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

                                    FORM 10-K

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

                   For the fiscal year ended December 31, 1998
                                       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
incorporation or organization)                              Identification No.)

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 5, 1999
Aggregate market value of the voting stock held by        ----------------------
non-affiliates of the registrant:                             $87,673,000
Number of shares outstanding: Common stock, no par value        6,561,000 shares


                       DOCUMENTS INCORPORATED BY REFERENCE
                       -----------------------------------

Portions  of  the   Watkins-Johnson   Company   Notice  of  Annual   Meeting  of
Shareowners--April  29,  1999 and  Proxy  Statement  filed  with the  commission
pursuant to Regulation 14A are incorporated by reference into Part III.

                                     Page 1

<PAGE>


                                     Part I

Item 1. Business

         The statements in this Annual Report on Form 10-K that relate to future
         plans,  events or performance are  forward-looking  statements.  Actual
         results could differ  materially due to a variety of factors  discussed
         under  "Risks and  Uncertainties  that May Affect  Future  Results" and
         other risks  described in this Annual Report on Form 10-K.  The company
         undertakes  no  obligation  to publicly  update  these  forward-looking
         statements to reflect events or circumstances  after the date hereof or
         to reflect the occurrence of unanticipated events.

     (a) General Development of Business

         Watkins-Johnson  Company (the  company) had operated in three  industry
         segments   in   1993:   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.

         During 1997 the  company's  structure was realigned to focus on its two
         high-growth  businesses:   Wireless  Communications  and  Semiconductor
         Equipment.  In  October  1997,  the  company  divested  its  Government
         Electronics  operations and reported such  divestiture as  discontinued
         operations  as  disclosed  in  Note  8 to  the  consolidated  financial
         statements  contained in Part II, Item 8 of this annual  report on Form
         10-K.

         Except for the land sale and write down of  discontinued  products  and
         related  restructuring  discussed  below,  other  than in the  ordinary
         course of  business  there  were no  acquisitions  or  dispositions  of
         material amounts of assets during 1998. No material  reclassifications,
         mergers or consolidations  of the company or its subsidiaries  occurred
         during the year.

         During  the  third  quarter  of  1998,  the  company  restructured  its
         operations    to    focus    on    its    core     atmospheric-pressure
         chemical-vapor-deposition   (APCVD)  operations  in  the  Semiconductor
         Equipment segment by discontinuing  efforts on its  high-density-plasma
         (HDP) initiative.  Also, the company's Wireless  Communications segment
         evaluated its Base2(TM) base-station product,  reassessing key customer
         needs and market conditions.  Inventory, demo equipment, and customized
         fixed assets  associated  with these  products were written down in the
         restructuring  as  discussed in Note 11 to the  consolidated  financial
         statements  contained in Part II, Item 8 of this annual  report on Form
         10-K.

         Subsequent  Events--On March 1, 1999,  Watkins-Johnson  announced that,
         after a strategic review  performed by its investment  banking firm, it
         would pursue a sale of the  company,  either in its entirety or through
         sales  of  its  individual   business  segments.   On  March  4,  1999,
         Watkins-Johnson  announced  that it had signed a non-binding  letter of
         intent to sell its  Semiconductor  Equipment  Group,  exclusive  of its
         discontinued  high-density-plasma  and certain other assets, to Silicon
         Valley  Group,  Inc.  (SVG).  The  sale is  subject  to  customary  due
         diligence,  execution of a definitive acquisition agreement,  Hart Scot
         Rodino  filings,  and  the  approval  of the  boards  of  directors  of
         Watkins-Johnson and SVG. There can be no assurance that the sale of the
         Semiconductor  Equipment Group to SVG will be completed,  nor can there
         be any  assurance  that  Watkins-Johnson  will be able to complete  its
         strategy for the sale of the entire company.

                                     Page 2

<PAGE>


Item 1. Business (continued)

     (b) Financial Information about Industry Segments

         The   company   operates   in  two   industry   segments   --  Wireless
         Communications  and  Semiconductor  Equipment.   Financial  information
         covering  these  industry  segments  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 wireless communications and semiconductor-manufacturing equipment.

         Wireless Communications

         The company's Wireless Communications business designs and manufactures
         solid-state  devices,  single function  components,  subassemblies  and
         equipment for the wireless telecommunications  industry. The foundation
         of the company's wireless-communications strength lies in the company's
         more than 20 year history with gallium-arsenide (GaAs) technology.  The
         company  produces  highly  reliable   proprietary  chips  that  perform
         signal-processing  functions in subassemblies and systems for PCS, GSM,
         cellular, and personal phone equipment.

         The company is  capitalizing on the healthy market for RF components by
         expanding its gallium  arsenide (GaAs)  integrated-circuit  fabrication
         capability and actively marketing  company-manufactured  devices to the
         wireless  industry.  Historically,  the company has  manufactured  GaAs
         devices  for  its own  use  only.  The WJ AH1  GaAs  amplifier  chip is
         achieving  acceptance  by base  station  manufacturers  worldwide.  The
         advantage of this amplifier is its ultralinear performance,  which base
         station producers need for quality digital wireless performance.  These
         devices  offer  excellent  performance,  and an  updated  and  expanded
         fabrication  facility  enables  the  company  to sell  them on the open
         market at competitive  prices. The relocation of the GaAs and thin film
         processing  and  design  organization  to  the  Milpitas,   California,
         facility is on schedule and is expected to be completed early in 1999.

         In addition  to  follow-on  orders for PCS  converter  assemblies,  the
         company received several large orders in 1998 from Lucent Technologies,
         Inc. for a  wireless-local-loop  assembly.  The company had  previously
         signed a contract with Lucent for the design for a  wireless-local-loop
         transceiver unit. The contract was for  wireless-local-loop  subscriber
         units, technical consultation and intellectual-property  rights. Lucent
         is optimistic  about the  potential  for its product and  established a
         co-production  relationship with the company to ensure adequate supply.
         Lucent is a major  customer  for the Wireless  Communications  segment,
         with approximately 29% of that segment's sales in 1998.

         The company has a second wireless-local-loop  program, which is smaller
         than the Lucent  program.  In  addition  to the  subscriber  unit,  the
         company is making  assemblies that go in the  transmitter.  The company
         has a 5-year manufacturing exclusive on this program.

