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, 1997
                                       OR

[ ]  TRANSITION  REPORT  PURSUANT  TO  SECTION  13 OR  15(d)  OF THE  SECURITIES
     EXCHANGE ACT OF 1934

        For the transition period from _______________ to _______________

                          Commission file number 1-5631

                             WATKINS-JOHNSON COMPANY
        ----------------------------------------------------------------
             (Exact name of registrant as specified in its charter)

           California                                   94-1402710
----------------------------------           ----------------------------------
 (State or other jurisdiction of            (I.R.S. Employer Identification No.)
 incorporation or organization)

       3333 Hillview Avenue,
       Palo Alto, California                            94304-1223
  ----------------------------------         ----------------------------------
(Address of principal executive offices)                (Zip Code)

                                 (650) 493-4141
                       ----------------------------------
              (Registrant's telephone number, including area code)

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

       Title of each class             Name of each exchange on which registered
----------------------------------     -----------------------------------------
   Common stock, no par value               New York Stock Exchange Pacific
                                                    Stock Exchange


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

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the  preceding 12 months,  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. [X].

                                                          As of February 9, 1998
Aggregate market value of the voting stock held           ----------------------
  by non-affiliates of the registrant:                         $160,863,000
Number of shares outstanding: Common stock, no par value     8,261,000 shares


                       DOCUMENTS INCORPORATED BY REFERENCE

Portions  of  the   Watkins-Johnson   Company   Notice  of  Annual   Meeting  of
Shareowners--April  18,  1998 and  Proxy  Statement  filed  with the  commission
pursuant to Regulation 14A are incorporated by reference into Part III.


<PAGE>


                                     Part I

Item 1.  Business

    (a)  General Development of Business

         Prior  to  1997  the  company  operated  in  three  industry  segments:
         Semiconductor   Equipment,    Government   Electronics   and   Wireless
         Communications.  During 1997 the company's structure was realigned from
         operating in three industry  segments to a focus on its two high-growth
         businesses:  Semiconductor  Equipment and Wireless  Communications.  In
         October  1997,  the  company   divested  its   Government   Electronics
         operations and reported such  divestiture as  discontinued  operations,
         restating  all  prior  years'  continuing   operations  results.   This
         realignment  is more  fully  discussed  in  Note 8 to the  consolidated
         financial statements contained in Part II, Item 8 of this annual report
         on Form 10-K.

         Historically  the company  operated  in a number of industry  segments.
         Beginning  in  1993,   operations  were  reported  as  three  segments:
         Semiconductor Equipment, Electronics and Environmental Services. At the
         end of 1994,  the  Environmental  Services unit was divested.  In 1995,
         Watkins-Johnson  divided its former Electronics Group,  recognizing the
         two major markets  that it  served,  into the  Wireless  Communications
         segment and the Government Electronics segment for reporting purposes.

         No other material  reclassifications,  mergers or consolidations of the
         company or its  subsidiaries  occurred  during 1997.  Other than in the
         ordinary  course of  business  and the  divestiture  of the  Government
         Electronics  segment,  there were no  acquisitions  or  dispositions of
         material amounts of assets during the year.

    (b)  Financial Information about Industry Segments

         The company  now  operates in two  industry  segments --  Semiconductor
         Equipment  and  Wireless   Communications.   As  discussed  above,  the
         Government   Electronics  segment  was  divested  in  1997.   Financial
         information  covering  these industry  segments and the  divestiture is
         included in Note 8 to the consolidated  financial  statements contained
         in Part II, Item 8 of this annual report on Form 10-K.

    (c)  Narrative Description of Business

         Watkins-Johnson Company is a high-technology  corporation  specializing
         in  semiconductor-manufacturing  equipment and wireless  communications
         products.

         Semiconductor Equipment

         The  company's  Semiconductor  Equipment  Group  designs,  develops and
         manufactures  equipment  to deposit thin  dielectric  films by chemical
         vapor   deposition   (CVD),   using  two   fundamental  CVD  processes:
         atmospheric-pressure  CVD (APCVD) and high  density  plasma  (HDP) CVD.
         This equipment functions by injecting the gases needed for the reaction
         over the substrate material.

                                     Page 2

<PAGE>


Item 1.  Business (continued)

         The earlier process,  atmospheric-pressure  CVD (APCVD),  accounted for
         all of the equipment sold in 1997.  Under this process,  the substrates
         are transported  under the injectors on a continuously  moving conveyor
         belt through a resistance  heated  muffle.  This  approach  allows high
         deposition   rates  with  a  simpler  reactor  design  yielding  higher
         reliability  operation and high wafer  throughput.  The company markets
         the APCVD  systems  as the  WJ-999  and the  WJ-1000.  The  WJ-999  and
         WJ-TEOS999  systems  are for  production  lines using  150-mm  (6-inch)
         semiconductor  wafers;  they are capable of simultaneous  processing of
         two wafers in parallel. The WJ-1000 is also offered with either hydride
         or  TEOS   reactant   processes  and  is   specifically   designed  for
         high-productivity   processing   on   200-mm   (8-inch)   semiconductor
         processing  lines.  The  company's  APCVD  process  is  mostly  used in
         depositing doped oxide films,  boro-phosphoro-silicate glass (BPSG) and
         phosphoro-silicate-glass  (PSG),  for  the  initial  dielectric  layers
         deposited on the wafers.  These initial  layers,  sometimes  termed the
         premetal  dielectric  (PMD),  are  deposited  prior to the metal layers
         which are used to connect  the  transistors  and  provide  the  circuit
         action.  BPSG is a useful  dielectric  layer since it  self-planarizes,
         offering a smoother  surface  for the  following  metal and  dielectric
         layers.  The WJ APCVD  equipment is well suited for these  applications
         and the company believes it is the PMD equipment market leader.

         The newer  process,  high  density  plasma  (HDP) CVD,  is a variant of
         plasma-enhanced CVD which uses an RF-induced glow discharge to transfer
         energy into the reactant gases.  This allows the substrate to remain at
         a lower  temperature  than in the APCVD  process.  Improved  generators
         allow  higher  density of plasmas  which will assist the  semiconductor
         industry in the production of future  integrated  circuits with smaller
         feature size transistors and conductors. These smaller (0.25 micron and
         below) features are being accelerated on the new Semiconductor Industry
         Association's  road map for 64 megabit dynamic random access memory (64
         Meg DRAM) and smaller chip size sixth generation  microprocessors.  The
         company accomplished a major goal in 1997 when it shipped and installed
         WJ-2000 HDP cluster  platforms at two Asian  locations.  The company is
         making good progress with the high-density  plasma (HDP) equipment with
         several  customers in Asia and  received  acceptance  of an  additional
         beta-site  placement for 1998.  The ability of the 200-mm HDP system to
         perform   superior    intermetal-dielectric    (IMD)   deposition   and
         shallow-trench  isolation  (STI)  processes is of keen  interest to the
         customers evaluating the system.

         Single-wafer  processing at 300 mm will be required for new fabrication
         facilities and  Watkins-Johnson is completing  development of a variant
         of its scalable cluster platform to perform premetal  dielectric (PMD),
         IMD, and STI  deposition on these large wafers.  The  equipment--called
         the WJ-3000  system--is  expected  to begin  running  customer  samples
         during 1998.  Market  researchers  expect that a number of  fabrication
         facilities  will be operating  developmental  and pilot 300-mm lines by
         the year 2000.

         Not only is WJ  concentrating on employing its equipment to perform new
         CVD processes,  the company is also  diligently  working to perfect its
         handling  of new  materials.  As  integrated-circuit  designers  employ
         smaller  geometries and multiple  layers to address future  performance
         requirements,  materials with improved  dielectric  performance--called
         low-k--are  being  employed in new  devices.  Also,  better  conducting
         metals--like  copper--are  being introduced to the production  process.
         Customer sample runs of low-k  dielectric films are scheduled for 1998.
         Future  equipment must be compatible  with these  processes,  and WJ is
         collaborating with other companies to ensure that compatibility.

                                     Page 3

<PAGE>


Item 1.  Business (continued)

         As chip complexity  increases,  additional metal layers are required to
         provide the circuit connections.  Another growing market for dielectric
         deposition  equipment is inter-metal  dielectric  (IMD) deposition used
         for  insulation  between the metal layers.  The  development of the new
         WJ-2000 HDP equipment is aimed specifically at this market.  WJ's APCVD
         equipment is not intended to compete for the IMD market since the lower
         temperature  required is technically  challenging for good films. Thus,
         success in the IMD market  would  nearly  double the  company's  served
         available market. Additionally, the IMD equipment market is forecast to
         grow more rapidly than the PMD equipment market.

         The smaller  and  smaller  feature  sizes used in the  construction  of
         integrated  circuits  are  opening a new  application  for the WJ APCVD
         equipment.  Small feature sizes allow smaller transistors to be defined
         and for them to be located closer together in the circuits. The desired
         packing  density is making  the  naturally  grown  LOCOS  (local  oxide
         separation)  step to become  difficult.  The LOCOS step can be replaced
         with a STI (shallow  trench  isolation)  approach using CVD. WJ's APCVD
         process is competitive for this newer step. The company is finding high
         interest in WJ equipment  for STI  applications.  Both the  atmospheric
         pressure (AP) systems and the cluster-tool HDP are candidates.

         Sales in the  Semiconductor  Equipment segment were 64% of consolidated
         sales in 1997 and 78% in 1996 and 1995.  Over the last three  years the
         company has changed  its mode of selling  and  servicing  semiconductor
         equipment. In place of a network of manufacturers'  representatives and
         distributors,  the company established a direct sales and service force
         world-wide to better serve its  customers.  Currently,  the company has
         direct offices in the United States,  Korea, Taiwan,  Singapore,  Japan
         and Europe.  Near the end of 1996, the  Semiconductor  Equipment  Group
         completed  construction of a new headquarters and technology  center in
         Japan.

         The major market for the CVD  equipment is the  semiconductor  industry
         where the  equipment is used to deposit thin films of doped and undoped
         silicon  dioxide  used  in  the  making  of  integrated  circuits.  The
         company's  APCVD process is highly  productive and offers an attractive
         cost  of  ownership.   The  equipment  is  sold   world-wide  to  major
         semiconductor manufacturers, especially to those engaged in high-volume
         integrated  circuit  manufacturing.  Customers  include both firms that
         manufacture and sell their own products and semiconductor foundry firms
         that contract  manufacturing  services to "fabless" companies.  As such
         the  company's  equipment  is used in the  manufacture  of all types of
         integrated circuits, from logic circuits to semiconductor memory chips.
         Although  there are many such  customers,  a majority of the integrated
         circuits  world-wide are produced by approximately  20 companies,  with
         roughly  two-thirds  of the  business  outside the United  States.  NEC
         (through Marubeni Hytech, the company's Japanese distributor),  Hyundai
         Electronics  Ind. Co. Ltd. and Samsung Pacific  International  Inc. are
         significant  customers of the segment.  There are several  domestic and
         international  competitors  (some of whom are larger than the  company)
         and  competition is intense.  In meeting the  competition,  emphasis is
         placed on selling quality products with good technical  performance and
         operational  reliability  with a  competitive  cost of  ownership.  The
         company's  growing  global  customer-support   network  is  a  possible
         competitive advantage.

                                     Page 4

<PAGE>


Item 1.  Business (continued)

         The  Semiconductor  Equipment Group's business depends upon the planned
         and actual capital expenditures of the semiconductor manufacturers, who
         react to the  current  and  anticipated  market  demand for  integrated
         circuits. This demand had been growing dramatically over the years from
         1992 through 1995,  however in 1996 its history of cyclical  variations
         returned with a market downturn which has persisted  through 1997. That
         downturn   was   exacerbated   in  the   fourth   quarter  of  1997  by
         financial-system  collapses  and  currency  devaluations  in Asia,  the
         company's  principal  overseas  market  region for  capital  equipment.
         Although the  cyclical  growth  trend of the  semiconductor  integrated
         circuits  business  is expected to return,  it is  recognized  that the
         semiconductor  equipment  business  can vary  rapidly  in  response  to
         customer demand.  Following placement of orders,  customers  frequently
         seek either faster or delayed delivery,  based on their changing needs.
         Uncertainty  increases  significantly when projecting product demand in
         the future.

         Wireless Communications

         This business segment serves original equipment  manufacturers (OEM) in
         the rapidly growing market for wireless communications  equipment.  The
         company's long-time leadership as a microwave-electronics  manufacturer
         and its historic strength in space communications  components provide a
         competitive  advantage in offering unique solutions to requirements for
         wireless network communications.

         The  company has entered two  wireless  communications  business  areas
         paralleling the skills it had developed as a former defense-electronics
         supplier.  In the  Palo  Alto,  California  facility,  the  company  is
         producing  components  and  subassemblies  for  cellular  and  personal
         communication  services (PCS). At the Gaithersburg,  Maryland facility,
         the company has  successfully  adapted its  communications-intelligence
         equipment   technology  to  the  design  and  production  of  low-cost,
         sensitive   receivers  and  wideband   transceivers  for  base  station
         applications.

         Both of these  operations take advantage of the processes,  devices and
         monolithic   microwave   integrated   circuits  (MMIC)   developed  and
         manufactured in the company's  gallium-arsenide  (GaAs) foundry.  These
         proprietary    devices   and   circuits    perform   highly    reliable
         signal-processing  functions in the various  equipment and have enabled
         the company to capture programs over its  competition.  Other strengths
         the company brings to this  marketplace are derived from the skills and
         technology  developed over many years of providing microwave components
         and communications receivers for defense-electronics  applications. The
         company has mined this  technology to take advantage of expected market
         growth in the wireless communications sector.  Substantial research and
         development  efforts are being expended in an attempt to take advantage
         of projected growth opportunities.

         The  group's  major  technical  accomplishment  of  the  year  was  the
         completion  of the analog  version of the Base2(TM)  wideband  cellular
         base  station   design  and  its  successful   installation   by  Telos
         Engineering,  Ltd.  in Dalian,  China.  This  installation  gives WJ an
         excellent  inroad to future  base-station  business  in China and other
         foreign  markets.  Although the initial  Base2(TM)  installation was an
         analog  system,  in  early  1998 WJ will  introduce  its new  Base2(TM)
         MacroCell,  the first  commercially  available  dual-mode  AMPS/IS-136A
         software-definable  base  station  for both  mobile and  fixed-wireless
         applications.  The Base2(TM)  MacroCell Base Station System  provides a
         seamless migration path from AMPS to TDMA by handling both protocols in
         a single base station and by configuring system resources based on user
         demand.

