,859    $  9,328
Furniture and fixtures ..........................     608         520
Leasehold improvements ..........................     325         215
                                                 --------    --------    
                                                   11,792      10,063
                                                 --------    --------    
Less accumulated depreciation and amortization ..  (9,210)     (6,738)
                                                 --------    --------    
                                                 $  2,582    $  3,325
                                                 ========    ========    

     Other Accrued Expenses:

                                                December 31,
                                              1998      1997
                                              ----      ----
                                              (in thousands)

Product warranty ...........................    853   $1,029
Professional fees ..........................    213      209
Restructuring charges ......................  1,240       --
Co-op advertising ..........................    293      107
Other ......................................  2,165    2,440
                                             ------   ------
                                             $4,764   $3,785
                                             ======   ======

3.   Commitments and Contingencies:

     Commitments:

     The Company  leases its  headquarters  facility  under an operating  lease.
Under  the  terms  of the  lease  agreement,  the  Company  is  responsible  for
insurance, maintenance and property taxes.

     Future  minimum lease  payments  under the lease are as follows at December
31, 1998 (in thousands):

                    1999                                     $1,072
                    2000                                      1,126
                    2001                                      1,182
                    2002                                      1,241
                    2003                                      1,019
                                                              -----
                    Total minimum lease payments             $5,640
                                                             ======

     Rent expense was $1,540,000, $883,000 and $619,000 for 1998, 1997 and 1996,
respectively.

     Contingencies:

     Certain  third  parties  have  expressed  their  belief that certain of the
Company's products may infringe patents held by them and have suggested that the
Company acquire licenses to such patents. The Company believes that licenses, to
the extent required, will be available;  however, no assurance can be given that
the terms of any offered licenses would be favorable to the Company. Management,
after  review  and  consultation  with  counsel,   believes  that  the  ultimate
resolution  of these  matters is uncertain  and there can be no  assurance  that
these assertions will be resolved without costly  litigation or in a manner that
is not adverse to the  Company.  While the  Company  has  accrued  approximately
$550,000  for these  matters  deemed  probable in prior  years,  it is currently
unable  to  estimate  the  ultimate  range  of  loss  regarding  these  matters.
Therefore,  it is  reasonably  possible  that the ultimate  resolution  of these
matters could result in final  settlement  that could exceed or be less than the
amount  accrued.  Adjustment to amounts accrued will take place in the period in
which such matters are resolved.

     In April 1996, a class action  complaint  was filed against the Company and
certain of its officers and directors in the Santa Clara  Superior  Court of the
State of California, alleging violations of the California Corporations Code and
California  Civil Code. In October 1996, a similar  parallel lawsuit against the
Company and the same  individuals  was filed in the United States District Court
for the  Northern  District of  California  alleging  violations  of the federal
securities  laws. The class period in both of these lawsuits runs from September
12,  1994  through  December  29,  1995,  and both  complaints  allege  that the
defendants  concealed and/or  misrepresented  material adverse information about
the  Company and that the  individual  defendants  sold shares of the  Company's
stock based upon material nonpublic information. The complaints seek unspecified
monetary damages.  Discovery to date has been limited in the state court action,
and the Superior Court has not set a trial date.
     In the  parallel  Federal  proceedings,  the Court on  September  11,  1997
granted the  Company's  motion to dismiss the  federal  complaint  with leave to
amend,  and plaintiff has filed an amended  complaint.  The Company has moved to
dismiss the amended  complaint,  the hearing on which is currently  scheduled to
take place on March 26, 1999. There has been no discovery in the federal action,
and no trial date has been set.
     The Company  believes  that both  actions are without  merit and intends to
defend  both  actions  vigorously.  However,  litigation  is subject to inherent
uncertainties  and, thus,  there can be no assurance that these lawsuits will be
resolved  favorably to the Company or that they will not have a material adverse
effect on the  Company's  financial  condition  and  results of  operations.  No
provision for any liability that may result upon  adjudication  has been made in
the accompanying financial statements.