         Other  products  include  high-dynamic  range  converters and terminals
         which  are   produced   in  high  volume  for  PCS   base-station   and
         wireless-local-loop  applications.  Related  subsystems  and  equipment
         perform signal-conversion,  signal-reception, repeater and base-station
         functions  by  government  agencies  for  signals-intelligence  mission
         requirements.

                                     Page 3

<PAGE>


Item 1. Business (continued)

         During 1998, the company discontinued its Base2 base-station product at
         its  Gaithersburg  plant as discussed in Part I, Item 7,  "Management's
         Discussion   and  Analysis  of  Financial   Condition  and  Results  of
         Operations,"  and in Note 11 to the consolidated  financial  statements
         contained in Part II, Item 8 of this annual report on Form 10-K.

         Sales by the Wireless  Communications  segment were 54% of consolidated
         sales in 1998,  36% in 1997 and 22% in 1996.  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.
         Lucent  Technologies,  Inc.,  Bartleys  R.F.  Systems  Inc.  (a  Lucent
         sub-contractor),  Nortel  LTD  and the  United  States  Government  are
         significant  customers of this business segment.  Although the customer
         community  represents  a large  business  opportunity,  the  number  of
         individual  customers  is  not  significant.  Approximately  19% of the
         segment's sales are to international customers.

         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  customers  by excellent  service and  superior  technical
         performance.  The group's customer,  Lucent Technologies,  acknowledged
         the  excellence of the company's  products and services by  recognizing
         Watkins-Johnson  Company  as a  premier  supplier  for two  consecutive
         years.  The company  seeks to protect its  intellectual  property by an
         aggressive patent and trade secret program.

         Additional information regarding the company's Wireless  Communications
         segment along with a discussion risks and uncertainties that may affect
         future  results is included in Part I, Item 7, of this annual report on
         Form 10-K.

         Semiconductor Equipment

         The company's  Semiconductor  Equipment  segment designs,  develops and
         manufactures  equipment to deposit thin  dielectric  films by using the
         process of atmospheric-pressure  chemical-vapor-deposition (APCVD). The
         company's products apply insulating,  or dielectric,  layers of silicon
         dioxide   (glass)  onto  silicon   wafers  during  the   processing  of
         integrated-circuit  chips.  This  equipment  functions by injecting the
         gases needed for the reaction over the substrate material.

         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.

                                     Page 4

<PAGE>


Item 1. Business (continued)

         The company has two proprietary  approaches to the APCVD process. Under
         one approach,  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 these APCVD systems as the WJ-999,  WJ-1000 and the
         recently introduced WJ-1500.  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 and WJ-1500 are  specifically  designed  for  production  lines
         using 200-mm (8-inch)  semiconductor  wafers.  Under a second approach,
         the  company's  recently   introduced   WJ-3000A  is  a  single  wafer,
         multiprocessing system with both 300-mm and 200-mm capability.

         The  semiconductor  industry had significant  over capacity and capital
         equipment  investment  continued to decline in 1998. The company took a
         number of actions to bring its cost  structure  into alignment with the
         extremely  low  conditions  of  this  cyclical  market.  As part of the
         resizing, the high-density-plasma (HDP) chemical-vapor-deposition (CVD)
         system  initiative was  discontinued as discussed in Part I, Item 7 and
         in Note 11 to the consolidated  financial  statements contained in Part
         II, Item 8 of this annual report on Form 10-K.

         The  company  will  continue  to offer its core APCVD  product  line to
         semiconductor  manufacturers.  It also  intends to preserve  its global
         service and key development activities to provide new equipment for the
         market   applications   in  premetal   dielectric  and  shallow  trench
         isolation.  Its future  development  activities  will be focused on two
         recently  announced  systems,  the WJ-1500 and the  WJ-3200A  which are
         described in Part I, Item 7, of this annual report on Form 10-K.

         The  decreasing  feature sizes  used in the  construction of integrated
         circuits  are  opening  a  new  application  for  the  company's  APCVD
         equipment.  Small feature sizes allow smaller transistors to be defined
         and located  closer  together  in the  circuits.  The  desired  packing
         density is causing 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. The company believes its
         APCVD process is competitive for this more recent step.

         Sales in the  Semiconductor  Equipment segment were 46% of consolidated
         sales  in 1998 and 64% in 1997  and 78% in  1996.  Over the last  three
         years the  company  has  changed  its method of selling  and  servicing
         semiconductor   equipment.   The   company   replaced   a  network   of
         manufacturers'  representatives  and distributors,  with a direct sales
         and service force world-wide to better serve its customers.  Currently,
         the  company  has direct  sales  offices in the United  States,  Korea,
         Taiwan, Singapore, Japan and Europe.

         The  company's  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  manufacturing  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.  Over a
         period of years,  NEC,  Hyundai  Electronics  Ind.  Co.  Ltd.,  Samsung
         Pacific  International  Inc.,  Motorola and Intel have been significant
         customers of the segment.  There are several domestic and international
         competitors  in this field (some of whom are larger  than the  company)
         and  competition is intense.  In meeting the  competition,  emphasis is
         placed on selling quality products with high technical  performance

                                     Page 5

<PAGE>


Item 1. Business (continued)

         and operational  reliability with a competitive cost of ownership.  The
         company's  global   customer-support   network  is  expected  to  be  a
         competitive advantage.

         Additional information regarding the company's  Semiconductor Equipment
         segment  along with a discussion  of risks and  uncertainties  that may
         affect  future  results is  included  in Part I, Item 7, of this annual
         report on Form 10-K.

         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
         company products. Business operations are not believed by management 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.

         Total company  backlog at December 31, 1998 was $79.5 million  compared
         to $98.2  million at  December  31,  1997.  The  percentage  of backlog
         attributable to the Wireless Communications and Semiconductor Equipment
         is 84% and 16%, respectively, in 1998, compared to 61% and 39% in 1997.
         The company includes in its backlog customer  released orders with firm
         schedules  for shipment.  Approximately  98% of all backlog at December
         31, 1998 is expected to be shipped within 12 months, compared to 93% at
         December 31, 1997. The company does not have any significant  long-term
         purchase  agreements  with  any of its  customers,  and  customers  can
         typically  cancel  or  reschedule  their  orders  without   significant
         penalty. As a result, customers frequently revise production quantities
         and delivery  schedules to reflect their changing needs.  Since most of
         the company's backlog can be canceled  or rescheduled, the company does
         not believe its backlog is a meaningful indicator of future revenue.