                                     Page 5

<PAGE>


Item 1.  Business (continued)

         The  company  also  is  capitalizing  on  the  healthy  market  for  RF
         components by expanding its gallium-arsenide (GaAs)  integrated-circuit
         fabrication capability and actively marketing  WJ-manufactured  devices
         to  the  wireless  industry.  Historically,  WJ has  manufactured  GaAs
         devices  for  its  own  use  only.   These  devices   offer   excellent
         performance,  and an updated  and  expanded  fabrication  facility  can
         enable WJ to sell them on the open market at competitive  prices.  As a
         way to accelerate the expansion of its  integrated-circuit  capability,
         the  company at  year-end  purchased  the  assets of Samsung  Microwave
         Semiconductor,  Inc.,  whose  ultimate  parent is  Samsung  Electronics
         Company of Seoul, Korea. The company has now begun the gradual transfer
         of its Palo Alto,  California,  GaAs and  thin-film  operations  to the
         newly acquired Milpitas, California facility.

         Sales by the Wireless  Communications  segment were 36% of consolidated
         sales in 1997 and 22% in 1996 and 1995.  The business is  international
         in scope.  Marketing  and sales are  performed by company  direct sales
         personnel  and  distributors.  Major  accounts  are  handled  by direct
         company  sales and service.  Components,  subassemblies,  receivers and
         transceivers  are primarily sold to companies  which  manufacture  base
         station   equipment  for  various  wireless   communication   carriers.
         Communications-intelligence  receivers  and tuners are sold to security
         agencies  of the U.S.  and other  governments.  Although  the  customer
         community  represents  a large  business  opportunity,  the  number  of
         individual customers is not large.

         Various  regulatory  agencies  of  federal,  foreign,  state  and local
         governments  can affect the  wireless  communication  market  dynamics,
         causing  unforeseen  ebb and flow of orders and delivery  requirements.
         Domestic and international competition from a number of companies, some
         of which are much larger than Watkins-Johnson,  is intense. The company
         seeks to win competitions by excellent  service and superior  technical
         performance. The group's customer, Lucent Technologies,  recognized the
         excellence   of  the   company's   products   and  services  by  naming
         Watkins-Johnson  Company its  "Supplier of the Year for 1997." WJ seeks
         to protect its intellectual  property by an aggressive patent and trade
         secret program as indicated below.

         Other Business Items

         Raw  materials  for  the  production  of  semiconductor  equipment  and
         wireless  communications  products are  acquired  from a broad range of
         suppliers.  Because  suppliers  are  numerous,  dependence  on any  one
         supplier is kept to a minimum. On occasion,  however,  the failure of a
         supplier to deliver key parts can jeopardize the on-time shipment of WJ
         products.  Business  operations  are not  believed to be  significantly
         seasonal.

         With respect to trade receivables from semiconductor  equipment systems
         sales,  generally  10%  to  20%  of the  balance  is  collectible  upon
         acceptance  of the  equipment  by the  customer.  Except for the use of
         letters  of credit on  international  sales and  negotiated  advance or
         progress  payments from customers on long-term  contracts  there are no
         other special working capital practices.

         The  company  has  been  active  in  securing   patents  and  licensing
         agreements to protect  certain  proprietary  technologies  and know-how
         resulting  from its ongoing  research and  development.  The  financial
         impact of the company's  efforts to protect its  intellectual  property
         are  unknown.   Management  believes  that  the  company's  competitive
         strength  derives  primarily from its core  competence in  engineering,
         manufacturing and  understanding its customers and markets;  therefore,
         aggressive steps to protect that knowledge are considered justifiable.

                                     Page 6

<PAGE>


Item 1.  Business (continued)

         Total company backlog at December 31, 1997 was $98,000,000  compared to
         $152,000,000   at  December  31,  1996.   The   percentage  of  backlog
         attributable to the Semiconductor Equipment and Wireless Communications
         were 39% and 61%,  respectively,  in 1997,  compared  to 60% and 40% in
         1996.  Approximately  93% of all backlog at year-end  1997 is shippable
         within 12 months, compared to 99% at year-end 1996

         Company-sponsored  research and development  expense was $50,182,000 in
         1997, $53,175,000 in 1996, and $42,656,000 in 1995.  Customer-sponsored
         research and development for the continuing operations was not material
         in 1997, 1996 and 1995.  Customer-sponsored research and development in
         prior years was performed mostly by the divested Government Electronics
         segment.

         The company's  employment  at December 31, 1997 was 1,520.  None of the
         company's  employees is covered by a  collective-bargaining  agreement.
         The company's relationship with its employees is generally good.

         Environmental  issues  are  discussed  in  Note 6 to  the  consolidated
         financial statements contained in Part II, Item 8 of this annual report
         on Form 10-K.

    (d)  Financial  Information about Foreign and Domestic Operations and Export
         Sales.

         Combined export sales and sales from foreign  operations  accounted for
         42% of the company's sales in 1997 and 59% in 1996 and 1995.  Assets of
         foreign operations  accounted for 14% and 15% of consolidated totals at
         December  31, 1997 and 1996,  respectively,  and were less than 10% for
         all years prior to 1996.  The  inherent  risks of foreign  business are
         similar to  domestic  business,  with the  additional  risks of foreign
         government  instability,  currency  fluctuations,  and  export  license
         cancellation.  A portion  of  foreign  product  orders in the  Wireless
         Communications  segment  requires export licensing by the Department of
         State prior to shipment.  For international  shipments for both company
         business  segments,  the company purchases  forward exchange  contracts
         and/or  generally  obtains customer letters of credit to reduce foreign
         currency  fluctuation  and credit  risks.  For further  information  on
         foreign  sales,  see Note 8 to the  consolidated  financial  statements
         contained in Part II, Item 8 of this annual report on Form 10-K.

Item 2.  Properties

         Watkins-Johnson  Company and subsidiaries conduct their main operations
         at plants in Palo Alto,  San Jose,  and Scotts  Valley,  California and
         Gaithersburg,  Maryland.  The sale and  exchange  of a  portion  of the
         company's  Palo Alto  lease  interest  was  successfully  completed  in
         December  1997.  About 7 acres at the Palo Alto campus were turned back
         for  consideration.  In  addition,  on  December  31,  1997 the company
         purchased the assets of Samsung  Microwave  Semiconductor and took over
         its leased facility in Milpitas,  California. Near the end of 1996, the
         Semiconductor   Equipment  Group   completed   construction  of  a  new
         technology center in Japan.

         At December 31, 1997, there were  approximately  698,000 square feet of
         plant  space in  California,  175,000  square feet in  Maryland,  and a
         36,000 square foot facility in Kawasaki,  Japan.  Of the 698,000 square
         feet of plant space in California, approximately 120,000 square feet is
         subleased  to Stellex  Microwave  Systems,  Inc.  for a period of up to
         three years as part of the divestiture  agreement.  The space is leased
         to Stellex at a price which recovers  utilities,  maintenance and other
         services,  and may be  canceled  by  Stellex  giving 6  months  notice.
         Excluding the plant space occupied by Stellex, approximately 85% of the
         company's   available   plant  space  is  occupied  for  the  company's
         operations. The company is pursuing opportunities to realize the market
         value of its  properties  while  ensuring  efficient  use of  available
         space.  As part of this effort,  approximately  15 acres of undeveloped
         land  adjacent to the San Jose  facility  was sold at the  beginning of
         1998.

                                     Page 7

<PAGE>


Item 2.  Properties (continued)

         The Wireless  Communications  segment utilizes substantially all of the
         Milpitas,  Gaithersburg and remaining Palo Alto facilities.  The Scotts
         Valley,  San Jose  and  Kawasaki  facilities  house  the  Semiconductor
         Equipment Group.

         The Palo Alto and Milpitas facilities,  and sales office locations, are
         leased.  Information  on  long-term  obligations  is in  Note  3 to the
         consolidated  financial statements contained in Part II, Item 8 of this
         annual report on Form 10-K.

Item 3.  Legal Proceedings

         Information  required  under  this item is  contained  in Note 6 to the
         consolidated  financial statements contained in Part II, Item 8 of this
         annual report on Form 10-K.

Item 4.  Submission of Matters to a Vote of Security Holders

         The company  submitted no matters to a vote of the  shareowners  during
         the last quarter of the period covered by this report.


<TABLE>
<CAPTION>
                                            Executive Officers of the Registrant

                                                                           Officer    Business Experience
Name                            Age     Office Held                        Since      Last Five Years
-------------------------------------------------------------------------------------------------------------------------
<S>                             <C>                                        <C>        <C>
Dr. Dean A. Watkins             75      Chairman of the Board              1957       Chairman of the Board
Dr. H. Richard Johnson          71      Vice Chairman of the Board         1957       Vice Chairman of the Board
Dr. W. Keith Kennedy, Jr.       54      President and Chief Executive      1977       President and Chief Executive
                                            Officer                                       Officer
Scott G. Buchanan               46      Vice President and Chief           1989       Vice President and Chief Financial
                                            Financial Officer                             Officer
Dr. Patrick J. Brady            52      Vice President                     1996       President, Semiconductor Equipment
                                                                                          Group; Prior to 1996, Vice
                                                                                          President of Engineering,
                                                                                          Semiconductor Equipment Group
Malcolm J. Caraballo            42      Vice President                     1996       President, Microwave Products
                                                                                          Group; Prior to 1996, Vice
                                                                                          President, Microwave Products
                                                                                          Division
Robert G. Hiller                60      Vice President                     1997       President, Telecommunications
                                                                                          Group, Prior to 1997, Vice
                                                                                          President, Telecommunications
                                                                                          Group, Prior to 1996, Director,
                                                                                          Engineering, Electronics
                                                                                          Equipment Division
Darryl T. Quan                  43      Controller                         1991       Controller
Claudia D. Kelly                57      Secretary                          1996       Secretary; Prior to 1996, Manager,
                                                                                          Palo Alto Customer and Export
                                                                                          Services
</TABLE>


Dr.  Watkins  and Dr.  Johnson  have been  directors  of the  company  since its
incorporation in 1957.
Dr. Kennedy has been a Director since August 1987.

None of the above  officers is related to any other  officer at  Watkins-Johnson
Company.

                                     Page 8

<PAGE>


                                     Part II


Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters

         The company's  common stock is  principally  traded on the New York and
         Pacific stock exchanges.  At December 31, 1997 there were approximately
         6,500  shareowners,  which  included  holders of record and  beneficial
         owners.  The  company  expects  that  comparable  cash  dividends  will
         continue in the future.

<TABLE>
         DIVIDENDS AND STOCK PRICES

<CAPTION>
1997 Quarters                                           1st       2nd       3rd       4th
-------------------------------------------------------------------------------------------------
<S>                                                     <C>       <C>       <C>       <C>
Dividends declared per share (in cents)                 12        12        12        12

Stock price                                High         26 7/8    32 3/8    37 1/4    35 3/4
(NYSE-in dollars)                          Low          22 1/8    22 1/4    30 3/4    24 3/16


1997 Quarters                                           1st       2nd       3rd       4th
-------------------------------------------------------------------------------------------------

Dividends declared per share (in cents)                 12        12        12        12

Stock price                                High         44 5/8    36 1/4    28 3/4    28 1/4
(NYSE-in dollars)                          Low          34 1/4    27 1/8    17        17 3/4
</TABLE>


<TABLE>
Item 6.  Selected Financial Data

<CAPTION>
(Dollars in thousands,
except per share amounts)                             1997              1996              1995             1994             1993
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                <C>               <C>               <C>              <C>              <C>        
OPERATING RESULTS
Sales                                              $   291,271       $   349,119       $   284,335      $   209,330      $   150,303
Net Income (Loss) from
    Continuing Operations                               (3,962)           (1,321)           21,854           19,652           12,382
Basic Net Income (Loss) Per Share
    From Continuing Operations                            (.48)             (.16)             2.75             2.65             1.64
Diluted Net Income (Loss) Per Share
    From Continuing Operations                            (.48)             (.16)             2.49             2.41             1.56
Dividends Per Share                                        .48               .48               .48              .48              .48
Basic Average Common Shares                          8,258,000         8,265,000         7,938,000        7,425,000        7,558,000
Diluted Average Common Shares                        8,258,000         8,265,000         8,776,000        8,153,000        7,925,000

FINANCIAL POSITION
Working Capital                                    $   153,607       $   122,982       $   124,796      $   102,361      $    95,206
Total Assets                                           358,212           293,744           269,565          220,223          206,728
Long-Term Obligations                                   33,234            37,801            20,469           21,332           24,997
Shareowners' Equity                                    220,392           194,711           191,253          149,626          133,888
</TABLE>

                                                               Page 9

<PAGE>


Item 7.  Management's Discussion and Analysis of Financial Condition and Results
         of Operations

         Financial Condition and Liquidity

         During 1997,  cash and equivalents  increased by $118.8  million,  from
         $15.7 million to $134.5 million. Net income for 1997 was $32.9 million,
         while net cash provided by operations was $57.1 million. Net income was
         $3.0 million and net cash provided by  operations  was $13.8 million in
         1996,  and net  income  was  $31.4  million  and net cash  provided  by
         operations  was $12.8 million in 1995.  For 1997,  net cash provided by
         operating  activities differed from net income for the period primarily
         because of increases  for:  depreciation  and  amortization  charges of
         $13.1 million,  $26.9 million of accounts  receivables  collections and
         $39.6  million in non-cash  increases  in accruals  and  payables;  and
         decreases  for: a $10.5  million  net change in deferred  taxes,  $36.9
         million  for  the  gain  and  net  income  of  discontinued  operations
         (discussed  below) and $11.2 million for net cash used by  discontinued
         operations.  For  1996,  net  cash  provided  by  operating  activities
         differed from net income for the period primarily  because of increases
         for: depreciation and amortization charges of $9.0 million, net changes
         in inventory of $16.9 million and  provisions for warranties and losses
         on contracts of $6.7  million;  and  decreases  for: a $3.3 million net
         change in deferred  taxes,  $4.4  million and $2.2  million for the net
         income and cash used by discontinued operations, respectively, and $4.5
         million and $4.3  million for net changes in  receivables  and accruals
         and payables,  respectively.  For 1995,  net cash provided by operating
         activities differed from net income for the period primarily because of
         increases for:  depreciation and amortization  charges of $7.3 million,
         net changes in accruals and payables of $9.1 million and $25.7  million
         in net cash provided by discontinued operations; and decreases for: the
         net  income  of  discontinued  operations  of $9.6  million,  and $12.8
         million and $35.6 million for net changes in receivables and inventory,
         respectively.

         Net cash  provided by investing  activities  was $67.9  million in 1997
         compared to net cash used by investing  activities of $53.1 million and
         $23.4  million in 1996 and 1995,  respectively.  In 1997,  the  company
         received  proceeds of $77.9  million and $8.5  million from the sale of
         discontinued operations and asset retirements,  respectively, offset in
         part by  investments  of $22.2 million in new capital  equipment.  Cash
         used for  investing  activities  in 1996 and  1995  was  primarily  for
         capital expenditures.