4.   Shareholders' Equity:

     Stock Option Plan:

     The Company has a 1992 Equity  Incentive Plan ("Plan"),  which succeeds the
Company's prior plan. All outstanding  stock options issued under the prior plan
will continue to be governed by the terms and  conditions  of that plan,  but no
additional stock options will be granted under that prior plan.  During 1995, an
additional  500,000  shares  were  authorized  for  grant or sale to  employees,
officers,  directors and consultants of the Company under the Plan. During 1997,
an additional  800,000  shares were  authorized  for grant or sale to employees,
officers,  directors and  consultants  of the Company  under the Plan.  The Plan
expires ten years after its adoption.
     Options  granted  under the Plan may be either  incentive  stock options or
nonqualified  stock options,  as designated by the Board of Directors.  The Plan
provides  that the  exercise  price of options  granted must be no less than the
fair market value of the Company's  common stock at the date of grant. The Board
of Directors  also has the  authority to set exercise  dates (no longer than ten
years  from the date of  grant),  payment  terms and other  provisions  for each
grant. Generally, options granted under the Plan through October 31, 1995 become
exercisable  annually as to 20% and options granted on or after October 31, 1995
become exercisable as to 25% of the shares one year after the first vesting date
and  thereafter  with  respect  to an  additional  2.084%  at the  end  of  each
succeeding month.
     The Plan also  provides for the award of common stock based on  performance
and the sale of restricted stock to eligible persons at the fair market value of
the common  stock of the  Company at the date of sale or at  discounts  of up to
15%, as determined by the Board of Directors.  All restricted stock awards under
this Plan are  subject to a  repurchase  option  that  expires  over a five year
period at the original  issuance  price.  As of December 31, 1998, no restricted
stock awards have been issued under the Plan.

Directors Stock Option Plan:

     In October 1994, the Company  adopted the 1994 Directors  Stock Option Plan
(the "Directors  Plan"). The Company has reserved 200,000 shares of Common Stock
for issuance to directors of the Company who are not employees of the Company.
The Directors Plan expires ten years after its adoption.
     Options  granted under the Directors Plan are  nonqualified  stock options.
The Directors Plan provides that the exercise price of options  granted shall be
the  fair  market  value of the  Company's  common  stock at the date of  grant.
Options  granted under the Directors Plan become  exercisable  ratably over four
years.  The maximum term of these options  granted is ten years from the date of
grant.

     Activity under the Plan and the Directors  Plan during 1998,  1997 and 1996
is as follows:
<TABLE>
<CAPTION>
                                                     (in thousands, except per share amounts)
                                                                Outstanding Options
                                   ------------------------------------------------------------------------
                                                                                                   Weighted
                                   Shares        Number               Price                        Average
                                   available     of                   per             Aggregate    Exercise
                                   for grant     Shares               Share           Price        Price
                                   ------------------------------------------------------------------------
                                         
<S>                                <C>         <C>                <C>                <C>          <C>     
Balances, December 31, 1995 .       1,091       1,462              $0.60-$28.25       $15,813      $  10.82
   Options granted ..........        (984)        984              $10.125-$23.25      15,302      $  15.55
   Options exercised ........          --        (199)             $0.60-$21.75          (546)     $   2.74
   Options cancelled ........         425        (425)             $0.83-$28.25        (6,079)     $  14.30
                                   -------     --------                               ---------
Balances, December 31, 1996 .         532       1,822              $0.83-$28.25        24,490      $  13.45
   Additional shares reserved         800          --                   --                 --            --
   Options granted ..........        (540)        540              $13.25-$25.75        9,637      $  17.86
   Options exercised ........          --        (311)             $12.50-$27.375      (1,885)     $   6.06
   Options cancelled ........         434        (434)             $1.00-$28.25        (6,029)     $  13.91
                                   -------     --------                               ---------
Balances, December 31, 1997 .       1,226       1,617              $1.00-$28.25        26,213      $  16.23
   Options granted ..........      (2,710)      2,710              $3.22-$12.38        19,051      $   7.03
   Options exercised ........          --         (21)             $6.13-$12.13           (48)     $   2.25
   Options cancelled ........       2,718      (2,719)             $3.22-$28.25       (37,402)     $  13.76
                                   -------     --------                               ---------
Balances, December 31, 1998 .       1,234       1,587              $1.33-$28.25       $ 7,814      $   4.94
                                   =======     ========                               =========
</TABLE>

The weighted-average  fair value of those options granted in 1998, 1997 and 1996
was $5.21, $11.63 and $8.47,  respectively.  Options to purchase 163,000 shares,
481,000  shares and 350,000  shares  were  exercisable  with a  weighted-average
exercise price of $12.71, $14.65 and $8.88, at December 31, 1998, 1997 and 1996,
respectively.