         Company-sponsored research and development expense was $49.9 million in
         1998,   $50.2   million   in  1997,   and   $53.2   million   in  1996.
         Customer-sponsored  research and  development was $3.2 million in 1998,
         $5.2  million  in 1997 and  $7.2  million  in 1996.  Customer-sponsored
         research and development  was performed by the Wireless  Communications
         segment.

         The  company's  headcount  at December  31,  1998 was 990.  None of the
         company's employees are 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.

                                     Page 6

<PAGE>


Item 1. Business (continued)

         Combined export sales and sales from foreign  operations  accounted for
         36% of the company's sales in 1998, 42% in 1997 and 59% in 1996. Assets
         of foreign  operations  accounted for 16%, 14% and 15% of  consolidated
         assets at December 31, 1998, 1997 and 1996, respectively.  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,  Scotts  Valley and  Milpitas,  California  and
         Gaithersburg,  Maryland.  The company  also has a facility in Kawasaki,
         Japan, for its  Semiconductor  Equipment Group and leases several sales
         and service  offices  throughout  the United States,  Asia-Pacific  and
         Europe.

         In 1998,  approximately  15 acres of  undeveloped  land adjacent to the
         company's  San Jose,  California,  facility  was  sold,  and due to the
         downsizing   discussed  in  Note  10  to  the  consolidated   financial
         statements  (contained in Part II, Item 8 of this annual report on Form
         10-K), the company's  190,000 square foot San Jose facility was vacated
         and is currently for sale. The company expects to sell this property in
         1999. The company is pursuing opportunities to realize the market value
         of its properties while ensuring efficient use of available space.

         In December  1997,  the sale and exchange of a portion of the company's
         Palo Alto lease interest was successfully  completed.  About 7 acres of
         the Palo Alto campus were returned to the lessor for  consideration  as
         discussed  in  Note  10  to  the  consolidated   financial   statements
         (contained in Part II, Item 8 of this annual report on Form 10-K).

         Excluding  the San Jose  facility,  at December  31,  1998,  there were
         approximately 508,000 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  508,000  square  feet of  plant  space  in  California,
         approximately  133,000 square feet in Palo Alto is subleased to Stellex
         Microwave Systems, Inc. (SMS) for a period through October 2000 as part
         of the stock purchase  agreement  included in Part II, Item 14(a)3,  by
         reference as Exhibit 10.1l. The space is leased to SMS at a price which
         recovers utilities, maintenance and other services, and may be canceled
         by SMS  with 6 months  notice.  In  addition,  a small  portion  of the
         Kawasaki, Japan, facility is leased to a tenant. Excluding the San Jose
         facility and the subleases  discussed above,  approximately  85% of the
         company's   available   plant  space  is  occupied  for  the  company's
         operations.

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

         The Palo Alto and Milpitas  facilities  and all sales office  locations
         are leased. Information on long-term obligations is discussed 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.

                                     Page 7

<PAGE>


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>
                                                Executive Officers of the Registrant

<CAPTION>
                                                                      Officer     Business Experience
Name                        Age     Office Held                        Since        Last Five Years
------------------------------------------------------------------------------------------------------------------------------------
<S>                         <C>     <C>                                <C>        <C>
Dr. Dean A. Watkins         76      Chairman of the Board              1957       Chairman of the Board
Dr. H. Richard Johnson      72      Vice Chairman of the Board         1957       Vice Chairman of the Board
Dr. W. Keith Kennedy, Jr.   55      President and Chief Executive      1977       President and Chief Executive Officer
                                      Officer
Scott G. Buchanan           47      Vice President, Chief Financial    1989       Vice President, Chief Financial Officer and
                                      Officer and Treasurer                         Treasurer, Prior to 1998, Vice President and
                                                                                    Chief Financial Officer
Dr. Patrick J. Brady        53      Vice President                     1996       President, Semiconductor Equipment Group;
                                                                                    Prior to 1996, Vice President of Engineering,
                                                                                    Semiconductor Equipment Group
Malcolm J. Caraballo        43      Vice President                     1996       President, Microwave Products Group;
                                                                                    Prior to 1996, Vice President, Microwave
                                                                                    Products Division
Robert G. Hiller            61      Vice President                     1997       President, Telecommunications Group, Prior to
                                                                                    1997, Vice President, Telecommunications Group,
                                                                                    Prior to 1996, Director, Engineering,
                                                                                    Electronics Equipment Division
Dr. Frank E. Emery          62      Vice President                     1998       Vice President, Corporate Planning and
                                                                                    Communication, Prior to 1998, Manager, Corporate
                                                                                    Planning and Communication
Darryl T. Quan              44      Controller                         1991       Controller
Claudia D. Kelly            58      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, 1998 there were approximately
         8,500  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>
1998 Quarters                                                    1st          2nd        3rd          4th
--------------------------------------- ------------------------ ------------ ---------- ------------ -----------
<S>                                                               <C>         <C>        <C>          <C>
Dividends declared per share (in cents)                           12          12         12           12

Stock price                                          High         28 1/2      28 1/2     29 1/2       22 9/16
(NYSE-in dollars)                                    Low          22 13/16    23 5/16    17 9/16      16 3/8


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

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
</TABLE>



<TABLE>
Item 6. Selected Financial Data

<CAPTION>
(Dollars in thousands,
except per share amounts)                                1998              1997              1996              1995             1994
------------------------------------------------------------------------------------------------------------------------------------
<S>                                               <C>               <C>               <C>               <C>              <C>        
OPERATING RESULTS
Sales                                             $   212,200       $   291,271       $   349,119       $   284,335      $   209,330
Net income (loss) from
    continuing operations                             (49,208)           (3,962)           (1,321)           21,854           19,652
Basic net income (loss) per share
    from continuing operations                          (6.36)            (0.48)            (0.16)             2.75             2.65
Diluted net income (loss) per share
    from continuing operations                          (6.36)            (0.48)            (0.16)             2.49             2.41
Dividends per share                               $      0.48       $      0.48       $      0.48       $      0.48      $      0.48
Basic average common shares                         7,737,000         8,258,000         8,265,000         7,938,000        7,425,000
Diluted average common shares                       7,737,000         8,258,000         8,265,000         8,776,000        8,153,000