         The company used $7.0 million in financing  activities in 1997 compared
         to cash  provided by financing  activities  of $20.4  million and $10.7
         million in 1996 and 1995,  respectively.  The company  reactivated  its
         stock  repurchase  program  during the first quarter of 1997 and during
         the year  repurchased  204,200  shares  of its  common  stock  for $5.7
         million  which was  partially  offset by $2.8 million in proceeds  from
         stock option  exercises.  The goal is to repurchase  approximately  the
         same number of shares  added by the  exercise of options.  During 1997,
         the company paid  approximately  $4 million in  dividends.  The primary
         source of cash  provided by financing  activities in 1996 was long-term
         borrowings of about $20 million for the purchase and  construction of a
         new facility in Japan for the company's  Semiconductor Equipment Group,
         while the primary  source of cash  provided by financing  activities in
         1995 was proceeds from stock option exercises.

         At December  31,  1997,  the  company's  principal  source of liquidity
         consisted of $134.5 million in cash and cash  equivalents.  The company
         has arrangements with several banks to provide a $50,000,000  unsecured
         credit  facility.  This  facility  expires on December 8, 1998.  During
         1997, the company  incurred no borrowings  under this credit  facility.
         Because of the operating  loss  reported in the fourth  quarter of 1997
         the company is not in  compliance  with certain terms under this credit
         facility.  The company is coordinating with its banks to re-establish a
         compliant  condition.  Management  does not anticipate any  significant
         near  term  borrowing  requirements  and does not  expect  the  current
         noncompliance condition to materially affect the company's liquidity or
         financial  position  for 1998.  From time to time the company may enter

                                    Page 10

<PAGE>


         into certain  long-term  borrowing  arrangements with financial lending
         institutions for capital acquisitions of property, plant and equipment.
         At December 31, 1997,  long-term  borrowings consisted of two unsecured
         loans used for the company's  land,  building and equipment  located in
         Kawasaki,   Japan.   The  loans  are   denominated  in  Yen,  of  which
         approximately  $6.6  million is  amortizable  in  monthly  installments
         through the year 2011,  bears interest at 2.5%, and  approximately  $12
         million  requires  a  balloon  payment  due in the year  2006 and bears
         interest at 3.1%, payable semiannually. At December 31, 1997 there were
         no material commitments for capital expenditures.

         Current Operations and Business Outlook

         On October 31, 1997,  the company  completed the sale of its Palo Alto,
         Calif.-based  Tactical  Subsystems and Microwave  Devices sectors to an
         affiliate of Mentmore  Holdings  Corporation for  consideration of $103
         million, consisting mostly of cash. The sale resulted in a pre-tax gain
         of approximately $49.9 million.  The divested businesses now operate as
         Stellex Microwave Systems, Inc. (Stellex). In connection with the sale,
         the  company  transferred   approximately  $77  million  of  Government
         Electronics  and Wireless  Communications  backlog to Stellex.  Stellex
         remains a WJ customer for GaAs devices and  thin-film  substrates.  The
         divestiture enables Watkins-Johnson to concentrate its resources on two
         chosen areas of technology:  semiconductor-manufacturing  equipment and
         wireless-infrastructure products.

         In the fourth quarter of 1997 the company elected the early adoption of
         Statement of Financial Accounting Standards No. 131, "Disclosures about
         Segments of an Enterprise  and Related  Information,"  (SFAS 131),  and
         restated its reportable  business  segments  accordingly.  Prior to the
         adoption of SFAS 131, the company reported operations in three industry
         segments:   Semiconductor  Equipment,   Wireless  Communications,   and
         Government  Electronics.  The former Government Electronics segment was
         redefined according to SFAS 131 to consist of the business sectors sold
         to Stellex as described  above.  The  divested  business is reported as
         discontinued  operations  in  the  financial  statements.  For  further
         information  regarding  discontinued  operations and business segments,
         see Note 8 to the consolidated  financial  statements contained in Part
         II, Item 8 of this annual report on Form 10-K.

         For 1997,  the company  reported  sales and a net loss from  continuing
         operations  of  $291.3  million  and $4.0  million,  respectively.  The
         company  ended the year with $98 million of backlog for the  continuing
         business  compared  to $152  million  last year.  The  current  backlog
         excludes  $19 million in  semiconductor  equipment  backlog  from Korea
         which has been removed from the backlog until adequate  financial terms
         can be worked out.  Comparative 1996 sales and net loss from continuing
         operations were $349.1 million and $1.3 million, respectively.

         The sale and  exchange  of a portion of the  company's  Palo Alto lease
         interest was successfully  completed in December 1997. About 7 acres at
         the Palo Alto campus were turned back for consideration, resulting in a
         $7.6 million  pre-tax gain  reflected as "Gain on real property" in the
         statement  of  operations.  As part of the deal the company was able to
         extend the lease so that the  remaining 16 acres are available for over
         50 years without lease payments.

         Looking forward, long-term growth for the continuing businesses appears
         bright.  The semiconductor  equipment  business is a cyclical business.
         The company  anticipates  that overall  revenues in calendar  year 1998
         will  experience a slight  decrease as the  anticipated  decline of the
         semiconductor  equipment  business  will more than  offset  the  growth
         expected  in the  wireless  business.  Even with heavy  investment  for
         research  and  development,  the  Wireless  Communications  segment  is
         expected  to make a profit.  However,  those  Wireless  profits are not
         expected  to  overcome  the  losses  anticipated  in the  Semiconductor
         Equipment Group. In any event,  the 1998  profitability of WJ will come
         from the net  interest on cash and the land sale in San Jose,  which is
         discussed below.

                                    Page 11

<PAGE>


         Semiconductor Equipment Group

         Sales of semiconductor equipment in 1997 amounted to $186 million, down
         32 percent from the $272 million recorded in 1996. The book-to-bill for
         the fourth quarter was only 0.7-to-1 as a result of events  relating to
         Korea. Orders were $32 million during the fourth quarter of 1997, which
         were flat with the third quarter's $32 million,  but were down compared
         to the $78 million of last  year's  fourth  quarter.  These order rates
         mean that the group is below the long-term  goal of a 5-month  backlog.
         At this level, the company is able to service the order requirements of
         its  customers  rapidly,  and they  continue to take  advantage  of the
         shorter  lead  time.  This  business  segment is  entering  1998 with a
         backlog totaling approximately $38 million.

         The worldwide  oversupply of memory devices continued  throughout 1997,
         prompting  DRAM   manufacturers   to  expedite   their   transition  to
         smaller-geometry devices. The overall capital-equipment market remained
         flat.  Because the  company's  installed CVD equipment was adaptable to
         the production of the newer-generation  memory devices, the company did
         not benefit from the retooling  undertaken during the year. The general
         market  weakness was  exacerbated  at year-end as the  magnitude of the
         Asian economic  crisis began to unfold,  and IMF spending  restrictions
         increased the uncertainty  surrounding any near-term business prospects
         from Asian customers.  As a result, the company took certain actions in
         the fourth  quarter of 1997 to minimize  its  financial  exposure.  The
         company  deferred  shipment and revenue  recognition with certain Asian
         customers,  and the  business  is being sized to reflect  these  market
         changes.  This resulted in certain  non-performing assets being written
         off which consist  primarily of inventory,  capital  assets and a small
         lease  commitment  in Scotts  Valley,  California.  The effect of these
         actions  resulted  in a pre-tax  impact of  approximately  $17  million
         during the fourth quarter of 1997. The group is reviewing its worldwide
         infrastructure to reduce cost while still  maintaining  quality service
         to its customers. The group is taking steps to insure that research and
         development  spending  will  result in  higher  potential  for  certain
         projects,  while other projects are to be either reduced or delayed. In
         spite of these  actions,  fixed  costs  and what are  considered  to be
         necessary   development   expenses   will   probably   make  the  group
         unprofitable in 1998 due to the lower anticipated revenues.

         The company continues to believe the long-range  industry forecasts for
         the  semiconductor   industry  remain  bright.   Current  semiconductor
         integrated circuit demand appears to be increasing in dollar terms over
         last year. However, the industry is still in an overcapacity  situation
         and is purchasing less capital equipment.  Unfortunately, the near-term
         orders  picture  is lower  than  1997's  average  run rate of about $47
         million per quarter.

         Wireless Communications

         Wireless-communications   sales  in  1997  totaled  $105   million,   a
         36-percent  increase over the prior year's  comparable  $77 million for
         this segment (as restated for the adoption of SFAS 131). Orders for the
         fourth quarter 1997 totaled approximately $36 million,  compared to $31
         million for the same  period  last year,  and $22 million for the third
         quarter of 1997.  The business  segment is entering 1998 with a backlog
         totaling approximately $60 million.

         The segment  achieved  exceptional  revenue  growth  during 1997 as its
         radio-frequency   assemblies   for  cellular  and  PCS  systems  gained
         widespread  acceptance.   Orders  were  good  for  the  CDMA  and  TDMA
         assemblies,  which are  produced for Lucent  Technologies.  The company
         believes that a good shipment  rate will continue  throughout  1998 for
         these  assemblies.  The company is gaining  business at other  wireless
         OEMs and is  beginning  to receive  additional  orders for volume  GaAs
         parts.

         On December 31, the company  purchased the assets of Samsung  Microwave
         Semiconductor,   and  its  gallium-arsenide   semiconductor   business.
         Although the company picked up a small

                                    Page 12

<PAGE>


         amount of business,  the primary  reason for this  acquisition  was the
         in-process technology and equipment.  Significant  additional work will
         be  necessary  to  successfully  bring these  products  to market.  The
         acquisition   resulted  in  a  $5.0  million   pre-tax  charge  against
         operations consisting principally of in-process R&D. The acquisition of
         the Samsung  facility  and its GaAs  capability  enables the segment to
         expand its existing capacity.

         In 1997, the company completed its Base2TM cellular base station design
         and the system was  successfully  installed in Dalian,  China, by Telos
         Engineering,  Ltd.  as part of its Sonata  Wireless  Telecommunications
         System.  There are several  good  opportunities  for this  equipment in
         other Chinese cities and in South and Central America where the company
         is supporting the work of its system  integrator  customers.  Hopes for
         major U.S.  business  for the  Base2TM  system did not come to fruition
         when the customer was unable to get their major  supplier to open their
         switching  specification  to WJ.  The  company  is  re-emphasizing  the
         international  marketing of the system.  International  customers  seem
         more  willing to work with the  open-systems  switches.  The company is
         hopeful that these opportunities will materialize into orders in 1998.

         1997 Compared to 1996

         Wireless   Communications   sales  increased  36%  while  Semiconductor
         Equipment  Group sales  decreased 32%,  resulting in an overall company
         decrease of 17%.  By the third  quarter of 1996,  the company  began to
         experience the drop in semiconductor equipment shipments. Gross margins
         decreased from 34% to 32.5%.  Gross margins in 1997 include the effects
         of  $15  million  in  fourth  quarter  Semiconductor   Equipment  Group
         write-offs discussed above,  compared to 1996 which included nearly $20
         million in  write-offs  due mostly to  slow-moving  inventory  and some
         termination costs.  Selling and administrative  expenses decreased 12%,
         due  mostly to the  decreased  volume  and  cost-cutting  efforts,  but
         increased  slightly as a percentage of sales.  Excluding a write-off of
         $4.6 million for in-process research and development connected with the
         Samsung GaAs  acquisition,  research and development  expenses remained
         relatively  flat as a percentage of sales.  Interest  income  increased
         $1.4  million  over the prior year due to the increase in cash and cash
         equivalents. Other income decreased due primarily to about $1.4 million
         in  foreign  currency  translation  losses in 1997  from the  company's
         Southeast  Asian  subsidiaries.  The sale and  exchange  of a Palo Alto
         lease interest was successfully  completed in 1997, resulting in a $7.6
         million  pre-tax  gain  reflected  as  "Gain on real  property"  in the
         consolidated financial statements.  The effective tax rate for federal,
         state and foreign income taxes on continuing  operations  resulted in a
         tax  benefit  rate of about 43%  compared  to 37% in 1996.  The 43% tax
         benefit rate resulted mostly from the effect of the operating loss with
         positive  benefits from export sales and research  credits,  which were
         offset  by taxes  incurred  by  foreign  operations.  Due to the  above
         factors,  the net loss from continuing  operations  increased from $1.3
         million for 1996 to about $4.0  million for 1997.  Including  the after
         tax gain on the disposition and results of discontinued operations, net
         income increased from $3.0 million for 1996 to $32.9 million for 1997.

         1996 Compared to 1995

         Semiconductor  Equipment Group sales and Wireless  Communications sales
         both  increased 23% over the prior year.  Gross margins  decreased from
         46.2%  to 34%  due  mostly  to  slow-moving  inventory  write-offs  and
         termination  costs totaling  nearly $20 million and an increased  fixed
         cost base associated with early 1996 expansion  efforts in anticipation
         of increased  business by the Semiconductor  Equipment Group.  Although
         selling and administrative expenses decreased as a percentage of sales,
         due mostly to cost cutting efforts and lower foreign sales  commissions
         resulting from direct sales efforts, 1996 expenses were slightly higher
         due to the increased volume and  infrastructure  development.  Research
         and  development  expenses  remained  flat at about 15% of sales due to
         continuing  efforts to develop  next-generation  products  for both the
         semiconductor equipment and wireless communications segments.  Interest
         expense increased

                                    Page 13

<PAGE>


         over 1995 due to long-term  borrowings.  Other income decreased as 1995
         results included $1.3 million from a favorable insurance settlement for
         certain environmental expenditures. The effective tax rate for federal,
         state and foreign income taxes on continuing  operations  resulted in a
         tax benefit rate of 37% in 1996 compared to a 28.5% tax expense rate in
         1995.  The 37% tax benefit rate resulted  mostly from the effect of the
         operating  loss with  positive  benefits from export sales and research
         credits, which were offset by taxes incurred by foreign operations. Due
         to the above factors,  results of continuing  operations decreased from
         income of $21.9  million  for 1995 to a loss of $1.3  million for 1996.
         Including the results of discontinued operations,  net income decreased
         from $31.4 million for 1995 to $3 million for 1996.

         Subsequent Events

         In January 1998, the company sold approximately 15 acres of undeveloped
         land  adjacent to its San Jose,  California,  facility  for a net sales
         price  of  about  $16   million,   resulting   in  a  pre-tax  gain  of
         approximately  $15  million.  The  transaction  will be reported in the
         company's results for the first quarter ending March 27, 1998.