     On January 21, 1998, the  Compensation  Committee of the Board of Directors
adopted a plan for repricing of stock  options under which all current  officers
and  employees  (other  than the  Company's  chief  executive  officer)  who had
outstanding  options  that were granted  under the Plan on or after  November 1,
1995 (the  "Options"),  had the right to reprice such  options.  With respect to
each officer of the Company, the exercise price of each option was determined as
of the closing price of the Company's common stock on February 9, 1998 with four
year vesting beginning again on February 9, 1998 and thereafter otherwise to the
same terms as the original  stock  options  being  amended.  With respect to all
other  employees of the Company,  the exercise  price of each amended option was
determined to be the closing price of the Company's  common stock on February 9,
1998, no change was made in the vesting schedule.  However,  the amended options
were not available for exercise until February 9, 1999.
     On September 25, 1998, the Compensation Committee of the Board of Directors
adopted a plan for repricing of stock  options under which all current  officers
and employees who had outstanding  options that were granted under the Plan with
an exercise  price greater than the closing price of the Company's  common stock
on October  19,  1998 could be  amended.  With  respect  to all  employees,  the
exercise  price of each option was  determined  to be the  closing  price of the
Company's  common stock on October 19, 1998. The vesting schedule was amended to
a three year vesting  period  beginning on October 19, 1998 with the options not
being  available  for  exercise  until  October 19,  1999.  The number of shares
subject to the amended options that were originally granted prior to November 1,
1995 was  reduced  to  twenty-five  (25%) of the  number of  unexercised  shares
subject to the original grant with any remaining shares being forfeited.

The  following  table  summarizes  information  with  respect  to stock  options
outstanding at December 31, 1998:

<TABLE>

<CAPTION>
                                                       (number of options in thousands)
                                              Options Outstanding                     Options Exercisable
                                ---------------------------------------------------------------------------
                                                                                  Weighted    
                                Number            Average                         Number          Weighted
                                Outstanding at    Remaining       Weighted        Exercisable at  Average
                                December 31,      Contractual     Average         December 31,    Exercise
Range of Exercise Price         1998              Life (years)    Exercise Price  1998            Price
-----------------------         --------------    ------------    --------------  -------------   ---------

<S>                                   <C>             <C>            <C>             <C>          <C>   
$ 1.00 - $ 1.67                       18              4.19           $ 1.41          18           $ 1.41
$ 3.22 - $ 4.88                    1,354              9.74           $ 3.47          21           $ 3.93
$ 5.38 - $ 8.50                       13              8.70           $ 6.75           3           $ 8.20
$ 9.00 - $11.00                       90              7.17           $10.09          36           $ 9.53
$12.38 - $14.00                       10              8.79           $13.23           6           $13.02
$15.13 - $17.38                       38              6.18           $15.32          35           $15.29
$18.25 - $21.75                       43              7.29           $21.08          30           $21.25
$23.00 - $24.00                       15              6.69           $23.40          12           $23.44
$25.75 - $28.25                        6              8.37           $26.17           2           $26.48
                                =============                                   ===========
$  1.33 - $28.25                   1,587              8.41           $ 4.94         163           $12.71
                                =============                                   ===========
</TABLE>

Employee Stock Purchase Plan:

     In December 1993, the Company  established the 1993 Employee Stock Purchase
Plan (the "Purchase  Plan") under which 300,000 shares of Common Stock have been
reserved  for  issuance.  Under the  Purchase  Plan,  an eligible  employee  may
purchase shares of Common Stock from the Company  through payroll  deductions of
up to 10% of his or her base compensation and commissions,  at a price per share
equal to 85% of the  lesser of the fair  market  value of the  Company's  Common
Stock as of the first day or last day of each  six-month  offering  period under
the Purchase  Plan.  The Company sold 122,700  shares,  40,000 shares and 19,000
shares to employees in 1998, 1997 and 1996,  respectively.  The weighted-average
fair value of those purchase  rights  granted in 1998,  1997 and 1996 was $5.45,
$6.02 and $5.66, respectively.



<PAGE>


     Pro Forma Stock-Based Compensation:

     The Company  accounts for the fair value of its grants under the Plan,  the
Directors Plan and the Purchase Plan in accordance with APB 25. Accordingly,  no
compensation  expense has been  recognized  for these  plans.  Had  compensation
expense  been  determined  based on the fair value at the grant dates for awards
under these plans  consistent  with the method of SFAS 123,  the  Company's  net
income (loss) would have been adjusted to the pro forma amounts indicated below:

(Amounts in thousands, except per share data)                         
                              
                                        1998        1997      1996
                                        ----        ----      ----