FINANCIAL POSITION
Working capital                                   $    91,018       $   153,607       $   122,982       $   124,796      $   102,361
Total assets                                          245,478           358,212           293,744           269,565          220,223
Long-term obligations                                  32,701            33,234            37,801            20,469           21,332
Shareowners' equity                                   131,699           220,392           194,711           191,253          149,626
Shareowners' equity per share                     $     20.11       $     26.68       $     23.38       $     23.54      $     19.75
Number of shareowners                                   8,500             6,500             5,400             4,900            4,600
</TABLE>

                                                               Page 9

<PAGE>


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

         The  following  discussion  should  be read  in  conjunction  with  the
         company's  consolidated financial statements and related notes included
         elsewhere in this annual  report.  Except for historic  actual  results
         reported,  the following discussion may contain predictions,  estimates
         and other forward-looking statements that involve a number of risks and
         uncertainties.  See "Risks  and  Uncertainties  that May Affect  Future
         Results"  included below for a discussion of certain factors that could
         cause  future  actual  results to differ  from those  described  in the
         following discussion.

         Financial Condition and Liquidity

         At the end of 1998,  cash and  equivalents  and short-term  investments
         totaled  $64.6  million,  a  decline  of  $69.9  million  from the 1997
         year-end cash and equivalent  balance of $134.5  million.  The decrease
         resulted  primarily from the company's  operating loss, working capital
         requirements,  and repurchase of the company's common stock. A total of
         1,795,800 shares were repurchased for $36.2 million.  Proceeds from the
         sale of undeveloped  land, as described in Note 10 to the  consolidated
         financial   statements,   helped  fund  the   company's   1998  capital
         acquisitions.

         In 1997,  cash and  equivalents  increased  $118.8  million  from $15.7
         million  to  $134.5  million.  The  increase  was  attributed  to funds
         generated   from   continuing   operations,   gain  from  the  sale  of
         discontinued  operations  as  described  in Note 8 to the  consolidated
         financial  statements,  and  proceeds  received  from the exchange of a
         subleasehold  interest  as  explained  in Note  10 to the  consolidated
         financial  statements.  The cash inflow from the above  activities  was
         sufficient to fund the  acquisition  of capital  assets  totaling $22.2
         million in 1997.

         In 1996,  cash and  equivalents  decreased  $18.9  million,  from $34.6
         million to $15.7  million.  Net cash provided by continuing  operations
         was $16.0 million.  This helped  partially  fund the company's  capital
         asset  acquisitions  totaling  $48.3  million,  including a facility in
         Kawasaki  Japan.  The company  completed  the financing of 1996 capital
         asset  acquisitions  with  long-term  borrowings  of $20.2  million  as
         described in Note 3 to the consolidated financial statements.

         As of December 31, 1998,  the company's  principal  source of liquidity
         consisted  of $19.3  million in cash and  equivalents  plus  short-term
         investments valued at $45.4 million.  During 1998, the company invested
         its excess cash and equivalents in securities with maturities exceeding
         90  days to take  advantage  of the  higher  yields.  These  short-term
         investments,  consisting  mostly of high  grade  debt  securities,  are
         subject to interest rate risk and will rise and fall in value if market
         interest rates change.

         The company  previously  had arranged  with several  banks to provide a
         $50.0 million unsecured credit facility,  which was scheduled to expire
         on March 31, 1999.  During 1998,  the company did not borrow under this
         credit  facility.  Due to the operating  losses  reported in 1998,  the
         company was technically not in compliance with certain terms under this
         credit facility.  The company  evaluated the proposed revised terms and
         elected to terminate the facility  based on the company's cash balances
         and  short-term   investments.   Management  does  not  anticipate  any
         significant  near term borrowing  requirements  and does not expect the
         termination of the credit  facility to materially  affect the company's
         liquidity or financial position.

                                     Page 10

<PAGE>


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

         From  time to  time  the  company  may  enter  into  certain  long-term
         borrowing  arrangements with financial lending institutions for capital
         acquisitions of property, plant and equipment. As of December 31, 1998,
         long-term  borrowings of $20.2 million  consisted of three  outstanding
         loans which are payable  through the year 2011,  as disclosed in Note 3
         to the  consolidated  financial  statements.  At the end of 1998, there
         were no material commitments for capital expenditures.

         Based on current plans and business  conditions,  the Company  believes
         that its existing cash and equivalents, short-term investments and cash
         generated  from  operations  is  expected to be  sufficient  to satisfy
         anticipated cash requirements for the next twelve months.

         Current Operations and Business Outlook

         For 1998,  the company  reported sales of $212.2 million and a net loss
         of $49.2  million,  or $6.36 loss per share.  This loss includes  $44.4
         million of pre-tax charges for the write down of discontinued  products
         and  related  restructuring  as  discussed  below and in the  company's
         announcement  on September 8, 1998  reported on Form 8-K. Also included
         in  1998  results  is a  $15.0  million  pre-tax  gain  on the  sale of
         undeveloped land.

         In 1997,  sales were $291.3 million and net income was $32.9 million or
         $3.99 per share.  The 1997 net income was  comprised of a net loss from
         continuing  operations of $4.0 million,  or $0.48 loss per share, and a
         gain  and net  income  related  to  discontinued  operations  of  $36.9
         million, or $4.47 per share. Firm backlog on December 31, 1998 stood at
         $79.5 million, compared to the 1997 backlog of $98.2 million.