         Year 2000 Computer Software Conversion

         The company regularly updates its information systems capabilities, and
         has  evaluated  all  significant  computer  software  applications  for
         compatibility  with the year 2000. With the system changes  implemented
         to date and other planned  changes,  the company  anticipates  that its
         computer  software  applications will be compatible with the year 2000.
         Expenditures  specifically  related to software  modifications for year
         2000  compatibility  are not expected to have a material  affect on the
         company's  operations or financial  position.  However,  the company is
         dependent on numerous vendors and customers which may incur disruptions
         as a result of year 2000 software issues. Accordingly, no assurance can
         be given that the company's  results of operations will not be impacted
         by this industry-wide issue.

         Risks and Uncertainties That May Affect Future Results

         Statements  in  this  Annual  Report,   including  this   "Management's
         Discussion   and  Analysis  of  Financial   Condition  and  Results  of
         Operations"   which  are  not  historical  facts  are   forward-looking
         statements.  The words "expect",  "anticipate",  "looking  forward" and
         other  similar  expressions  are  intended to identify  forward-looking
         statements that involve risks and  uncertainties  that may cause actual
         results  to differ  materially  from  those  expressed.  Such risks and
         uncertainties  include,  but are not  limited  to:  product  demand and
         market acceptance risks, the effect of economic conditions,  the impact
         of   competitive    products   and   pricing,    product   development,
         commercialization and technological  difficulties,  capacity and supply
         constraints or difficulties,  business cycles, the results of financing
         efforts, actual purchases under agreements, the effect of the company's
         accounting  policies,  U.S.  Government  export  policies,   geographic
         concentrations, natural disasters and other risks.

Item 7A. Quantitive and Qualitative Disclosures About Market Risks.

         Disclosures under this item are not required for the current year.

                                    Page 14

<PAGE>


Item 8.  Financial Statements and Supplementary Data


<TABLE>
                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                                CONSOLIDATED STATEMENTS OF OPERATIONS

<CAPTION>
                                                                                                              Year Ended December 31
------------------------------------------------------------------------------------------------------------------------------------
(Dollars in thousands, except per share amounts)                                 1997                1996                  1995
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>                  <C>                  <C>        
Sales                                                                         $   291,271          $   349,119          $   284,335
------------------------------------------------------------------------------------------------------------------------------------

Costs and expenses:
    Cost of goods sold                                                            196,675              230,556              153,080
    Selling and administrative                                                     58,696               66,687               60,114
    Research and development                                                       50,182               53,175               42,656
------------------------------------------------------------------------------------------------------------------------------------
                                                                                  305,553              350,418              255,850
------------------------------------------------------------------------------------------------------------------------------------

Income (loss) from operations                                                     (14,282)              (1,299)              28,485

Other income (expense):
    Interest income                                                                 2,198                  789                2,400
    Interest expense                                                               (1,425)              (1,574)                (873)
    Other income (expense)--net                                                    (1,062)                 (12)                 552
    Gain on real property (Note 3)                                                  7,609
------------------------------------------------------------------------------------------------------------------------------------

Income (loss) from continuing operations before
    federal, state and foreign income taxes                                        (6,962)              (2,096)              30,564
Federal, state and foreign income tax credits (expense)                             3,000                  775               (8,710)
------------------------------------------------------------------------------------------------------------------------------------

Income (loss) from continuing operations                                           (3,962)              (1,321)              21,854
Discontinued operations (Note 8):
    Income from discontinued operations, net of taxes                               7,210                4,355                9,574
    Gain on disposition, net of taxes                                              29,677
------------------------------------------------------------------------------------------------------------------------------------
Net income                                                                    $    32,925          $     3,034          $    31,428
====================================================================================================================================

Basic per share amounts:

    Income (loss) from continuing operations                                  $      (.48)         $      (.16)         $      2.75
    Income from discontinued operations                                               .87                  .53                 1.21
    Gain on disposition of discontinued operations                                   3.60
------------------------------------------------------------------------------------------------------------------------------------
Net income                                                                    $      3.99          $       .37          $      3.96
====================================================================================================================================
Basic average common shares                                                     8,258,000            8,265,000            7,938,000

Diluted per share amounts:

    Income (loss) from continuing operations                                  $      (.48)         $      (.16)         $      2.49
    Income from discontinued operations                                               .87                  .53                 1.09
    Gain on disposition of discontinued operations                                   3.60
------------------------------------------------------------------------------------------------------------------------------------
Net income                                                                    $      3.99          $       .37          $      3.58
====================================================================================================================================
Diluted average common shares                                                   8,258,000            8,265,000            8,776,000

<FN>
                                           See notes to consolidated financial statements.
</FN>
</TABLE>

                                                              Page 15

<PAGE>


                    WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS


                                                                     December 31
--------------------------------------------------------------------------------
(Dollars in thousands, except per share amounts)           1997          1996
--------------------------------------------------------------------------------
ASSETS

CURRENT ASSETS:
      Cash and equivalents                               $ 134,462    $  15,702
      Receivables (net of allowance for doubtful
           accounts of $3,176 in 1997 and
           $747 in 1996)                                    45,690       73,217
      Inventories:
           Finished goods                                    9,283        3,105
           Work in process                                  18,519       24,000
           Raw materials and parts                          18,873       23,153
      Deferred income taxes                                 24,830       14,395
      Net assets of discontinued operations (Note 8)                     25,717
      Other                                                  6,536        4,925
      --------------------------------------------------------------------------
      Total current assets                                 258,193      184,214
      --------------------------------------------------------------------------

PROPERTY, PLANT AND EQUIPMENT:
      Land                                                  12,102       13,075
      Buildings and improvements                            55,155       54,035
      Plant facilities, leased                              11,012       13,060
      Machinery and equipment                              100,526      106,648
      --------------------------------------------------------------------------
                                                           178,795      186,818
      Accumulated depreciation and amortization            (82,382)     (88,348)
      --------------------------------------------------------------------------
      Property, plant and equipment--net                    96,413       98,470
      --------------------------------------------------------------------------

OTHER ASSETS:
      Net assets of discontinued operations (Note 8)                      4,100
      Other                                                  3,606        6,960
      --------------------------------------------------------------------------
      Total other assets                                     3,606       11,060
--------------------------------------------------------------------------------
                                                         $ 358,212    $ 293,744
================================================================================

LIABILITIES AND SHAREOWNERS' EQUITY

CURRENT LIABILITIES:
      Accounts payable                                   $  16,188    $  16,560
      Accrued expenses                                      23,209       10,362
      Advances on contracts                                  1,867        1,432
      Provision for warranties and losses on contracts      15,898       14,478
      Payroll and profit sharing                            15,825       10,094
      Income taxes                                          31,599        8,306
      --------------------------------------------------------------------------
      Total current liabilities                            104,586       61,232
      --------------------------------------------------------------------------

LONG-TERM OBLIGATIONS                                       33,234       37,801
--------------------------------------------------------------------------------

COMMITMENTS AND CONTINGENCIES (Notes 3 and 6)

SHAREOWNERS' EQUITY:
      Preferred stock, $1.00 par value--authorized
         and unissued, 500,000 shares
      Common stock, no par value--authorized,
         45,000,000 shares; outstanding: 1997,
         8,261,036 shares; 1996, 8,329,248 shares           40,631       38,998
      Retained earnings                                    179,761      155,713
      --------------------------------------------------------------------------
      Total shareowners' equity                            220,392      194,711
--------------------------------------------------------------------------------
                                                         $ 358,212    $ 293,744
================================================================================

                 See notes to consolidated financial statements.

                                    Page 16

<PAGE>


<TABLE>
                                       WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                    CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY

<CAPTION>
                                                                                                              Total
                                                          Common Stock                                       Share-
(Dollars in thousands,                               -----------------------             Retained           owners'
except per share amounts)                            Shares          Dollars             Earnings            Equity
-------------------------------------------------------------------------------------------------------------------
<S>                                                 <C>               <C>                <C>                 <C>   
Balance, January 1, 1995                          7,576,471          $20,279             $129,347          $149,626
      Net income for 1995                                                                  31,428            31,428
      Dividends declared--$.48 per share                                                   (3,829)           (3,829)
      Stock option transactions                     547,584           14,028                                 14,028
-------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1995                        8,124,055           34,307              156,946           191,253
      Net income for 1996                                                                   3,034             3,034
      Dividends declared--$.48 per share                                                   (3,973)           (3,973)
      Stock option transactions                     205,193            4,691                                  4,691
      Cumulative translation adjustments                                                     (294)             (294)
-------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1996                        8,329,248           38,998              155,713           194,711
      Net income for 1997                                                                  32,925            32,925
      Dividends declared--$.48 per share                                                   (3,974)           (3,974)
      Stock option transactions                     135,988            2,778                                  2,778
      Repurchase of common stock                   (204,200)          (1,145)              (4,602)           (5,747)
      Cumulative translation adjustments                                                     (301)             (301)
-------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1997                        8,261,036       $   40,631           $  179,761       $   220,392
===================================================================================================================

<FN>
                                   See notes to consolidated financial statements.
</FN>
</TABLE>

                                                       Page 17

<PAGE>


<TABLE>
                                     WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                       CONSOLIDATED STATEMENTS OF CASH FLOWS


<CAPTION>
                                                                                            Year Ended December 31
-------------------------------------------------------------------------------------------------------------------
(Dollars in thousands)                                                      1997             1996              1995
-------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>              <C>               <C>    
OPERATING ACTIVITIES:

      Net income                                                        $ 32,925         $  3,034          $ 31,428
      Adjustments to reconcile net income to net cash
        provided by operating activities:
           Depreciation and amortization                                  13,112            8,996             7,341
           Gain on disposal of property, plant and equipment              (3,513)
           Deferred income taxes                                         (10,470)          (3,280)             (785)
           Results of discontinued operations and
               gain on disposal                                          (36,887)          (4,355)           (9,574)
           Net changes in:
               Receivables                                                26,897           (4,506)          (12,819)
               Inventories                                                 3,364           16,877           (35,636)
               Other assets                                                1,584           (1,752)           (1,733)
               Accruals and payables                                      39,635           (4,257)            9,127
               Advances on contracts                                         435           (1,114)           (1,926)
               Provision for warranties and losses on contracts            1,420            6,688             2,498
               Environmental remediation                                    (198)            (327)             (817)
-------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by continuing operating activities         68,304           16,004           (12,896)
           Net cash provided (used) by discontinued operations           (11,180)          (2,181)           25,670
-------------------------------------------------------------------------------------------------------------------
      Net cash provided by operating activities                           57,124           13,823            12,774
-------------------------------------------------------------------------------------------------------------------

INVESTING ACTIVITIES:

      Additions of property, plant and equipment                         (22,177)         (48,303)          (23,366)
      Restricted plant construction funds                                  3,738           (3,738)
      Proceeds from sale of discontinued operations                       77,884
      Proceeds on asset retirements and other                              8,475           (1,070)              (35)
-------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by investing activities                    67,920          (53,111)          (23,401)
-------------------------------------------------------------------------------------------------------------------

FINANCING ACTIVITIES:

      Long-term borrowings                                                 1,642           20,241
      Payments on long-term borrowings                                    (1,132)            (135)             (112)
      Proceeds from issuance of common stock                               2,778            4,691            14,028
      Repurchase of common stock                                          (5,747)
      Dividends paid                                                      (3,974)          (3,973)           (3,829)
      Other                                                                 (531)            (390)              627
-------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by financing activities                    (6,964)          20,434            10,714
-------------------------------------------------------------------------------------------------------------------

-------------------------------------------------------------------------------------------------------------------
      Effect of exchange rate changes on cash                                680
-------------------------------------------------------------------------------------------------------------------

Net increase (decrease) in cash and equivalents                          118,760          (18,854)               87
Cash and equivalents at beginning of year                                 15,702           34,556            34,469
===================================================================================================================
Cash and equivalents at end of year                                     $134,462         $ 15,702           $34,556
===================================================================================================================

<FN>
                                   See notes to consolidated financial statements.
</FN>
</TABLE>

                                                       Page 18

<PAGE>


                    WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)


                                                          Year Ended December 31
--------------------------------------------------------------------------------
(Dollars in thousands)                              1997       1996       1995
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
Other cash flow information:
--------------------------------------------------------------------------------
Income taxes paid-net of refunds                   $ 3,143    $ 5,700   $ 5,828
Interest paid                                        1,389      1,574       872
--------------------------------------------------------------------------------
Noncash investing and financing activities:
--------------------------------------------------------------------------------
Noncash effect on "Property, Plant and
   Equipment" and "Other Assets" due to a
   plant held for sale in 1994 and returned
   to service in 1995.  Plant  transferred at
   book value which is below market.                                    $(5,107)
--------------------------------------------------------------------------------

                 See notes to consolidated financial statements.

                                    Page 19

<PAGE>


                    WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1.       SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation--The consolidated financial statements include those
of the company and its subsidiaries  after elimination of intercompany  balances
and  transactions.  In 1997, the company disposed of its Government  Electronics
operating  segment  which  has been  reported  as  discontinued  operations,  as
described more fully in Note 8.

Cash   Equivalents--Cash   equivalents  consist  of  municipal  bond  funds  and
commercial paper acquired with remaining maturity periods of 90 days or less and
are  stated at cost plus  accrued  interest  which  approximates  market  value.
Year-end cash and cash  equivalents  totaled $134.5 million and $15.7 million in
1997  and  1996,   respectively.   The  company's  investment  guidelines  limit
investments with a single issuer, which is not the U.S. Government or any agency
thereof, to the greater of $5,000,000 or 10 percent of the investment portfolio.

Inventories--Inventories  are  stated  at the  lower  of cost,  using  first-in,
first-out and average-cost basis, or market. Cost of inventory items is based on
purchase  and  production  cost.   Long-term  contract  costs  and  selling  and
administrative  expenses are excluded from inventory.  Progress payments are not
netted against inventory.

Property, Plant and Equipment--Property, plant and equipment are stated at cost.
Provision  for   depreciation   and  amortization  is  primarily  based  on  the
straight-line and  sum-of-the-years'-digits  methods.  Leases which at inception
assure the lessor full  recovery of the fair market value of the  property  over
the lease term are  capitalized  and amortized over the lease term in accordance
with Statement of Financial Accounting Standards No. 13 "Accounting for Leases."
The  provisions  of this  Statement  derive  from  the  view  that a lease  that
transfers  substantially  all of the benefits and risks  incidental to ownership
should be accounted for as the  acquisition of an asset and the incurrence of an
obligation by the lessee.

Revenue Recognition--Revenues, from other than long-term contracts, are recorded
upon shipment or  completion  of tasks as specified in the  contract.  Estimated
product warranty costs are accrued at the time of shipment.  Sales and allowable
fees under  cost-reimbursement  contracts  are  recorded as costs are  incurred.
Long-term  contract  sales  and cost of  goods  sold are  recognized  using  the
percentage-of-completion  method based on the actual physical completion of work
performed and the ratio of costs incurred to total  estimated  costs to complete
the contract.  Any anticipated  losses on contracts are charged to earnings when
identified.