Net income (loss)
     As reported....................  ($6,472)     $1,932     $4,697
     Pro forma......................  ($8,713)     $ (338)    $3,771
Earnings per share (Basic)
     As reported....................   ($0.71)     $ 0.21      $0.52
     Pro forma......................   ($0.95)     $(0.04)     $0.41
Earnings per share (Diluted)
     As reported....................   ($0.71)     $ 0.20      $0.50
     Pro forma......................   ($0.95)     $(0.04)     $0.40

     The fair value of each  option is  estimated  on the date of grant  using a
type of Black-Scholes  option-pricing model with the following  weighted-average
assumptions  used for grants under the Plan and the Directors Plan in 1998, 1997
and 1996:

                                        1998           1997             1996
                                        ----           ----             ----

Dividend yield                           0.00%           0.00%            0.00%
Expected life of option             4.54 years      4.50 years       4.50 years
Risk-free interest rate                  5.09%           5.74%            6.05%
Expected volatility                        99%             80%              60%

     The  Company  has also  estimated  the fair value for the  purchase  rights
issued under the Purchase Plan using the Black-Scholes option-pricing model with
the following assumptions for grants in 1998, 1997 and 1996:

                                         1998          1997             1996
                                         ----          ----             ----

Dividend yield                            0.00%          0.00%            0.00%
Expected life of option              0.50 years     0.50 years       0.50 years
Risk-free interest rate                   4.88%          5.80%            5.34%
Expected volatility                         80%            80%              60%

     The above pro forma  disclosures are not likely to be representative of the
effects on reported net income for future years.

5. Segments, Significant Customers, Suppliers and Foreign Revenues:

     The  Company  has  adopted  the  Financial   Accounting  Standards  Board's
Statement of Financial Accounting  Standards No. 131 ("SFAS 131"),  "Disclosures
about  Segments of an Enterprise and Related  Information."  SFAS 131 supersedes
Statement  of Financial  Accounting  Standards  No. 14 ("SFAS  14"),  "Financial
Reporting  for  Segments of a Business  Enterprise."  SFAS 131  changes  current
practice under SFAS 14 by  establishing a new framework on which to base segment
reporting and also requires interim reporting of segment information.
     The Company operates in a single industry segment  encompassing the design,
development,  manufacture,  marketing and support of high-speed  digital  access
products for wide area networks  worldwide.  Management  uses one measurement of
profitability and does not disaggregate its business for internal reporting. The
Company markets and sells its products primarily in North America, Europe, South
America and Asia, through a direct sales force, VARs and OEMs. In 1998, sales to
one  customer  accounted  for 11% of net  sales and  sales to  another  customer
accounted for 10% of net sales. In 1997, sales to one customer accounted for 20%
of net sales.  In 1996,  sales to two  customers  each  accounted for 13% of net
sales.  The  loss  of any one or more of the  Company's  major  customers  could
materially adversely affect the Company's business and operating results.
     The Company's  product designs are  proprietary  but generally  incorporate
industry standard hardware components.  However,  certain  semiconductor devices
and  components  and  subassemblies  are  presently  available  only from single
sources,  and certain other components are presently  available or acquired only
from a limited  number of sources.  To date, the Company has been able to obtain
adequate supplies of these components, as well as subassemblies from third party
contractors,  in a timely manner from existing sources or, when necessary,  from
alternative  sources.  The inability to obtain sufficient sole or limited source
components or subassemblies as required in the future, or to develop alternative
sources or redesign its products if and as required in the future,  could result
in  delays  or  reductions  in  product  shipments.  Any such  occurrence  could
materially  adversely  affect the Company's  business and  operating  results or
damage customer relationships.

     Outside  of Europe,  no  geographic  segment  had sales in excess of 10% of
total sales.

                                               Revenue   Long Lived Assets
                                               -------   -----------------
                                                 (in thousands)
December 31, 1998
     United States .........................   $42,901       $ 2,972
     Europe ................................     6,595             3
     Other International ...................     5,131            --
                                               -------       -------   
     Total .................................   $54,627       $ 2,975
                                               =======       =======

December 31, 1997
     United States .........................   $54,655       $ 4,449
     Europe ................................     5,888            23
     Other International ...................     5,465            --
                                               -------       -------   
     Total .................................   $66,008       $ 4,472
                                               =======       =======

December 31, 1996
     United States .........................   $43,412       $ 2,421
     Europe ................................     4,142            20
     Other International ...................     4,524            --
                                               -------       -------   
     Total .................................   $52,078       $ 2,441
                                               =======       =======

6.   Employee Benefit Plan:

     The Company has a 401(k)  profit  sharing plan for its full time  employees
who  have  attained  the  age of  21.  Eligible  employees  may  make  voluntary
contributions  to the Plan up to 18% of their annual  compensation.  The Company
makes a matching contribution equal to 50% of each employee's contributions.  In
applying this matching contribution, however, only contributions up to 6% of the
employee's compensation will be considered. For 1998, 1997 and 1996, the Company
contributed $421,000, $356,000 and $191,000, respectively.