         During  the  third  quarter  of  1998,  the  company  restructured  its
         operations    to    focus    on    its    core     atmospheric-pressure
         chemical-vapor-deposition   (APCVD)  operations  in  the  Semiconductor
         Equipment segment by discontinuing  efforts on its  high-density-plasma
         initiative.   Also,  the  company's  Wireless   Communications  segment
         evaluated its Base2(TM) base-station product,  reassessing key customer
         needs and market conditions.  Inventory, demo equipment, and customized
         fixed assets  associated  with these  products were written down in the
         restructuring.  As a result,  the company reduced its global work force
         and downsized its  operations.  The company  recorded  charges of $44.4
         million  of  which  $40.5   million   relates  to  the  write  down  of
         nonproductive  facilities,  equipment,  and discontinued  products; and
         $3.9 million  relates to severance,  benefits,  and other exit costs as
         disclosed in Note 11 to the consolidated financial statements.

         As discussed  above,  the company faced some very  difficult  decisions
         throughout  1998,  especially in the third quarter.  The company took a
         number of actions  required to bring its cost  structure into alignment
         with the extremely poor market conditions. Looking forward, the company
         believes the  realignment  and refocusing will set the stage for future
         growth and  profitability.  Operations and business outlook for each of
         the company's business segments are discussed below.

                                     Page 11

<PAGE>


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

         Wireless Communications

         Wireless  Communications  sales for 1998 totaled $115.2 million,  a 10%
         increase from the prior year's $104.8 million.  The business segment is
         entering  1999  with a backlog  totaling  approximately  $67.1  million
         compared to $60.3 million on December 31, 1997.

         Aside  from the  restructuring  activities  discussed  previously,  the
         Wireless  Communications segment experienced both positive and negative
         events in 1998.  The segment  sustained  strong growth as a high-volume
         manufacturer  of  custom  RF (radio  frequency)  subassemblies  for PCS
         base-station and wireless-local-loop customer-premise equipment. Fourth
         quarter  1998  shipments  included  the first  large  order for outdoor
         repeaters from a major wireless  carrier.  However,  1998 revenues were
         adversely affected by the company's  decision to discontinue  marketing
         its wideband digital base station product directly to service providers
         and the smaller system integrator firms.

         Part  of  the  difficulty  the  company  experienced  in  the  Wireless
         Communications  segment  stems  from the  delay  of a major  government
         order,  which is budgeted and has funding  established.  The company is
         following  this  program  closely  and is  hopeful  it  will be able to
         receive the order during 1999.

         Looking  forward,  it is too  early to tell  how  strong  the  Wireless
         Communications  shipment  rate will be in 1999.  However,  the  company
         expects  this  segment to continue  growing.  If the economy in general
         stays strong, the company expects the Wireless  Communications  segment
         to be  profitable  next  year.  The  segment  intends  to  focus on the
         following opportunities to continue its growth: gallium-arsenide (GaAs)
         semiconductor devices, repeaters, advanced RF technology subassemblies,
         and communications surveillance receiver programs with strong follow-on
         potential.

         The company accelerated its entry to the GaAs semiconductor market with
         the  purchase  of the  assets  and  intellectual  property  of  Samsung
         Microwave   Semiconductor   in  December  1997.  GaAs  devices  include
         low-noise and power amplifiers,  mixers and doublers. The consolidation
         of the GaAs and Thin Film  processing  and design  organization  to the
         Milpitas  facility is on schedule and is expected to be completed early
         in 1999.

         The company offers a line of  "over-the-air"  repeaters to PCS carriers
         to assist in extending cell size and broadening  their signal coverage.
         The newest  products are the PCS  in-building  repeaters for CDMA, TDMA
         and GSM air interfaces.  These repeaters provide quick installation and
         easy coverage for indoor  locations such as shopping  malls,  airports,
         convention centers and multistory office buildings.

         Continued  worldwide growth of RF infrastructure for wireless telephone
         systems is  expected.  With its strong base in advanced RF  technology,
         the segment is in an excellent position to participate in this growth.

         The communications  surveillance  receiver  requirements and orders are
         expected to remain at a fairly steady level. Going forward, the segment
         intends  to market  communications  systems,  receiving  equipment  and
         sub-systems as a value added supplier to customers in the  intelligence
         and   military   communities;   and   commercial   original   equipment
         manufacturers.  The company  intends to emphasize  programs with strong
         follow-on  potential,  especially  those  which  enhance  the  segments
         overall product strength for additional business opportunities.

                                     Page 12

<PAGE>


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

         Semiconductor Equipment

         Sales of  semiconductor  equipment for 1998 amounted to $97.0  million,
         down 48% from the  $186.5  million  recorded  for  1997,  as  customers
         dramatically   reduced  equipment  orders.  This  business  segment  is
         entering  1999  with a backlog  totaling  approximately  $12.4  million
         compared to $37.9 million at December 31, 1997.

         The semiconductor  industry capital spending  dramatically  declined in
         1998  and the  company  took a number  of  actions  to  bring  its cost
         structure into line with the extremely  unfavorable  conditions of this
         cyclical  market.  The  high-density-plasma   chemical-vapor-deposition
         (HDPCVD) system initiative was discontinued, as previously discussed.

         The   intellectual   property   relating  to  the   high-density-plasma
         development  effort is being offered to potential buyers.  Employing an
         investment  banking firm,  Alliant Partners,  the company continued its
         strategic partnering  discussions with a number of parties in an effort
         to leverage the technology and business  prospects of the Semiconductor
         Equipment Group.

         The group also  reviewed  the  requirements  for its  global  sales and
         service force.  These operations were reduced in order to bring them in
         line with the lower business expectations.  While the group is watching
         these expenses carefully,  the company believes it is taking the proper
         steps to assure effective support of customers for both service and new
         orders.

         The company  intends to preserve its global service and key development
         activities  to provide new  equipment  for the market  applications  in
         premetal  dielectric,  shallow trench isolation and very-low dielectric
         constant  (VLK)  films.  The  company  will  continue to offer its core
         atmospheric-pressure  chemical-vapor-deposition (APCVD) product line to
         semiconductor manufacturers.  Its future development activities will be
         focused  on  two  recently  announced  systems,  the  WJ-1500  and  the
         WJ-3000A.

         The WJ-1500  extends the  continuous  processing  APCVD to  0.15-micron
         design-rule  fabrication  capability.  The  system is an upgrade to the
         conveyor  transport  system with  improved film  capability  and higher
         reliability  for the  smaller  design  rules  (0.18  micron)  now being
         employed.  The company  believes it will  participate  in the market as
         geometries  are scaled  down to 0.15 micron  with the  WJ-1500.  In the
         third quarter of 1998, the company captured a multiple-system order for
         this tool,  consisting  of three  systems  and one  upgrade  kit,  from
         Samsung Electronics Company.