Foreign Currency Translation--The functional currency for all foreign operations
is the U.S.  dollar with the  exception of the company's  subsidiary  located in
Japan which uses the local functional  currency.  Gains or losses,  which result
from the  process of  remeasuring  foreign  currency  financial  statements  and
transactions into U.S. dollars,  are generally  included in net income.  For the
Japanese  subsidiary,   the  cumulative  translation  adjustments  are  recorded
directly in retained  earnings.  For 1997 the company incurred a net translation
loss of approximately $1.4 million resulting  primarily from its Southeast Asian
subsidiaries and is included in "Other income (expense)-net" in the Consolidated
Statements of Operations.  Translation  gains or losses are not material for any
prior years presented.

Forward Exchange  Contracts--The  company enters into forward exchange contracts
to  hedge  sales  transactions  and  firm  commitments  denominated  in  foreign
currencies.  Gains and losses on the forward  contracts are recognized  based on
changes in exchange rates, as are offsetting  foreign  exchange gains and losses
on the underlying transactions.  The company does not engage in foreign currency
speculation.

                                    Page 20

<PAGE>


1.       SIGNIFICANT ACCOUNTING POLICIES (continued)

Income Taxes--The  consolidated  statements of operations include provisions for
deferred  income  taxes using the  liability  method for  transactions  that are
reported in one period for financial  accounting  purposes and in another period
for  income  tax  purposes.  Prior to 1997  state and local  income  taxes  were
included in selling and administrative  expenses.  State taxes for 1996 and 1995
have been reclassified to conform to the 1997 presentation.

Per Share  Information--Net  income  per share is  computed  using the basic and
diluted weighted average number of common shares  outstanding during the year in
accordance with the recently issued Statement of Financial  Accounting Standards
No. 128 (SFAS 128),  "Earnings Per Share."  Basic net income per share  excludes
dilution and is computed  using the  weighted  average  number of common  shares
outstanding for the period.  Diluted net income per share reflects the potential
dilution that could occur if securities or other contracts to issue common stock
(dilutive  stock  options) were  exercised or converted  into common stock.  Per
share amounts for prior periods have been restated in accordance with SFAS 128.

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 amount of revenues and expenses during the reporting
period. Actual results could differ from those estimates.

Stock-Based  Compensation--The  company  continues  to account  for  stock-based
compensation granted to employees and directors under the intrinsic value method
as defined in Accounting  Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees."

Business  Segment  Reporting--The  company  has  elected  the early  adoption of
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an  Enterprise  and Related  Information."  The  Statement  requires  certain
expanded  disclosures about operating segments and requires that an enterprise's
operating segments be determined in the manner in which management  operates the
business.  Specifically,  financial  information  is to be reported on the basis
that  is used  internally  by the  chief  operating  decision  maker  in  making
decisions related to resource allocation and segment performance.

Recently  Issued  Accounting  Standard--In  June 1997, the Financial  Accounting
Standards Board issued Statement of Financial Accounting Standards No. 130 (SFAS
130), "Reporting  Comprehensive  Income." This Statement is effective for fiscal
years  beginning after December 15, 1997. The company will be required to comply
with the  provisions of this standard in 1998.  The company has not assessed the
effect that this new standard will have on its consolidated financial statements
and or disclosures.

Reclassification--Certain  amounts for 1996 and 1995 have been  reclassified  to
conform to the 1997 presentation.


2.       FINANCIAL INSTRUMENTS

Financial  instruments that potentially subject the company to concentrations of
credit  risk  consist  principally  of cash and  equivalents,  receivables,  and
financial  instruments  used in hedging  transactions.  The company invests in a
variety of financial  instruments  such as commercial  paper and municipal  bond
funds,  and,  by  policy,  limits  the  amount of credit  exposure  with any one
financial  institution or commercial  issuer.  Concentration of credit risk with
respect to trade  receivables  is limited  due to the variety of  customers  and
market  segments  into which the  company's  products are sold, as well as their
dispersion  across  geographic  areas.  The company  maintains an allowance  for
doubtful accounts based upon the expected collectibility of receivables.

                                    Page 21

<PAGE>


2.       FINANCIAL INSTRUMENTS (continued)

The carrying value of cash and  equivalents,  receivables,  accounts payable and
short-term  notes  payable are a reasonable  approximation  of their fair market
value due to the short-term maturities of those instruments.  The carrying value
of the company's  long-term debt  approximates  fair value based on the interest
rates  currently  available to the company for long-term debt with similar terms
as those  borrowings  of the  company.  Considerable  judgment  is  required  in
interpreting  market data to develop estimates of fair value, so these estimates
are not necessarily indicative of the amounts that could be realized or would be
paid in a current market exchange.

The company is a party to financial instruments with  off-balance-sheet  risk in
the normal course of business to reduce its exposure to  fluctuations in foreign
exchange rates. At December 31, 1997 and 1996, the company had forward  exchange
contracts  to sell  Japanese  Yen with a market  value  of  approximately  $12.4
million and $17.9 million,  respectively, for a contract amount of $12.8 million
and $19.6 million,  respectively.  These  contracts  mature within one year. The
market value of forward exchange  contracts were obtained from published foreign
exchange  market  rates.  The company's  risk in these  contracts is the cost of
replacing,  at current market rates,  these contracts in the event of default by
the other party. Management believes the risk of incurring such losses is remote
as the contracts are entered into with major financial institutions.


3.       LONG-TERM OBLIGATIONS AND LINES OF CREDIT

Long-term  obligations,  excluding  amounts due within one year,  consist of the
following at December 31:

(in thousands)                                           1997              1996
--------------------------------------------------------------------------------
Long-term borrowings                                    $18,630          $20,241
Deferred compensation                                     1,977            2,360
Environmental remediation                                 7,437            7,635
Long-term leases                                          5,190            7,565
--------------------------------------------------------------------------------
Total                                                   $33,234          $37,801
================================================================================


The current portion of long-term obligations is included in current liabilities.
The  expected  maturity  amounts  are  as  follows:  1998,   $4,145,000;   1999,
$2,050,000; 2000, $2,040,000;  2001, $1,080,000;  2002, $1,200,000;  thereafter,
$26,864,000.

Long-term  Borrowings--Consists  of two  unsecured  loans used for the company's
land,  building  and  equipment  located  in  Kawasaki,  Japan.  The  loans  are
denominated  in Yen.  Approximately  $6.6  million  is  amortizable  in  monthly
installments through the year 2011, which bears interest at 2.5%.  Approximately
$12  million  requires  a balloon  payment  due in the year  2006,  which  bears
interest at 3.1%, payable semiannually.

Deferred   Compensation--The   company   has   several   nonqualified   deferred
compensation  and bonus plans  covering  selected  members of management and key
technical  employees.  The  purpose of these  plans is to reward  and  encourage
talented  employees  to remain  with the  company.  Such  amounts are payable in
accordance with various fixed payment schedules.

Environmental  Remediation--As  discussed in Note 6, the company is obligated to
remediate  groundwater  contamination  at  its  Scotts  Valley  and  Palo  Alto,
California,  facilities.  The  portion  expected  to be paid  within one year is
included in current liabilities.

                                    Page 22

<PAGE>


3.       LONG-TERM OBLIGATIONS AND LINES OF CREDIT (continued)

Leases--Certain  long-term  leases for plant  facilities  are treated as capital
leases for financial statement purposes. The leases expire during the years 2014
to 2029. Renewal options provide for lease extensions in which the leases expire
during the years 2029 to 2056.  The company  also has  noncancellable  operating
leases for plant facilities and equipment  expiring through the year 2004. These
leases may be renewed for various periods after the initial term.

During 1997 the company exchanged a portion of its subleasehold  interest at its
Palo Alto,  California,  facility for  consideration  consisting of cash and the
sublessor's  leasehold  rights in the  remaining  parcels  under the lease.  The
exchange resulted in a pretax gain of $7.6 million which is reported in the 1997
Consolidated  Statements of Operations as "Gain on real  property." The terms of
this  lease  now  provide  for no lease  payments  through  the year 2029 with a
nominal  bargain  renewal option  extending the terms through the year 2056. The
other Palo Alto lease provides for below market lease payments  through the year
2014 with a renewal option extending the lease to the year 2029.

Payment  obligations  under existing capital and operating leases as of December
31, 1997 are as follows:

                                                    Capital       Operating
(in thousands)                                      Leases         Leases
---------------------------------------------------------------------------
Lease payments:
      1998                                         $    635         $1,206
      1999                                              635            808
      2000                                              635            636
      2001                                              635            547
      2002                                              635            121
      Remaining years                                 7,457            108
---------------------------------------------------------------------------
Total                                                10,632         $3,426
Imputed interest                                     (5,294)        ======
------------------------------------------------------------
Present value of lease payments
  (including current portion of $148)              $  5,338
============================================================


Rent expense  included in  continuing  operations  for  property  and  equipment
relating to operating leases is as follows:

(in thousands)                           1997           1996           1995
----------------------------------------------------------------------------
Real property                           $2,446         $2,384         $1,195
Equipment                                1,041            782            502
----------------------------------------------------------------------------
Total                                   $3,487         $3,166         $1,697
============================================================================


Lines  of  Credit--The   company  arranged  with  several  banks  to  provide  a
$100,000,000  unsecured  credit  facility.  This facility expires on December 8,
1998. No material compensating  balances are required or maintained.  Borrowings
under this  facility  generally  bear interest at the lower of the prime rate or
London Interbank Offered Rates (LIBOR) plus 0.75%.  During 1997, the company did
not borrow  under this credit  facility  and  renegotiated  to reduce the credit
facility to  $50,000,000.  Because of the operating  loss reported in the fourth
quarter of 1997 the company is not in  compliance  with certain terms under this
credit  facility,  and  accordingly the banks are not required to fund requested
borrowings.  The  company  is  coordinating  with its  banks to  re-establish  a
compliant  condition.  Management does not anticipate any significant  near term
borrowing  requirements and does not expect the current noncompliance  condition
to materially affect the company's liquidity or financial position.

The  amount of  outstanding  letters  of credit  and  other  guarantees  was not
material at December 31, 1997. In addition to the $50,000,000  unsecured  credit
facility,  the company's foreign subsidiaries  maintain separate lines of credit
totaling approximately $500,000.

                                   Page 23

<PAGE>


4.       SHAREOWNERS' EQUITY

Stock Repurchase  Program--The  Board of Directors has authorized the company to
repurchase a maximum of 2,500,000 shares of company stock.  Through December 31,
1997, 1,704,200 shares have been repurchased,  of which 204,200 were repurchased
in 1997. No shares were  repurchased in 1996 and 1995.  The program  enables the
company to acquire its common stock from time to time when appropriate.

Common  Share   Purchase   Rights--For   each  share  of  company  common  stock
outstanding,  one Common Share  Purchase  Right (the  Rights) is  attached.  The
Rights expire  October 20, 2006, and may be redeemed by the company for $.01 per
Right at any time prior to 10 days after a person or group  acquires 15% or more
of  the  company's  common  stock.  The  Rights  become  exercisable  and  trade
separately  from the common stock if any person or group acquires 15% or more of
the company's  outstanding common stock, or announces a tender or exchange offer
which  would  result  in  such  person  or  group  acquiring  15% or more of the
company's common stock. When the Rights first become  exercisable as a result of
the  announcement  of a tender or  exchange  offer,  a holder of a Right will be
entitled to buy one share of the company's common stock for $160. If, instead or
thereafter,  a person or group not previously approved by the Board of Directors
acquires 15% or more of the  company's  shares,  a holder of a Right (other than
that  person or group)  will be  entitled to buy that number of shares of common
stock  from the  company  which have a market  value of twice the $160  exercise
price of each Right.  If the  company is acquired in a merger or other  business
combination  after any  person or group  acquires  15% or more of the  company's
common  stock,  each Right will  entitle its holder to buy a number of shares of
common stock of the  surviving  company  having a market value of twice the $160
exercise  price.  After the acquisition by any person or group of 15% or more of
the company's common stock and up to the time that such person or group acquires
a 50%  interest,  the company will also have the ability to exchange some or all
of the Rights  (other than Rights held by the  acquiror) for one share of common
stock per Right at no expense to the holder.

Stock Option  Plans--The  Employee  Stock  Option Plans (the Plans)  provide for
grants of nonqualifying and incentive stock options to certain key employees and
officers.  The company may grant  options to purchase up to 4,300,000  shares of
common  stock.  During  1997 the company  increased  the number of shares it may
grant from  3,900,000  shares to 4,300,000  shares through the adoption of a new
nonqualified stock option plan for nonofficer employees. The options are granted
at the  market  price on the date of grant and  expire at the tenth  anniversary
date.  One-third of the options  granted are  exercisable on each of the second,
third and fourth  anniversary  dates following the grant.  The Plans allow those
employees who are subject to the insider  trading  restrictions  certain limited
rights to receive  cash in the event of a change in control.  Shares  issued are
net of retirement of shares used in payment for options exercised.  In addition,
the Plans permit the award of restricted stock rights subject to a fixed vesting
schedule.  The holder of vested restricted stock has certain  dividend,  voting,
and other shareowner  rights.  No restricted stock awards have been made through
December 31, 1997.

The  Nonemployee  Directors  Stock Option Plan provides for a fixed  schedule of
options  to be  granted  through  the year 2005.  Nonemployee  directors  of the
company are  automatically  granted  3,000 shares of common stock each year that
such person  remains a director of the  company.  The options are granted at the
market price on the date of grant and expire on the tenth  anniversary date. The
options  granted  become  exercisable  after six months  from the date of grant.
Prior to 1996, options granted were exercisable  similarly to the Employee Stock
Option  Plans.  The total  number of shares to be issued under this plan may not
exceed 350,000 shares.  Included in the tables below,  21,000 option shares were
granted at $26.88 in 1997,  21,000 option shares were granted at $34.63 in 1996;
and  12,600  and  5,440  option  shares  were  granted  at  $39.75  and  $39.88,
respectively, in 1995.

Included in the Consolidated  Statements of Shareowners' Equity are tax benefits
related to sales under stock option plans of $719,000, $1,161,000 and $4,735,000
for 1997, 1996 and 1995, respectively.