7.   Income Taxes (Benefit):

     The provision (benefit) for income taxes comprises:

                                1998                 1997                 1996
                                ----                 ----                 ----
                                                (in thousands)

Current:
     Federal                  $(3,745)             $2,246               $2,376
     State                       (240)                390                  135
                              --------             ------               ------
                               (3,985)              2,636                2,511

Deferred:
     Federal                     (221)             (1,613)                (295)
     State                        (42)               (176)                 (67)
                              --------             -------              -------
                                 (263)             (1,789)                (362)
                              --------             -------              -------
                              $(4,248)             $  847               $2,149
                              ========             =======              =======

     The  difference  between the actual tax provision  (benefit) and the amount
obtained by applying the U.S.  Federal  statutory  rate to income  (loss) before
provision for income taxes (benefit) is as follows:

                                                     1998      1997     1996
                                                     ----      ----     ----

Tax provision (benefit) at federal statutory rate    (34.0%)   34.0%    34.0%
State taxes, net of federal tax benefit .........     (5.2)     6.6      5.4
Nontaxable municipal interest ...................     (1.2)    (6.3)    (2.1)
Foreign sales corporation .......................     (0.5)    (2.5)    (0.6)
Research and development tax credit .............       --     (3.2)    (6.3)
Other ...........................................      1.3      1.9      1.0
                                                     -----     -----    -----
                                                     (39.6%)   30.5%    31.4%
                                                     =====     =====    =====



<PAGE>


     The components of the deferred tax asset are as follows:

                                                            December 31,
                                                            ------------
                                                         1998       1997
                                                         ----       ----
                                                          (in thousands)

Deferred tax assets:
     Allowance for doubtful accounts receivable .......  $  210   $  203
     Allowance for excess and obsolete inventories ....     640      885
     Depreciation .....................................     345      379
     Amortization of purchased research and
       development ....................................   1,317    1,216
     Accrual for warranty, royalties and other ........   1,859    1,483
     Other ............................................     258      200
                                                         ------   ------   
         Total deferred tax assets ....................  $4,629   $4,366
                                                         ======   ======

     The Company has not  provided a valuation  allowance  on the  deferred  tax
assets as those  amounts can be realized  through  carryback to prior years when
the  Company  paid  income  taxes or are  expected  to be  realized  from future
operations based upon the Company's history of profitable operations.

8.       Acquisitions:

     The  Company  incurred  an expense  of $2.3  million  related to  purchased
research  and  development  for  which  technological  feasibility  had not been
achieved in the second quarter of 1998 related to the  acquisition of Semaphore.
Such in-process technology was valued, along with other acquired assets, using a
discounted  cash flow analysis with separate cash flow  projections for existing
and  in-process  technology.  The  value  of  in-process  technology  for  which
technological  feasibility  had not been  established and for which there was no
alternative  use was expensed  upon  acquisition  in accordance  with  Financial
Accounting  Standards  ("FAS") No. 2,  "Accounting  for Research and Development
Costs".
     The  Company  incurred  an expense  of $3.7  million  related to  purchased
research  and  development  for  which  technological  feasibility  had not been
achieved in the third  quarter of 1997 in  connection  with its  acquisition  of
certain assets and in-process technology for $5 million in cash from Performance
Telecom.  Such  in-process  technology  was  valued,  along with other  acquired
assets,   using  a  discounted  cash  flow  analysis  with  separate  cash  flow
projections  for existing and  in-process  technology.  The value of  in-process
technology for which technological  feasibility had not been established and for
which there was no alternative  use was expensed upon  acquisition in accordance
with  Financial   Accounting  Standard  No.  2,  "Accounting  for  Research  and
Development  Costs."  This  technology  was designed to enable  network  service
providers  to offer  applications  such as Internet  access,  interactive  video
services,    remote    data    access    and    multimedia    applications    at
multi-megabit-per-second speeds over standard voice-grade copper lines.
     The results  attributable  to the  acquisition of the assets of Performance
Telecom and Semaphore have been  consolidated  with the Company's  results since
September 30, 1997 and April 3, 1998, respectively.
     The following  unaudited pro forma condensed combined results of operations
information  has been  presented to give effect to the purchase of the Semaphore
assets as if such  transaction  had  occurred  at the  beginning  of each of the
periods  presented.  The historical  results of operations have been adjusted to
reflect  additional  depreciation  and  amortization  expense based on the value
allocated  to  assets  acquired  in  the  purchase.   In-process   research  and
development  costs  in  the  amount  of  $2,299,000,   which  were  written  off
immediately after the purchase was completed,  have been included in the results
of both periods  presented.  The pro forma results of operations  information is
presented for informational  purposes only and is not necessarily  indicative of
the  operating  results  that  would  have  occurred  had the  acquisition  been
consummated as of the beginning of the periods  presented,  nor is it indicative
of future operating results.