         The  WJ-3000A  (or AP Next)  cluster  platform,  is a "bridge"  product
         designed to facilitate  chip makers'  transition  from 200-mm to 300-mm
         wafer  processing.  The  WJ-3000A  is a single  wafer,  multiprocessing
         system  with both  300-mm and 200-mm  capability.  The company has been
         demonstrating  its  capability to customers  during 1998 with excellent
         results.   The  system  has  performed  very  narrow  gap-fills  to  50
         nanometers.   A  number  of   customers   are   discussing   beta  site
         opportunities and the company expects to have a beta placement in 2000.

                                     Page 13

<PAGE>


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

         Looking forward, the company believes that the Semiconductor  Equipment
         segment is now sized to match the level of forecasted revenue for 1999.
         However,  it is  difficult to predict what the future might hold in the
         semiconductor  equipment  business.  Current  semiconductor  integrated
         circuit demand  appears to be increasing  slightly in dollar terms over
         last year.  The recent  industry  forecasts seem to be in line with the
         company's expectations, with demand increasing slightly each quarter as
         the year  progresses.  Based on its  interactions  with customers,  the
         company believes that certain customers may be considering  moving into
         the buying  mode.  The company  believes  the  Semiconductor  Equipment
         segment will be appropriately positioned as the industry recovers.

         Although the very long-range  industry  forecasts for the semiconductor
         industry  remain  bright,  the  industry  remains  in  an  overcapacity
         situation.  Capital  equipment  decisions  are  affected by a number of
         parameters and the company is watching its customers'  market  dynamics
         closely.  The industry is confident of an upturn,  but it appears to be
         well into or beyond 1999.

         1998 Compared to 1997

         Wireless   Communications   sales  increased  10%  while  Semiconductor
         Equipment sales decreased 48%, resulting in an overall company decrease
         of 27%. Gross margins  decreased from 32% to 16%. The decrease in gross
         margins is due mostly to the lower sales  volume and $17.1  million for
         the  write   down  of   discontinued   products   resulting   from  the
         restructuring.  As previously  discussed,  the  restructuring and other
         charges came primarily from the results of the semiconductor  equipment
         market  decline  as the  company  worked  to bring  costs in line  with
         revenues. Gross margins for the fourth quarter of 1998 improved to 33%.

         Excluding   restructuring   charges  of  $27.3  million,   selling  and
         administrative expenses increased to 24% of sales compared with 20% for
         1997,  due  mostly  to the  lower  sales  volume.  Actual  selling  and
         administrative expenses, excluding restructuring charges, decreased 13%
         from $58.7 million in 1997 to $51.0 million in 1998.

         Research and development expenses were $49.9 million in 1998, or 24% of
         sales,  compared to $50.2  million,  or 17% of sales in 1997.  Although
         research and  development  is high as a percentage  of sales due to the
         lower  sales  volume,  spending  remained  high since the effect of the
         downsizing  did not impact  results  until  after the third  quarter of
         1998. As previously discussed, earlier in the year the company began to
         curtail research and development  efforts on certain projects which are
         not  expected  to have orders  impact in 1999,  and in  September  1998
         discontinued its efforts on the HDP initiative and the Base2 product.

         The pre-tax  operating loss in 1998,  before other income and a gain on
         the sale of undeveloped  land,  was $94.7 million  compared with a loss
         from  continuing  operations  of $14.3  million for 1997.  Interest and
         other  income (net of other  expenses)  increased  to $6.7  million due
         primarily  to interest  income  earned on the  increased  average  cash
         balance and short-term  investments.  Also included in other income for
         1998 is $1.2  million of net income from two leases,  the  sub-lease of
         part of our Palo Alto  facility  to Stellex and a lease of a portion of
         the company's Japanese facility. In January 1998, the company concluded
         the sale of vacant land adjacent to its San Jose,  California facility,
         resulting in a $15.0  million  pre-tax gain  reflected as "Gain on real
         property" in the consolidated financial statements.

                                     Page 14

<PAGE>


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

         For 1998, the effective tax benefit rate for federal, state and foreign
         income  taxes was  about  33%  compared  to a 43% tax  benefit  rate on
         continuing  operations  for 1997. The 33% tax benefit rate in 1998 is a
         result of the reported loss and is below the statutory  rate  primarily
         due  to  taxes  accrued  for  certain   profitable  foreign  operations
         offsetting  benefits from federal and state  research tax credits.  The
         43% tax benefit rate for 1997 resulted primarily from the effect of the
         operating  loss with  positive  benefits from export sales and research
         credits,  which were  offset in part by taxes  incurred  by  profitable
         foreign operations.

         As a result, the net loss from continuing  operations was $49.2 million
         in 1998  compared  to $4.0  million  in 1997,  or $6.36  loss per share
         compared to $0.48 loss per share, respectively.

         1997 Compared to 1996

         Wireless   Communications   sales  increased  37%  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 significant decreases in semiconductor  equipment shipments.
         Gross margins  decreased  from 34% to 32%.  Gross margins in both years
         were  adversely   affected  by  write-offs  of  excess   inventory  and
         nonperforming assets.

         Selling and  administrative  expenses  decreased 12%, due mostly to the
         decreased volume and cost-cutting  efforts, but increased slightly as a
         percentage of sales.  Research and development  expenses remained above
         15% of revenue due to continued emphasis on new product  development in
         both business segments.

         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  Asia-Pacific  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, or
         $0.16 to $0.48 loss per share,  respectively.  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.