                                  Page 24

<PAGE>


4.       SHAREOWNERS' EQUITY (continued)

<TABLE>
Activity related to all stock option plans is as follows:

<CAPTION>
                                                                                                   Weighted Average
1997                                                                      Shares                     Exercise Price
-------------------------------------------------------------------------------------------------------------------
<S>                                                                    <C>                                 <C>   
Granted                                                                  242,000                           $26.41
Exercised                                                                135,988                           $15.14
Terminated                                                               191,309                           $34.76
At December 31:
      Outstanding                                                      1,443,940                           $27.33
      Exercisable                                                        693,966                           $23.70
      Reserved for future grants                                       1,147,282

1996
-------------------------------------------------------------------------------------------------------------------
Granted                                                                  205,000                           $25.54
Exercised                                                                209,393                           $17.57
Terminated                                                               328,443                           $29.39
At December 31:
      Outstanding                                                      1,529,237                           $27.32
      Exercisable                                                        463,119                           $19.11

1995
-------------------------------------------------------------------------------------------------------------------
Granted                                                                  680,290                           $40.13
Exercised                                                                566,198                           $17.81
Terminated                                                                87,346                           $24.35
At December 31:
      Outstanding                                                      1,862,073                           $26.79
      Exercisable                                                        249,704                           $21.25
</TABLE>


<TABLE>
The following table summarizes  information concerning currently outstanding and
exercisable options at December 31, 1997:

<CAPTION>
                                        Options Outstanding                            Options Exercisable
                      --------------------------------------------------------    ----------------------------------
                                                  Weighted
                                             Average Years           Weighted                              Weighted
            Range of           Number         of Remaining            Average              Number           Average
     Exercise Prices      Outstanding     Contractual Life     Exercise Price         Exercisable    Exercise Price
--------------------------------------------------------------------------------------------------------------------
<S>                           <C>                     <C>              <C>                <C>                <C>   
    $10.00 to $21.63          362,410                 5.86             $15.12             247,410            $12.12
    $22.75 to $25.13          488,170                 7.15             $23.66             218,155            $22.97
    $25.50 to $36.75          456,157                 7.35             $34.63             183,569            $34.01
    $37.25 to $55.00          137,203                 7.68             $48.35              44,832            $48.95
--------------------------------------------------------------------------------------------------------------------
    $10.00 to $55.00        1,443,940                 6.94             $27.33             693,966            $23.70
====================================================================================================================
</TABLE>

                                                       Page 25

<PAGE>


4.       SHAREOWNERS' EQUITY (continued)

As discussed in Note 1, the company applies Accounting  Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees," and related  interpretations
in  accounting  for its plans.  Accordingly,  no  compensation  expense has been
recognized for its stock-based compensation plans. Had compensation cost for the
company's  stock option plans been  determined  based upon the fair value at the
grant date for awards  under these  plans,  and  amortized  to expense  over the
vesting period of the awards  consistent with the methodology  prescribed  under
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation,"  the company's pro forma net income for 1997, 1996 and 1995 would
have been $31,724,000, $1,256,000 and $29,849,000,  respectively, or $3.84, $.15
and $3.76 per basic share,  respectively,  and $3.84, $.15 and $3.40 per diluted
share, respectively. However, the impact of outstanding non-vested stock options
granted  prior  to 1995  has  been  excluded  from  the pro  forma  calculation;
accordingly, the 1997, 1996 and 1995 pro forma adjustments are not indicative of
future  period pro forma  adjustments,  when the  calculation  will apply to all
applicable  stock options.  The weighted  average fair value of options  granted
during 1997, 1996 and 1995 is calculated as $8.02 per share, $7.96 per share and
$13.96 per share,  respectively,  on the date of grant  using the  Black-Scholes
option-pricing model with the following weighted average assumptions:

                                                           1997    1996    1995
--------------------------------------------------------------------------------
Dividend yield                                              1.2%    1.5%    1.7%
Volatility                                                 38.1%   37.5%   37.5%
Risk free interest rate at the time of grant                6.1%    6.2%    7.1%
Expected term to exercise (in months from the vest date)    4.5     3.5     3.5


The company's calculations are based on a multiple option valuation approach and
forfeitures are recognized as they occur.

The Black-Scholes  model used by the company to calculate option values, as well
as other currently accepted option valuation models,  were developed to estimate
the fair values of freely tradable,  fully transferable  options without vesting
restrictions, which significantly differ from the company's stock option awards.
These models also require highly subjective assumptions,  including future stock
price  volatility,  and expected time until  exercise,  which greatly affect the
calculated values.

                                    Page 26

<PAGE>


5.       INCOME TAXES

The provision for income taxes includes  deferred  taxes  reflecting the net tax
effects of temporary  differences  that are reported in one period for financial
accounting purposes and in another period for income tax purposes.  Deferred tax
assets  are  recognized  when  management  believes  realization  of future  tax
benefits of temporary  differences is more likely than not. In estimating future
tax consequences, generally all expected future events are considered other than
enactments of changes in the tax law or rates.  The  components of income (loss)
from  continuing  operations  before  federal,  state and foreign  income  taxes
consists of the following:

(in thousands)                        1997              1996              1995
--------------------------------------------------------------------------------
U.S.                                $(10,330)         $ (4,662)         $ 29,230
Foreign                                3,368             2,566             1,334
--------------------------------------------------------------------------------
Total                               $ (6,962)         $ (2,096)         $ 30,564
================================================================================


The provision  for federal,  state and foreign  income tax expense  (credits) on
income from continuing operations consists of the following:

(in thousands)                         1997             1996              1995
--------------------------------------------------------------------------------
Current:
    U.S                              $    425         $  1,928         $  9,230
    State                               1,275             (152)             300
    Foreign                             1,870            1,264              517
--------------------------------------------------------------------------------
Total current                           3,570            3,040           10,047
--------------------------------------------------------------------------------
Deferred:
    U.S                                (4,385)          (3,497)          (1,295)
    State                              (2,185)            (318)             (42)
--------------------------------------------------------------------------------
Total                                $ (3,000)        $   (775)        $  8,710
================================================================================


Deferred foreign taxes were not significant for all years presented.

Deferred tax assets (liabilities) are comprised of the following at December 31:

(in thousands)                                 1997         1996          1995
--------------------------------------------------------------------------------
Deferred compensation                        $  2,556     $  1,915     $  2,859
Loss accruals                                  18,041       10,495        4,853
Environmental remediation                       3,274        3,147        3,298
Uniform capitalization                          1,212        1,007        1,356
Vacation accrual                                1,663        1,580        1,594
Other                                           3,334        2,111        1,406
--------------------------------------------------------------------------------
      Gross deferred tax assets                30,080       20,255       15,366
--------------------------------------------------------------------------------
Depreciation                                   (2,610)      (3,197)      (2,097)
Other                                                          (58)         (84)
--------------------------------------------------------------------------------
      Gross deferred tax liabilities           (2,610)      (3,255)      (2,181)
--------------------------------------------------------------------------------
Net deferred tax asset                       $ 27,470     $ 17,000     $ 13,185
================================================================================

                                    Page 27

<PAGE>


5.       INCOME TAXES (Continued)

<TABLE>
The  differences  between  the  effective  income  tax  (benefit)  rate  and the
statutory federal income tax (benefit) rate are as follows:

<CAPTION>
                                                                            1997             1996              1995
-------------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>               <C>                <C>  
Statutory federal tax (benefit) rate                                      (35.0)%           (34.0)%            35.0%
      Export sales benefit                                                 (6.5)            (10.0)             (7.4)
      Research credit                                                      (8.5)            (14.6)             (2.0)
      Effect of foreign operations taxed at various rates                   9.8              18.7                .2
      State taxes (benefit) net of federal tax                             (8.4)             (4.8)               .6
      Other                                                                 5.5               7.7               2.1
-------------------------------------------------------------------------------------------------------------------
Effective tax (benefit) rate                                              (43.1)%           (37.0)%            28.5%
===================================================================================================================
</TABLE>


6.           ENVIRONMENTAL REMEDIATION AND OTHER CONTINGENCIES

The company remains in compliance with the remedial action plans being monitored
by various regulatory agencies at its Scotts Valley and Palo Alto sites. In 1991
the company recorded a $15 million charge for estimated  remediation actions and
cleanup   costs.   No  additional   provision  has  been  recorded  since  1991.
Expenditures  charged  against the  provision  totaled  $198,000,  $327,000  and
$778,000 for the years 1997, 1996 and 1995,  respectively.  While the timing and
ultimate  amount of expenditures of restoring the sites cannot be predicted with
certainty,  management  believes that the provision  taken is adequate  based on
facts known at this time.  Included in other income for 1995 are recoveries from
insurers totaling $1,331,000. The company will continue to vigorously pursue any
potential  recoveries  from insurers or other  responsible  parties.  Changes in
environmental  regulations,  improvements in cleanup technology and discovery of
additional  information  concerning these sites and other sites could affect the
estimated costs in the future.

In  addition  to the above  environmental  matters,  the  company is involved in
various  legal  actions  which  arose in the  ordinary  course  of its  business
activities.  Except for the  environmental  provision  noted  above,  management
believes the final resolution of these matters should not have a material impact
on its results of operations, cash flows, and financial position.

                                    Page 28

<PAGE>



7.       EMPLOYEE BENEFIT PLANS

Employees'  Investment  Plan--The  Watkins-Johnson  Employees'  Investment  Plan
conforms to the requirements of the Employee  Retirement  Income Security Act of
1974 (ERISA) and the Internal Revenue Code as a qualified  defined  contribution
plan. The Plan covers  substantially all employees and provides that the company
match  employees'  401(k)  salary  deferrals  up  to  3%  of  eligible  employee
compensation.  The  amount  charged to income  from  continuing  operations  was
$2,001,000, $1,920,000 and $1,680,000 in 1997, 1996 and 1995, respectively.

Employee Stock  Ownership  Plan  (ESOP)--The  ESOP was  established to encourage
employee  participation  and  long-term  ownership of company  stock.  The Board
determines each year's discretionary  contribution  depending on the performance
and  financial  condition  of the  company.  The  contribution  is  consistently
determined as a percentage of eligible employee base compensation. All employees
on the U.S.  payroll of the company are eligible to  participate in the plan and
vesting is immediate.  The Board approved a contribution equal to 1% of eligible
employee  compensation  for 1997,  1996, and 1995,  which resulted in charges to
income  from   continuing   operations  of  $657,000,   $639,000  and  $553,000,
respectively.  The ESOP held  229,231  and  220,941  shares  of common  stock at
December  31,  1997 and 1996,  respectively,  and there  are no  unallocated  or
unearned  shares  held by the plan.  There  are no  material  matters  affecting
comparability  of information for all years  presented.  Shares held by the ESOP
are included in the company's  earnings per share  computations.  Dividends paid
with  respect to common  stock held by the ESOP are used to purchase  additional
shares and were not  material for all years  presented.  The ESOP is a qualified
defined contribution plan under ERISA and the Internal Revenue Code.

8.       BUSINESS SEGMENT REPORTING

In the  fourth  quarter  of 1997 the  company  elected  the  early  adoption  of
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an Enterprise and Related  Information,"  (SFAS 131). The Statement  requires
that an  enterprise's  operating  segments be  determined in the manner in which
management operates the business.  Specifically,  financial information is to be
reported on the basis that is used  internally by the chief  operating  decision
maker  in  making   decisions   related  to  resource   allocation  and  segment
performance.  The  company's  reportable  segments  are  operated and managed as
strategic  business  units and are  organized  based on products  and  services.
Business  units  operated at different  locations are  aggregated  for reporting
purposes when their products and services are similar.

Under SFAS 131,  the  company's  operations  were  divided  into three  industry
segments:  Semiconductor  Equipment,  Wireless  Communications,  and  Government
Electronics. As discussed below, the Government Electronics segment was divested
during  1997.  At the end of  1997,  the  company's  operations  consist  of two
industry  segments:   Semiconductor   Equipment  and  Wireless   Communications.
Operations  in the  Semiconductor  Equipment  segment  involve the  development,
production, sales and service of chemical-vapor-deposition equipment used in the
manufacture of semiconductor products. Operations in the Wireless Communications
segment  involve  the  design,  development,  manufacture  and sale of  advanced
wireless  telecommunication  products for cellular service  providers,  personal
communication  systems,  and other  radio-frequency  products for commercial and
government communications  requirements.  The Wireless Communications segment is
composed  of the Palo Alto,  California-based  Wireless  Products  Group and the
Gaithersburg,   Maryland,   Telecommunications  Group,  including  that  group's
communications-intelligence business.

                                    Page 29

<PAGE>


8.       BUSINESS SEGMENT REPORTING (continued)

Prior to the  adoption of SFAS 131,  the company  reported  segment  information
under Statement of Financial  Accounting  Standards No. 14, "Financial Reporting
for Segments of a Business  Enterprise,"  which  required  disclosures  based on
identifiable  industry segments.  Accordingly,  the company previously  reported
operations  in  three  industry  segments:   Semiconductor  Equipment,  Wireless
Communications,  and Government  Electronics.  The former Government Electronics
segment was  redefined  according to SFAS 131 to be  comprised of the  company's
Palo Alto,  Calif.-based  Tactical  Subsystems and Microwave Devices sectors. On
October 31, 1997 the company  completed the sale of its  Government  Electronics
segment to an affiliate of Mentmore  Holdings  Corporation for  consideration of
$103 million,  consisting mostly of cash. The sale resulted in a pre-tax gain of
approximately  $49.9 million.  The divested business is reported as discontinued
operations in the accompanying financial statements.  Operations of the divested
business  included  the design,  development,  manufacture  and sale of advanced
microwave devices and tactical electronic systems and devices for guided-missile
programs and other government applications.  The divested Government Electronics
business included some microwave devices business previously included as part of
the Wireless Communications segment. The  communications-intelligence  receivers
business  now  included in the  Wireless  Communications  segment  was  formerly
reported  as part  of the  company's  Government  Electronics  segment.  Amounts
reported  for  1996  and  1995  have  been  restated  to  conform  to  the  1997
presentation.