          Unaudited Pro Forma Condensed Combined Results of Operations
                  (amounts in thousands except per share data)

                                           Twelve Months Ended December 31,
                                              1998            1997
                                              ----            ----

Revenue .................................   $ 55,113       $ 69,992
Net loss ................................     (7,857)        (3,345)
Earnings per share (Basic)
     Net loss per share .................      (0.83)         (0.35)
     Shares used in per share calculation      9,467(1)       9,540(1)
Earnings per share (Diluted)
     Net loss per share .................      (0.83)         (0.35)
     Shares used in per share calculation      9,467(1)       9,540(1)


(1) Shares used in the per share calculation  reflect Digital Link shares issued
to  Semaphore  as if they were  outstanding  from the  beginning  of each period
presented and existing Digital Link shares.

Shares used in pro forma earnings per share basic and diluted  calculations  for
the twelve months ended December 31, 1998 are as follows (in thousands):

         Digital Link shares issued in asset acquisition       291(2)
         Existing Digital Link shares                        9,176
                                                             -----
                                                             9,467
                                                             -----

Share used in pro forma  earnings per share basic and diluted  calculations  for
the twelve months ended December 31, 1997 are as follows (in thousands):
        
         Digital Link shares issued in asset acquisition       291(2)
         Existing Digital Link shares                        9,249
                                                             -----
                                                             9,540
                                                             -----


(2) The  number  of shares  issued  was  determined  by  dividing  $3,200 by the
volume-weighted  average  price per share (as  reported by  Bloomberg  Financial
Services) at which Digital  Link's common stock traded on the five business days
immediately preceding the execution of the Asset Sale Agreement by the parties.

9.       Restructuring Charges:

     The  Company  incurred an expense of $2.5  million in the third  quarter of
1998 related to the  termination of its DL7100 and VPN product lines,  including
termination  of 25  project  employees,  abandonment  of a leased  facility  and
related fixed assets. Since the products included use of, or planned integration
of, technologies and other assets acquired through the Company's acquisitions of
Semaphore and  Performance  Telecom,  the Company also evaluated  those acquired
assets,   which  had  no  alternative   future  use,  for   realizability.   The
restructuring  expense of $2.5 million consisted primarily of severance costs of
$500,000,  legal and lease  commitment  costs of $500,000  and the  write-off of
goodwill  and  fixed  assets  of  $1.5  million  related  to the  aforementioned
acquisitions.  In addition to these costs the Company  reflected $3.2 million of
restructuring  related  costs in cost of sales  for  inventory  write-downs  and
warranty reserves.
     All 25 project  employees  were  notified  of their  termination  severance
benefits by September  30, 1998 and 84% of these  benefits were actually paid by
the end of December 1998. The Company's  leased facility was exited in the first
quarter  of 1999.  Remaining  accrued  restructuring  charges  amounted  to $1.2
million as of December 31, 1998, primarily for legal product claims and warranty
expenses associated with the termination of the aforementioned product lines.

10.  Subsequent Event:

     During the period from January 1, 1999 through March 12, 1999,  the Company
repurchased  on the open  market a total of  334,700  shares of common  stock at
prices  ranging from $4.81 to $8.25 a share.  This stock has  subsequently  been
retired.




<PAGE>



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

     Not Applicable

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Information  required by this Item is  incorporated  by reference  from the
sections  titled  "Nominees"  under  "Proposal  No. 1 - Election of  Directors,"
"Executive   Officers"  and  "Section  16(a)  Beneficial   Ownership   Reporting
Compliance"  from the Definitive Proxy Statement to be filed with the Securities
and Exchange Commission relative to the Company's annual meeting of shareholders
to be held on or about June 7, 1999 (the "Definitive Proxy Statement").