                                     Page 15

<PAGE>


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

         Risks and Uncertainties That May Affect Future Results

         All  statements  in  this  annual  report,  other  than  statements  of
         historical  facts, are  forward-looking  statements.  By way of example
         only,  those  include   statements  about  the  company's   strategies,
         objectives,   plans,   expectations   and  anticipated   results,   and
         expectations  for the economy  generally or for the company's  specific
         industries.  The words "expect",  "anticipate",  "looking  forward" and
         other  similar  expressions  used in this annual report are intended to
         identify   forward-looking    statements   that   involve   risks   and
         uncertainties  that may cause actual results and expectations 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,  dependence on single large customers, the results of financing
         efforts,  the results of the  company's  decision to pursue the sale of
         the  company  in  its  entirety  or in  separate  transactions,  actual
         purchases  under  agreements,  the effect of the  company's  accounting
         policies,  U.S. Government export policies,  governmental budgeting and
         spending cycles,  results of restructuring  efforts,  geographic market
         concentrations,  natural  disasters  and  other  risks.  Investors  and
         prospective  investors  are  cautioned  not to place undue  reliance on
         these forward-looking  statements. The company undertakes no obligation
         to announce any revisions to its forward-looking  statements to reflect
         events  or  circumstances  as they  actually  develop  or  occur in the
         future.

         The wireless  communications  industry is subject to various regulatory
         agencies of federal,  foreign,  state and local  governments  which can
         affect market dynamics,  causing  unforeseen ebb and flow of orders and
         delivery  requirements.  Domestic and international  competition from a
         number of  wireless  communications  companies,  some of which are much
         larger than Watkins-Johnson,  is intense. The effect of these and other
         factors  could  significantly  affect the  company's  future  operating
         results.

         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.  In 1996 its history of cyclical  variations  returned with a
         market downturn. 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.
         The market  downturn  continued in 1998.  The  semiconductor  equipment
         business can vary rapidly in response to  individual  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.
         While the company cannot predict what effect these various factors will
         have on operating results, these factors along with other factors could
         significantly affect the company's future operating results.

         Year 2000 Compatibility

         The Year 2000 (Y2K) issue involves the ability of computer  software to
         properly  utilize dates for years after the year 1999.  Computers  have
         traditionally   used  the  last  two   digits  of  the  year  for  date
         calculations  and could  interpret the year 2000 as the year 1900.  The
         critical areas being addressed by the company are its internal computer
         systems,  products made by the company and relationships  with external
         organizations.  The company is addressing both  information  technology
         ("IT") and non-IT systems which typically  include embedded  technology
         such as microcontrollers.

                                     Page 16

<PAGE>


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

         The company regularly updates its information systems capabilities, and
         has  evaluated   significant   computer   software   applications   for
         compatibility with the year 2000. Several years ago the company adopted
         a strategic  plan for its  internal  computer  systems with the goal of
         going to an off-the-shelf  real time system. As a result, the company's
         domestic  operations  run  all  financial  and  manufacturing  business
         applications  on  an  Oracle  data  base  with  the  associated  Oracle
         application  modules.  Oracle's  stated  solution to Y2K is its version
         10.7 of the  application  software.  As of  June  1998,  the  company's
         domestic   operations   are  on  Oracle  version  10.7.  The  company's
         international  operations run all business  applications  on SunSystems
         software  which is deemed  Y2K  compliant.  There  are  other  software
         implementations  that are minor in nature  that may take until mid 1999
         to be completed.  There are no known non-IT issues that will  adversely
         impact the company's information systems capabilities.  With the system
         changes  implemented  to date and other  planned  changes,  the company
         anticipates that its internal  computer  software  applications will be
         compatible with the year 2000. In the event of any Y2K disruptions, the
         company will follow the software vendors' contingency directives.

         The Y2K  issue  (both IT and  non-IT)  for  company  products  is being
         addressed by the respective business units. The Semiconductor Equipment
         segment has identified the issues, addressed the problems and developed
         solutions.   The   solutions   have  been  tested  and  found  to  work
         satisfactorily.  The  Y2K  issues  do not  affect  the  ability  of the
         products to process wafers, but involve  maintaining  temporary records
         of wafer production  history on systems produced prior to 1998. The Y2K
         situation  is an issue for only some of the  products  in the  Wireless
         Communications  segment.  The group is in the  process  of  identifying
         which products are affected.  If a product is affected,  the group will
         seek to develop a solution and then  communicate  it to customers.  The
         current  schedule  is to identify  all  affected  products  and develop
         solutions by mid 1999 to ensure timely  communication to the customers.
         The respective  business  units have also addressed  non-IT issues with
         respect to their manufacturing facilities and there are no known non-IT
         issues that will adversely impact the company's operations.

         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  operations
         will not be  impacted  by this  industry-wide  issue.  The  company  is
         addressing  the Y2K issues with external  organizations.  This involves
         customers, suppliers and service providers. Although the initial review
         does not indicate any significant risk, this will be an ongoing effort.
         The company is considering alternative vendors as a contingency plan.

         With the actions that have been taken and the other planned activities,
         the company is not anticipating any significant disruption of business,
         however,   no  absolute  assurances  can  be  given.  The  most  likely
         disruption that could occur is where the company uses wire transfers to
         move funds to vendors  and  subsidiaries,  some of which are located in
         foreign countries. Since the status of all banking systems in the world
         cannot be determined in advance,  there may be minor  disruption in the
         ability  to  transfer  funds in real  time  along the  current  routes.
         Contingency plans, which include  alternative banks and standby letters
         of  credit,  are in place to  address  what is needed to  minimize  any
         business interruption.

         Expenditures  specifically  related to software  modifications for year
         2000  compatibility  are not expected to have a material  effect on the
         company's  operations  or financial  position.  The cost to address and
         remedy the company's Y2K issues were $0.1 million in 1997, $0.2 million
         in 1998 and expected to be $0.2 million in 1999.

                                     Page 17

<PAGE>


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

         Single European Currency Conversion

         The  company has  established  a team to address  issues  raised by the
         introduction  of  the  Single  European  Currency  (Euro)  for  initial
         implementation as of January 1, 1999, and through the transition period
         to January 1, 2002.  The company  believes it has met the related legal
         requirements  effective for January 1, 1999,  and it expects to be able
         to meet the legal  requirements  through  the  transition  period.  The
         company  does not  expect the cost of any  system  modifications  to be
         material and does not currently expect that introduction and use of the
         Euro will materially affect its foreign exchange and hedging activities
         or will result in any material increase in costs to the company.  While
         the  company  will  continue  to  evaluate  the impact over time of the
         introduction  of the Euro;  based on  currently  available  information
         management does not believe that the introduction of the Euro will have
         a material adverse impact on the company's  financial  condition or the
         overall trends in results of operations.