<TABLE>
Management  evaluates  segment  performance based primarily on segment revenues,
pre-tax operating profit or loss before interest and other  nonoperating  income
and expenses,  and return on assets.  Sales between continuing  segments are not
significant for any year presented.  Continuing  operations by business  segment
are as follows:

<CAPTION>
(in thousands)                                                                         Year Ended December 31, 1997
-------------------------------------------------------------------------------------------------------------------
                                                                            Year-
                                                           Pre-tax            End         Capital
                                                Sales       Income         Assets       Additions      Depreciation
-------------------------------------------------------------------------------------------------------------------
<S>                                        <C>            <C>          <C>              <C>              <C>      
Semiconductor Equipment                    $  186,454     $(13,328)    $ 132,528        $ 15,152         $  10,144
Wireless Communications                       104,817         (954)       54,408           6,881             2,510
Corporate                                                                171,276             144               458
-------------------------------------------------------------------------------------------------------------------
Income from continuing operations                          (14,282)
Other income (expense)--net                                  7,320
-------------------------------------------------------------------------------------------------------------------
Total                                      $  291,271     $ (6,962)    $ 358,212        $  22,177        $  13,112
===================================================================================================================

                                                                                       Year Ended December 31, 1996
-------------------------------------------------------------------------------------------------------------------
Semiconductor Equipment                    $  272,436     $  7,212     $ 174,549        $  46,122        $   7,231
Wireless Communications                        76,683       (8,511)       50,754            1,941            1,252
Corporate                                                                 68,441              240              513
-------------------------------------------------------------------------------------------------------------------
Income from continuing operations                           (1,299)
Other income (expense)--net                                   (797)
-------------------------------------------------------------------------------------------------------------------
Total                                      $  349,119     $ (2,096)    $ 293,744        $  48,303        $   8,996
===================================================================================================================

                                                                                       Year Ended December 31, 1995
-------------------------------------------------------------------------------------------------------------------
Semiconductor Equipment                    $  222,212     $ 34,236     $ 147,051        $ 18,518         $   4,687
Wireless Communications                        62,123       (5,438)       42,644           4,522             2,253
Corporate                                                     (313)       79,870             326               401
-------------------------------------------------------------------------------------------------------------------
Income from continuing operations                           28,485
Other income (expense)--net                                  2,079
-------------------------------------------------------------------------------------------------------------------
Total                                      $  284,335      $30,564     $ 269,565        $ 23,366         $   7,341
===================================================================================================================
</TABLE>


Corporate assets consist primarily of cash, cash equivalents and deferred taxes,
and  included  in 1996 and 1995  balances  are net  assets  of the  discontinued
Government Electronics segment.

                                    Page 30

<PAGE>


8.       BUSINESS SEGMENT REPORTING (continued)

Sales  to  individual  customers   representing  greater  than  10%  of  company
consolidated sales are as follows:

(in thousands)                                         1997     1996       1995
--------------------------------------------------------------------------------
Semiconductor Equipment:
        Marubeni Hytech (a Japanese distributor)     $21,000   $47,000   $61,000
        Hyundai Electronics Industries Co., Ltd. 
            (and affiliates)                          15,000    37,000    28,000
Wireless Communications:
        United States Government                      36,000    28,000    29,000


Sales from continuing  operations to  unaffiliated  customers by geographic area
are as follows:

(in thousands)                                  1997         1996         1995
--------------------------------------------------------------------------------
United States                                 $169,001     $143,510     $116,479
Export sales from United States:
      Europe                                     8,924       29,759       13,762
      Japan                                     23,035       65,952       56,956
      Korea                                     29,531       52,572       53,259
      Other Asia-Pacific countries              13,955       35,767       28,980
      Other                                      3,307        3,728        5,792
Europe                                          34,701        9,759        6,734
Japan                                            2,742        3,312
Other Asia-Pacific countries                     6,075        4,760        2,373
--------------------------------------------------------------------------------
Total                                         $291,271     $349,119     $284,335
================================================================================


Intercompany  transfers of products and services between geographic regions were
$59,040,000,  $37,533,000  and  $12,130,000 in fiscal years 1997, 1996 and 1995,
respectively,  and are accounted for at prices the company  believes to be arm's
length.

<TABLE>
Operating  profit  and  year-end  long-lived  assets by  geographic  area are as
follows:

<CAPTION>
                                                                                                           Year-end
                                                                       Operating profit           long-lived assets
(in thousands)                                                      1997           1996          1997          1996
----------------------------------------------------------- ------------- -------------- ------------- -------------
<S>                                                             <C>             <C>          <C>           <C>     
United States                                                   $(19,385)       $(4,231)     $118,606      $121,483
Europe                                                             3,640            700         1,729         2,290
Japan                                                                185            952        26,493        30,076
Other Asia-Pacific countries                                       1,278          1,280         3,762         4,159
----------------------------------------------------------- ------------- -------------- ------------- -------------
Total                                                           $(14,282)       $(1,299)     $150,590      $158,008
=========================================================== ============= ============== ============= =============
</TABLE>


For 1995, foreign operations' sales, profits, and identifiable long-lived assets
are less than ten percent of  consolidated  totals.  Long-lived  assets  exclude
financial instruments,  deferred tax assets, and for 1996 exclude the net assets
of discontinued operations totaling $29,817,000.

                                    Page 31

<PAGE>

8.       BUSINESS SEGMENT REPORTING (continued)

<TABLE>
Summarized below are operating results and assets of the discontinued government
electronics  business.  Intersegment  sales were transferred based on negotiated
prices.
<CAPTION>
                                                                                                              Year Ended December 31
(in thousands)                                                                  1997                  1996                  1995
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>                   <C>                   <C>      
Net sales                                                                     $  75,700             $  89,200             $ 102,696
====================================================================================================================================

------------------------------------------------------------------------------------------------------------------------------------
Gross profit                                                                  $  21,900             $  21,100             $  32,200
====================================================================================================================================

Income from operations before income taxes                                    $  11,500             $   6,663             $  15,189
Income taxes                                                                     (4,290)               (2,308)               (5,615)
Gain on disposition-net of taxes of $20,219                                      29,677
------------------------------------------------------------------------------------------------------------------------------------
Net income from discontinued operations                                       $  36,887             $   4,355             $   9,574
====================================================================================================================================

------------------------------------------------------------------------------------------------------------------------------------
Year-end net assets                                                                                 $  29,817             $  23,281
====================================================================================================================================
</TABLE>

9.       EARNINGS PER SHARE

<TABLE>
Basic and diluted earnings per share from continuing operations were computed as follows:
<CAPTION>

                                                                                                              Year Ended December 31
(In thousands, except per share amounts)                                                1997               1996               1995
------------------------------------------------------------------------------------------------------------------------------------
Basic per share amounts:

------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                    <C>                <C>                <C>    
    Income (loss) from continuing operations (numerator)                               $(3,962)           $(1,321)           $21,854
------------------------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------------------------------------------
    Weighted average shares outstanding (denominator)                                    8,258              8,265              7,938
------------------------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------------------------------------------
    Basic income (loss) per share                                                      $  (.48)           $  (.16)           $  2.75
====================================================================================================================================


Diluted per share amounts:

------------------------------------------------------------------------------------------------------------------------------------
    Income (loss) from continuing operations (numerator)                               $(3,962)           $(1,321)           $21,854
------------------------------------------------------------------------------------------------------------------------------------

    Weighted average shares outstanding                                                  8,258              8,265              7,938

    Effect of dilutive stock options                                                                                             838

------------------------------------------------------------------------------------------------------------------------------------
    Diluted shares outstanding (denominator)                                             8,258              8,265              8,776
------------------------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------------------------------------------
    Diluted income (loss) per share                                                    $  (.48)           $  (.16)           $  2.49
====================================================================================================================================
</TABLE>

For 1997 and 1996 the  incremental  shares from the assumed  exercise of 251,000
and 272,000  stock  options,  respectively,  are not included in  computing  the
dilutive per share amounts because continuing  operations resulted in a loss and
such assumed  conversion would be antidilutive.  Additionally,  weighted average
options  outstanding  to purchase  564,000,  685,000 and 53,000 shares of common
stock were not included in the computation of diluted per share amounts in 1997,
1996 and 1995,  respectively,  because the weighted average exercise prices were
greater than the average  market prices of the common shares.  Weighted  average
exercise  prices of $39.61 in 1997,  $39.62 in 1996 and $50.80 in 1995  exceeded
the average market prices of $29.75, $28.62 and $43.95, respectively.

                                    Page 32
<PAGE>


10.      SUBSEQUENT EVENTS

In January 1998, the company sold  approximately  15 acres of  undeveloped  land
adjacent to its San Jose,  California,  facility  for a net sales price of about
$16  million  realizing  a  pre-tax  gain  of  approximately  $15  million.  The
transaction  will be reported  in the  company's  results for the first  quarter
ending March 27, 1998.

<TABLE>
11.      QUARTERLY FINANCIAL DATA--UNAUDITED

Unaudited quarterly financial data are as follows:

<CAPTION>
(in thousands, except per share amounts)
------------------------------------------------------------------------------------------------------------------------------------
1997 Quarters                                                         1st                2nd              3rd               4th
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                 <C>                <C>              <C>               <C>     
Sales                                                               $ 67,216           $72,679          $ 79,176          $ 72,200
Gross profit                                                          22,905            26,068            30,435            15,188
Income (loss) from continuing operations                                (318)              886             1,762            (6,292)
Income from discontinued operations                                    2,796             2,196             1,828            30,067
Net income                                                             2,478             3,082             3,590            23,775
Basic income (loss) per share from
    continuing operations                                           $   (.04)          $   .11          $    .21          $   (.76)
Diluted income (loss) per share from
    continuing operations                                           $   (.04)          $   .10          $    .21          $   (.76)
Basic net income per share                                          $    .30           $   .37          $    .44          $   2.88
Diluted net income per share                                        $    .30           $   .36          $    .42          $   2.88


------------------------------------------------------------------------------------------------------------------------------------
1996 Quarters                                                         1st                2nd              3rd               4th
------------------------------------------------------------------------------------------------------------------------------------
Sales                                                               $  99,642         $ 107,047         $  76,162         $  66,268
Gross profit                                                           40,110            35,888            29,541            13,024
Income (loss) from continuing operations                                5,220              (761)            2,116            (7,896)
Income from discontinued operations                                     1,214             1,119               716             1,306
Net income                                                              6,434               358             2,832            (6,590)
Basic income (loss) per share from                                                    
    continuing operations                                           $     .64         $    (.09)        $     .25         $    (.95)
Diluted income (loss) per share from                                                  
    continuing operations                                           $     .61         $    (.09)        $     .25         $    (.95)
Basic net income per share                                          $     .79         $     .04         $     .34         $    (.79)
Diluted net income per share                                        $     .75         $     .04         $     .33         $    (.79)
</TABLE>

                                                               Page 33

<PAGE>


11.      QUARTERLY FINANCIAL DATA--UNAUDITED (continued)

Due to the continued overcapacity in the semiconductor memory market, compounded
by the Asian  financial  crisis,  the company took certain actions in the fourth
quarter  of 1997 to  minimize  its  financial  exposure.  The  company  deferred
shipment and revenue  recognition  with certain  Asian  customers as a result of
financing issues with these  customers.  The company's  semiconductor  equipment
business is being sized to reflect these market  changes and resulted in certain
non-performing assets being written off which consist primarily of inventory and
capital assets.  The effect of the above actions resulted in a pre-tax impact of
approximately $17 million during the fourth quarter.

The fourth quarter of 1997 also includes a pre-tax charge of $5 million  related
to the acquisition of Samsung Microwave  Semiconductor (of which $4.6 million is
for in-process research and development), and a $7.6 million pre-tax gain on the
sale and exchange of certain leasehold  interests on the Palo Alto,  California,
facility.

The  fourth  quarter  of 1996  includes  a charge  of $11  million  relating  to
slow-moving inventories and severance costs.

The total of  quarterly  amounts  for  diluted  net  income  per share  will not
necessarily equal the annual amount. The computations  exclude common equivalent
shares in loss periods since they are  antidilutive,  and the  computations  are
based on the  average  number of basic and  diluted  common  shares  outstanding
during each period.

                                    Page 34

<PAGE>


                              REPORT OF MANAGEMENT


The   consolidated   financial   statements  of   Watkins-Johnson   Company  and
subsidiaries  were  prepared  by  management,  which is  responsible  for  their
integrity and  objectivity.  The  statements  were  prepared in conformity  with
generally accepted accounting  principles and, as such, include amounts that are
based on the best judgments of management.

The system of internal controls of the company is designed to provide reasonable
assurance  that assets are  safeguarded  and that  transactions  are executed in
accordance with management's  authorization and are reported properly.  The most
important  safeguard for shareowners is the company's emphasis in the selection,
training and  development of professional  accounting  managers to implement and
oversee the proper  application  of its internal  controls and the  reporting of
management's  stewardship  of corporate  assets and  maintenance  of accounts in
conformity with generally accepted accounting principles.

Deloitte  & Touche  LLP,  independent  auditors,  are  retained  to  provide  an
objective,   independent   review   as  to   management's   discharge   of   its
responsibilities  insofar as they relate to the  fairness of reported  operating
results and financial position. They obtain and maintain an understanding of the
company's accounting and financial controls,  and conduct such tests and related
procedures as they deem necessary to arrive at an opinion on the fairness of the
financial statements.

The Audit Committee of the Board of Directors, composed solely of Directors from
outside the  company,  meets  periodically,  separately  and  jointly,  with the
independent  auditors and  representatives  of  management to review the work of
each. The functions of the Audit Committee  include  recommending the engagement
of the  independent  auditors,  reviewing the scope and results of the audit and
reviewing management's evaluation of the system of internal controls.


       W. Keith Kennedy, Jr.                         Scott G. Buchanan
       President and                                 Vice President and
           Chief Executive Officer                      Chief Financial Officer

                                    Page 35

<PAGE>


INDEPENDENT AUDITORS' REPORT


The Shareowners and Board of Directors
    of Watkins-Johnson Company:

We have audited the accompanying  consolidated balance sheets of Watkins-Johnson
Company  and  subsidiaries  as of December  31,  1997 and 1996,  and the related
consolidated  statements of operations,  shareowners' equity, and cash flows for
each of the three years in the period ended December 31, 1997.  These  financial
statements   are  the   responsibility   of  the   company's   management.   Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

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

In our opinion,  such consolidated  financial  statements present fairly, in all
material  respects,  the  financial  position  of  Watkins-Johnson  Company  and
subsidiaries at December 31, 1997 and 1996, and the results of their  operations
and their cash flows for each of the three  years in the period  ended  December
31, 1997 in conformity with generally accepted accounting principles.

In 1997, the company  adopted  Statement of Financial  Accounting  Standards No.
131,  "Disclosures about Segments of an Enterprise and Related  Information," as
described in Note 8 to the consolidated financial statements.



Deloitte & Touche LLP
San Jose, California
February 9, 1998

                                    Page 36

<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

         The  information   required  by  this  item  concerning  the  company's
         directors  is shown under the caption  "Election of  Directors"  in the
         company's definitive proxy statement filed with the Commission pursuant
         to Regulation 14A.

         The  information  relating  to  the  company's  executive  officers  is
         presented  in Part I of this Form 10-K  under  the  caption  "Executive
         Officers of the Registrant".

Item 11. Executive Compensation

         See this caption in the definitive  proxy  statement  which the company
         has filed with the Commission pursuant to Regulation 14A.

Item 12. Security Ownership of Certain Beneficial Owners and Management

         This  information  is shown under the captions  "Security  Ownership of
         Certain  Beneficial  Owners & Management"  in the company's  definitive
         proxy statement filed with the Commission pursuant to Regulation 14A.