ITEM 11.  EXECUTIVE COMPENSATION

     Information  required by this Item is  incorporated  by reference  from the
sections  titled  "Director  Compensation"  under  "Proposal No. 1 - Election of
Directors" and "Executive Compensation" from the Definitive Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
         MANAGEMENT

     Information  required  by  this  Item is  incorporated  by  reference  from
"Security  Ownership  of  Certain  Beneficial  Owners and  Management"  from the
Definitive Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Information  required  by  this  Item is  incorporated  by  reference  from
"Certain Transactions" from the Definitive Proxy Statement.


<PAGE>


                                     PART IV

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

     The following financial  statements and schedules are filed as part of this
report:

                                                                          Page
(a)1.             Financial Statements

                  See index in Part II, Item 8...........................  26

(a)2. and (d)     Financial Statement Schedules

                  Schedule II - Valuation and Qualifying Accounts........  51

     All schedules not listed above are omitted  because they are not applicable
or the required  information  is included in the  financial  statements or notes
thereto.

(a)3. and (c)  Exhibits


2.01           Asset Sale Agreement between Registrant and Semaphore 
               Communications Corporation dated April 3, 1998.  (9)
3.01           Registrant's  Amended  and  Restated  Articles of  Incorporation
               filed on February 7, 1994. (1) 3.02 Registrant's Certificate of
               Correction of Amended and Restated Articles of Incorporation 
               filed on April 7, 1994. (1)
3.03           Registrant's Bylaws, as amended. (2)
4.01           Form of Specimen Certificate for Registrant's Common Stock. (3)
4.02           Registration Rights Agreement among Registrant, Vinita Gupta, 
               Summit Ventures L.P., SV Eurofund C.V. and Summit Investors, L.P.
               dated December 23, 1987 and certain exhibits thereto. (3)
4.03           Registration Rights Agreement between Registrant and Semaphore 
               Communications Corporation dated April 3, 1998. (9)
+10.01         Registrant's 1986 Stock Option Plan, as amended. (3)
+10.02         Form of Agreement for Registrant's 1986 Stock Option Plan. (1)
+10.03         Registrant's 1986 Stock Purchase Plan. (3)
+10.04         Form of Agreement for Registrant's 1986 Stock Purchase Plan, as 
               amended. (1)
+10.05         Registrant's 1992 Equity Incentive Plan, as amended. (8)
+10.06         Form of Agreement for Registrant's 1992 Equity Incentive Plan, 
               as amended. (1)
+10.07         Registrant's 1993 Employee Stock Purchase Plan. (3)
+10.08         Registrant's 1994 Directors Stock Option Plan. (1)
+10.09         Form of Agreement for Registrant's 1994 Directors Stock Option 
               Plan. (1)
10.10          Form of Indemnity Agreement entered into with each of
               Registrant's directors. (3)
10.11          Lease Agreement between Registrant and John Hancock Mutual Life 
               Insurance Company dated June 17, 1992. (3)


<PAGE>



10.12          Form of Patent License Agreement between Registrant and QPSX 
               Communications Ltd. dated December 1993. (3)
10.13*         Software License Agreement between Registrant and Epilogue 
               Technology Corporation dated January 20, 1992. (3)
10.14          Stockholder Agreement among Registrant, Vinita Gupta, Narendra 
               Gupta, Summit Ventures, L.P., SV Eurofund C.V. and Summit 
               Investors, L.P. dated December 23, 1987. (3)
10.22          Separation Agreement between Registrant and Jack A. Musgrove 
               dated March 16, 1998. (10)
10.23          Executive Retention and Severance Agreement dated 
               December 14, 1999.

21.01          List of Subsidiaries. (3)
23.01          Consent of Independent Accountants
27.01          Financial Data Schedule
-----
        *      Confidential treatment has been obtained with respect to portions
               of this exhibit.
       (1)     Filed as an exhibit to Registrant's Form 10-K for the year ended 
               December 31, 1994 and incorporated herein by reference.
       (2)     Filed as an exhibit to Registrant's Registration Statement on 
               Form S-8 (No. 33-95176) filed on July 31, 1995 and incorporated 
               herein by reference.
       (3)     Filed as an exhibit to Registrant's Form S-1 Registration 
               Statement (File No. 33-72642), which was declared effective 
               January 31, 1994, and incorporated herein by reference.
       (4)     Filed as an exhibit to Registrant's Form 10-Q (File No. 0-23110)
               for the quarter ended June 30, 1995 and incorporated herein by 
               reference.
       (5)     Filed as an exhibit to Registrant's Form 10-K (File No. 0-23110) 
               for the year ended December 31, 1995 and incorporated herein by 
               reference.
       (6)     Filed as an exhibit to Registrant's Form 10-Q (File No. 0-23110)
               for the quarter ended September 30, 1996 and incorporated herein
               by reference.
       (7)     Filed as an exhibit to Registrant's Form 10-K (File No. 0-23110) 
               for the year ended December 31, 1996 and incorporated herein by 
               reference.
       (8)     Filed as an exhibit to Registrant's Registration Statement on 
               Form S-8 (No. 333-27855) filed on May 27, 1997 and incorporated 
               herein by reference.
       (9)     Filed as an exhibit to Registrant's Form 8-K (File No. 0-23110) 
               filed on April 17, 1998 and incorporated herein by reference.
       (10)    Filed as an exhibit to Registrant's Form 10-Q (File No. 0-23110) 
               for the quarter ended March 31, 1998 and incorporated herein by
               reference.
        +      Management contract or compensatory plan required to be filed as 
               an exhibit to this Form 10-K.

(b)            Reports on Form 8-K

               No reports on Form 8-K were filed  during the last  quarter
               of the period covered by this report.


<PAGE>


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

                                        DIGITAL LINK CORPORATION

March 26, 1999                           By:       /s/ Stanley E. Kazmierczak
                                             ----------------------------------
                                                  Stanley E. Kazmierczak
                                                  Chief Financial Officer

     Each person whose signature  appears below  constitutes and appoints Vinita
Gupta and Stanley E.  Kazmierczak,  jointly and  severally,  his or her true and
lawful attorneys-in-fact, each with the power of substitution, for him or her in
any and all  capacities,  to sign amendments to this Report on Form 10-K, and to
file the same,  with all  exhibits  thereto and other  documents  in  connection
therewith,  with the Securities and Exchange  Commission,  hereby  ratifying and
confirming  all  that  said  attorneys-in-fact,  or  his or  her  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 has been signed below by the following person on behalf of the Registrant
and in the capacities and on the dates indicated.

<TABLE>

<CAPTION>

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

                                 Chairperson of the Board, Chief Executive
/s/ Vinita Gupta                          Officer and President             March 26, 1999
-------------------------------      (Principal Executive Officer)
         Vinita Gupta              

                                      Chief Financial Officer
                                    and Vice President, Finance
                                           and Operations
                                      (Principal Financial and
/s/ Stanley E. Kazmierczak              Accounting Officer)                 March 26, 1999
-------------------------------
        Stanley E. Kazmierczak

/s/ Richard C. Alberding                      Director                      March 26, 1999
-------------------------------
         Richard C. Alberding

/s/ Louis Golm                                Director                      March 26, 1999
------------------------------                                
         Louis Golm

/s/ Narendra K. Gupta                         Director                      March 26, 1999
-------------------------------
         Narendra K. Gupta

/s/ Stephen Von Rump                          Director                      March 26, 1999
-------------------------------
         Stephen Von Rump

</TABLE>

<PAGE>



                                   SCHEDULE II


                            DIGITAL LINK CORPORATION

                        VALUATION AND QUALIFYING ACCOUNTS
   For the Years Ended December 31, 1996, 1997 and 1998(Amounts in thousands)


<TABLE>

<CAPTION>

                                                       
                                                                                                                
                                                         Balance at     Charged to           Deductions          Balance at
                                                        Beginning of    Costs and       --------------------      End of  
                     Description                         the Period      Expenses       Description    Amount    the Period
                     -----------                       ------------- ---------------- -------------- --------- -------------
<S>                                                     <C>             <C>               <C>          <C>        <C> 
Balances for the year ended December 31, 1996:
     Allowance for doubtful accounts receivable.......   $  895             --              (b)         383
                                                                                            (a)          47        $  465
     Allowance for excess and obsolete inventories....   $  844            457              (a)         167        $1,134
     
Balances for the year ended December 31, 1997
     Allowance for doubtful accounts receivable ......   $  465             66              (a)          14        $  517
     Allowance for excess and obsolete inventories ...   $1,134            555              (a)         (23)       $1,712

Balances for the year ended December 31, 1998:
     Allowances for doubtful accounts receivable .....   $  517             27              (a)           4        $  540
     Allowances for excess and obsolete inventories ..   $1,712          3,045              (a)       3,217        $1,540

</TABLE>



(a)  Write-offs & adjustments

(b)  Credit to selling, general and administrative expenses