Item 13. Certain Relationships and Related Transactions

         Information  concerning  certain business  relationships is shown under
         the caption "Executive  Compensation" in the definitive proxy statement
         which the company has filed with the Commission  pursuant to Regulation
         14A. There were no transactions  with  management for which  disclosure
         would be required by Item 404 of Regulation S-K.


                                     Part IV

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

(a)  1.  Consolidated Financial Statements                                  Page
                                                                            ----

         Consolidated Statements of Operations
         For the Years Ended December 31, 1997, 1996 and 1995                 15

         Consolidated Balance Sheets
         December 31, 1997 and 1996                                           16

         Consolidated Statements of Shareowners' Equity
         For the Years Ended December 31, 1997, 1996 and 1995                 17

         Consolidated Statements of Cash Flows
         For the Years Ended December 31, 1997, 1996 and 1995              18-19

         Notes to Consolidated Financial Statements                        20-34

         Report of Management                                                 35

         Independent Auditors' Report                                         36

                                    Page 37

<PAGE>


     2.  Financial Statement Schedules                                      Page
                                                                            ----
         Independent Auditors' Report                                         41

         II     Valuation and Qualifying Accounts and Reserves
                For the Years Ended December 31, 1997, 1996 and 1995          42


         Schedules  not  listed  above are  omitted  because  of the  absence of
         conditions  under  which  they are  required  or because  the  required
         information  is included in the  financial  statements  or in the notes
         thereto.

     3.  Exhibits

         A list of the  exhibits  required to be filed as part of this report is
         set  forth  in the  Exhibit  Index,  which  immediately  precedes  such
         exhibits. The exhibits are numbered according to Item 601 of Regulation
         S-K.  Exhibits   incorporated  by  reference  to  a  prior  filing  are
         designated by an asterisk.

         -----------------------
(b)      Reports  on Form 8-K and 8-K/A  were  filed on  November  14,  1997 and
         January 13, 1998, respectively. The reports are referrenced as Exhibits
         10-w and 10-x, respectively,  in the Exhibit Index. The reports contain
         the required  disclosures and pro forma financial  statements regarding
         the sale of the company's  government  electronics  business on October
         31, 1997. No other reports on Form 8-K were required to be filed during
         the last quarter of the period covered by this report.
(c)      The exhibits required to be filed by Item 601 of Regulation S-K are the
         same as Item 14(a)3 above.
(d)      Financial  statement  schedules  not included  herein have been omitted
         because of the absence of  conditions  under which they are required or
         because  the  required   information   is  included  in  the  financial
         statements or in the notes thereto.

                                    Page 38

<PAGE>


                                   SIGNATURES


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


                                                   WATKINS-JOHNSON COMPANY
                                                   -----------------------
                                                         (Registrant)




Date:       March 19, 1998                        By  /s/  Dean A. Watkins
            --------------                            -------------------------
                                                           Dean A. Watkins
                                                           Chairman of the Board


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


<CAPTION>
             Signature                            Title                        Date
             ---------                            -----                        ----
<S>                                        <C>                              <C>
Principal Executive Officer:


  /s/  W. Keith Kennedy, Jr.                  President and                 March 19, 1998
---------------------------------          Chief Executive Officer          ---------------
       W. Keith Kennedy, Jr.                         


Principal Financial and Accounting Officer:


  /s/   Scott G. Buchanan                    Vice President and             March 19, 1998
---------------------------------          Chief Financial Officer          --------------
        Scott G. Buchanan                  


                                    Page 39

<PAGE>


             Signature                            Title                        Date
             ---------                            -----                        ----


  /s/  H. Richard Johnson                        Director                    March 19, 1998
----------------------------------                                           --------------
       H. Richard Johnson


  /s/   John J. Hartmann                         Director                    March 19, 1998
----------------------------------                                           --------------
        John J. Hartmann


  /s/  Raymond F. O'Brien                        Director                    March 19, 1998
----------------------------------                                           --------------
       Raymond F. O'Brien


  /s/   William R. Graham                        Director                    March 19, 1998
----------------------------------                                           --------------
        William R. Graham


  /s/    Robert L. Prestel                       Director                    March 19, 1998
----------------------------------                                           --------------
         Robert L. Prestel


  /s/     Gary M. Cusumano                       Director                    March 19, 1998
----------------------------------                                           --------------
          Gary M. Cusumano
</TABLE>

                                    Page 40

<PAGE>


INDEPENDENT AUDITORS' REPORT



Watkins-Johnson Company:

We have audited the consolidated financial statements of Watkins-Johnson Company
and  subsidiaries  as of December  31, 1997 and 1996,  and for each of the three
years in the period ended  December 31, 1997, and have issued our report thereon
dated February 9, 1998; such  consolidated  financial  statements and report are
included in Item 8 of this annual report on Form 10-K.  Our audits also included
the consolidated  financial  statement schedule of  Watkins-Johnson  Company and
subsidiaries,  listed in Item 14. This consolidated financial statement schedule
is the  responsibility  of the company's  management.  Our  responsibility is to
express  an opinion  based on our  audits.  In our  opinion,  such  consolidated
financial  statement schedule taken as a whole,  presents fairly in all material
respects the information set forth therein.



Deloitte & Touche LLP
San Jose, California
February 9, 1998

                                    Page 41

<PAGE>


<TABLE>
                                                                                                         Schedule II


                                      WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                   VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
                                FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 and 1995


<CAPTION>
                                                 Balance at       Charged to                             Balance at
                                                  Beginning        Costs and                                 End of
Description                                       of Period         Expenses      Deductions(1)           Period(2)
<S>                                                <C>            <C>                   <C>              <C>       
1997
Allowance for doubtful accounts                    $746,720       $2,467,656            $38,453          $3,175,923
                                                   ========       ==========            =======          ==========

1996
Allowance for doubtful accounts                    $633,798         $119,649             $6,727            $746,720
                                                   ========         ========             ======            ========

1995
Allowance for doubtful accounts                    $614,898          $18,900                $ 0            $633,798
                                                   ========          =======             ======            ========


<FN>
(1)  Write-off of uncollectible accounts.
(2)  Reduction of accounts receivable.
</FN>
</TABLE>

                                                      Page 42

<PAGE>


                                                   EXHIBIT INDEX


    Exhibit
     Number    Description
     ------    -----------

      3-a      *Articles of Incorporation of Watkins-Johnson Company, as amended
               May 8, 1989.

      3-b      *By-Laws of  Watkins-Johnson  Company,  as amended April 27, 1989
               (Exhibit 3-b to Form 10-K for 1980, Commission File No. 1-5631).

     10        Material Contracts

     10-a      *Lease  and  Agreement  between  Lindco  Properties  Company  and
               Watkins-Johnson  Company commencing May 1, 1969 (Exhibit (b) I to
               Form 10-K for 1969, Commission File No. 2-22436).

     10-b      *Lease  and  Agreement  between  Morrco  Properties  Company  and
               Watkins-Johnson  Company  dated October 31, 1975 (Exhibit 2(c) to
               Form 10-K for 1976, Commission File No. 1-5631).

     10-c      *Lease  and  Agreement   between  Danac  Real  Estate  Investment
               Corporation and  Watkins-Johnson  Company (Exhibit 6 to Form 10-K
               for 1972, Commission File No. 2-22436) and the amendments thereto
               (Exhibit 1(b) to Form 10-K for 1976, Commission File No. 1-5631).

     10-d      *Building and Loan Agreement and Deed of Trust Note between Danac
               Real Estate Investment  Corporation and  Watkins-Johnson  Company
               (Exhibit 7 to Form 10-K for 1972, Commission File No. 2-22436).

     10-e      *Promissory Note and Deed of Trust Agreement entered into between
               the New England Mutual Life Insurance Company and Watkins-Johnson
               Company  dated  May,  1978  (Exhibit  2 to Form  10-K  for  1978,
               Commission File No. 1-5631).

     10-f      *Promissory  Note  and  Deed of  Trust  entered  into by the Wake
               County  Industrial  Facilities  and Pollution  Control  Financing
               Authority,   the  NCNB  National  Bank  of  North   Carolina  and
               Watkins-Johnson  Company dated December 28, 1984 (Exhibit 10-f to
               Form 10-K for 1984, Commission File No. 1-5631).

     10-g      *Deferred  Compensation Plan effective November 29, 1979 (Exhibit
               10-g to Form 10-K for 1984, Commission File No. 1-5631).

     10-h      *Key Top-Management Incentive Bonus Plan Summary (Exhibit 10-h to
               Form 10-K for 1985, Commission File No. 1-5631).

                                    Page 43

<PAGE>


    Exhibit
     Number    Description
     ------    -----------

     10-i      *Employment  Agreement Form, in effect for those employees listed
               in the  company's  definitive  proxy  statement  filed  with  the
               Commission  pursuant to Regulation 14A (Exhibit 10-i to Form 10-K
               for 1984, Commission File No. 1-5631).

     10-j      *Deferred  Compensation  Plan  effective  November  29,  1979  as
               amended  March  31,  1986  (Exhibit  10-j to Form  10-K for 1986,
               Commission File No. 1-5631).

     10-k      *Lease   and   Agreement    between   Seagate    Technology   and
               Watkins-Johnson Company dated September 19, 1986 (Exhibit 10-k to
               Form 10-K for 1986, Commission File No. 1-5631).

     10-k(1)   *Termination of Lease and Agreement  between  Seagate  Technology
               and  Watkins-Johnson  Company  dated  September 22, 1987 (Exhibit
               10-k(1) to Form 10-K for 1987, Commission File No. 1-5631).

     10-l      *Severance  Agreement Form, in effect for those employees  listed
               in the  company's  definitive  proxy  statement  filed  with  the
               Commission  pursuant to Regulation 14A (Exhibit 10-l to Form 10-K
               for 1986, Commission File No. 1-5631).

     10-m      *Form of Rights  Agreement  between  Watkins-Johnson  Company and
               Bank of America National Trust and Savings Association (Exhibit 4
               to the 1986 Third Quarter Form 10-Q, Commission File No. 1-5631).

     10-n      *Watkins-Johnson  Company  1976  Stock  Option  Plan,  as amended
               September 28, 1987 (Appendix A to the company's  definitive proxy
               statement dated March 1, 1988 filed with the Commission  pursuant
               to Regulation 14A).

     10-o      *Watkins-Johnson  Company 1989 Stock Option Plan for  nonemployee
               directors (Appendix A to the company's definitive proxy statement
               dated  February  28, 1990 filed with the  Commission  pursuant to
               Regulation 14A).

     10-p      *Watkins-Johnson  Company  1976 Stock  Option  Plan  amended  and
               renamed as the 1991 Stock Option and Incentive  plan  (Appendix A
               to the company's  definitive  proxy  statement dated February 28,
               1991 filed with the commission pursuant to Regulation 14A).

     10-q      *Watkins-Johnson  Company Credit Agreement covering the period of
               November 30, 1995 through December 8, 1998, ABN-AMRO BANK N.V. as
               Agent  (Exhibit  10-a  to  the  1996  Third  Quarter  Form  10-Q,
               Commission File No. 1-5631).

     10-r      *Loan   Agreement   dated  as  of  February   9,  1996   (English
               Translation) between Watkins-Johnson International Japan K.K. and
               The Bank of Yokohama, LTD, including Loan Guaranty Agreement with
               Watkins-Johnson  Company  dated January 31, 1996 (Exhibit 10-b to
               the 1996 Third Quarter Form 10-Q, Commission File No. 1-5631).

     10-s      *Loan  Agreement  dated as of June 12, 96  (English  Translation)
               between  Watkins-Johnson  International  Japan K.K. and The Japan
               Development   Bank,   including  Loan  Guaranty   Agreement  with
               Watkins-Johnson  Company dated June 12, 1996 (Exhibit 10-c to the
               1996 Third Quarter Form 10-Q, Commission File No. 1-5631).

     10-t      *Shareowners'  Rights  Agreement  dated as of September  30, 1996
               Between   Watkins-Johnson  Company  and  ChaseMellon  Shareholder
               Services,  L.L.C.,  as Rights Agent (Report on Form 8-K, filed on
               October 1, 1996, Commission File No.1-5631).

                                    Page 44

<PAGE>


    Exhibit
     Number    Description
     ------    -----------

     10-u      *First  Amendment to  Watkins-Johnson  Company  Credit  Agreement
               covering  the period of  November  30, 1995  through  December 8,
               1998,  ABN-AMRO BANK N.V. as Agent  (original  agreement filed as
               Exhibit 10-a to the 1996 Third Quarter Form 10-Q, Commission File
               No.  1-5631;  first  amendment  filed as Exhibit 10-a to the 1997
               First Quarter Form 10-Q, Commission File No. 1-5631).

     10-v      *Second  Amendment to  Watkins-Johnson  Company Credit  Agreement
               covering  the period of  November  30, 1995  through  December 8,
               1998,  ABN-AMRO BANK N.V. as Agent  (original  agreement filed as
               Exhibit 10-a to the 1996 Third Quarter Form 10-Q, Commission File
               No. 1-5631;  second  amendment  filed as Exhibit 10-a to the 1997
               Second Quarter Form 10-Q, Commission File No. 1-5631).

     10-w      *Stock Purchase  Agreement  dated  as of as of August 29, 1997 by
               and among Registrant and SMS and TSMD Acquisition Corp. (original
               agreement  filed as Exhibit 99.1 of Report on Form 8-K,  filed on
               November 14, 1997,  reporting the disposition of assets effective
               October 31, 1997, Commission File No.1-5631).

     10-x      *Watkins-Johnson   Company   Unaudited  Pro    Forma    Condensed
               Consolidated  Financial  Information  filed  as an  amendment  to
               Report on Form 8-K,  filed on November  14, 1997,  reporting  the
               disposition  of  assets  effective  October  31,  1997 and  Stock
               Purchase Agreement dated as of as of August 29, 1997 by and among
               Registrant and SMS and TSMD  Acquisition  Corp.,  Commission File
               No.1-5631 (Exhibit 10-x originally filed as Report on Form 8-K/A,
               filed on January 13, 1998, 1997, Commission File No.1-5631).

     10-y      Asset  Purchase  Agreement  between  Watkins-Johnson  Company And
               Samsung Semiconductor, Inc. dated as of December 31, 1997.

     10-z      Assignment  of Lease  Agreement  by and  between  Taylor  Woodrow
               Property Company, Inc.  ("Assignor") and Watkins-Johnson  Company
               ("Assignee") dated as of December 30, 1997.


                                    Page 45

<PAGE>


    Exhibit
     Number    Description
     ------    -----------

     21        Subsidiaries of Watkins-Johnson Company.

     23        Consent of Independent Auditors.

     27        Financial Data Schedule.

                                    Page 46