Item 7A. Quantitative and Qualitative Disclosures About Market Risks

         The following  discussion  about the company's  market risk disclosures
         involves  forward-looking  statements.   Actual  results  could  differ
         materially from those projected in the forward-looking  statements. The
         company is exposed to market risk related to changes in interest  rates
         and  foreign  currency   exchange  rates.  The  company  does  not  use
         derivative financial instruments for speculative or trading purposes.

         Short-Term  Investments--The  company maintains a short-term investment
         portfolio consisting mainly of debt securities with an average maturity
         of less than two years. These available-for-sale securities are subject
         to interest rate risk and will rise or fall in value if market interest
         rates  change.  The company  has the  ability to hold its fixed  income
         investments until maturity,  and therefore the company would not expect
         its operating  results or cash flows to be affected to any  significant
         degree by the effect of a sudden change in market interest rates on its
         investment portfolio.

         The following table provides information about the company's investment
         portfolio and constitutes a "forward-looking statement." For investment
         securities,  the  table  presents  principal  cash  flows  and  related
         weighted average interest rates by expected maturity dates.


                                            Expected Maturity        Weighted
                                                 Amounts        Average Interest
         Expected Maturity Dates              (in thousands)           Rate
         ----------------------------   ---------------------- -----------------
            Cash and equivalents:
                1999                            $19,271              4.41%

            Short-term investments:
                1999                             22,021              5.64%
                2000                             15,235              5.91%
                2001                              8,097              5.85%

                Fair value at
                   December 31, 1998            $45,353

                                     Page 18

<PAGE>


Item 7A. Quantitative and Qualitative Disclosures About Market Risks (continued)

         Long-term  Debt--On  December  31,  1998,  the  company  had fixed rate
         long-term debt of  approximately  $20.8 million  (including the current
         portion of $615,000),  which is denominated in Japanese Yen (113.45 yen
         per  dollar at  December  31,  1998).  The  company  has not hedged any
         interest  rate or foreign  currency  rate  exposures on this loan.  The
         table below provides information about the company's long-term debt and
         constitutes a "forward-looking  statement." The table presents expected
         debt maturity by year and related weighted average interest rates.


                                            Expected Maturity        Weighted
                                                 Amounts        Average Interest
             Expected Maturity Dates          (in thousands)           Rate
             --------------------------- --------------------- -----------------
                     1999 (current)             $   615               2.50%
                     2000                           615               2.50%
                     2001                           615               2.50%
                     2002                           615               2.50%
                     2003                           615               2.50%
                     Thereafter                  17,764               2.87%

                     Fair value at
                        December 31, 1998       $20,839


         Additional  information  regarding market risks with respect to company
         borrowings  is  disclosed  in  Note  3 to  the  consolidated  financial
         statements.

         Foreign  Exchange  Risks--The  company  has  limited  involvement  with
         derivative financial  instruments and does not use such instruments for
         trading  purposes.  The derivative  financial  instruments  are used to
         manage foreign currency  exchange risk. The company enters into foreign
         exchange forward contracts to hedge certain balance sheet exposures and
         intercompany  balances  against  future  movements in foreign  exchange
         rates.  Gains and losses on the forward contracts are largely offset by
         gains and losses on the underlying  exposure and  consequently a sudden
         or significant change in foreign exchange rates is not expected to have
         a material  impact on future net income or cash  flows.  The company is
         exposed  to  credit-related  losses in the event of  nonperformance  by
         counter parties to these financial instruments, but does not expect any
         counter party to fail to meet its obligation.

                                     Page 19

<PAGE>


Item 7A. Quantitative and Qualitative Disclosures About Market Risks (continued)

         The maturity of foreign  currency  exchange  contracts held at December
         31, 1998 is consistent  with the  contractual or expected timing of the
         transactions being hedged,  principally receipt of customer payments in
         Japanese Yen. These foreign exchange contracts mature within 1 year and
         are as follows:

         CONTRACTS TO PURCHASE

                                                         (Dollars in thousands)
         -----------------------------------------------------------------------
         Currency                                       At Contract    At Market
           Type      Contract Date     Maturity Date       Rate          Rate
         -----------------------------------------------------------------------
                     Fourth Quarter       First
           Yen           1998          Quarter 1999       $5,908       $5,972
         -----------------------------------------------------------------------


         CONTRACTS TO SELL

                                                         (Dollars in thousands)
         -----------------------------------------------------------------------
         Currency                                       At Contract    At Market
           Type      Contract Date     Maturity Date       Rate          Rate
         -----------------------------------------------------------------------
                     Fourth Quarter       First
           Yen           1998          Quarter 1999      $13,813       $14,055
         -----------------------------------------------------------------------


         Additional information regarding market risks are disclosed in Notes 1,
         2 and 3 to the consolidated financial statements.

                                     Page 20

<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)                                     1998                 1997                 1996
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>                  <C>                  <C>        
Sales                                                                         $   212,200          $   291,271          $   349,119
-----------------------------------------------------------------------------------------------------------------------------------

Costs and expenses:
    Cost of goods sold                                                            161,648              196,675              230,556
    Cost of goods sold-write down of
        discontinued products                                                      17,119
    Selling and administrative                                                     50,965               58,696               66,687
    Restructuring charges                                                          27,290
    Research and development                                                       49,871               50,182               53,175
-----------------------------------------------------------------------------------------------------------------------------------
                                                                                  306,893              305,553              350,418
-----------------------------------------------------------------------------------------------------------------------------------

Loss from operations                                                              (94,693)             (14,282)              (1,299)

Other income (expense):
    Interest income                                                                 5,681                2,198                  789
    Interest expense                                                               (1,168)              (1,425)              (1,574)
    Other income (expense)--net                                                     2,199               (1,062)                 (12)
    Gain on real property (Note 10)                                                14,973                7,609
-----------------------------------------------------------------------------------------------------------------------------------

Loss from continuing operations before
    income taxes                                                                  (73,008)              (6,962)              (2,096)
Income tax benefits                                                                23,800                3,000                  775
-----------------------------------------------------------------------------------------------------------------------------------

Loss from continuing operations                                                   (49,208)              (3,962)              (1,321)
Discontinued operations (Note 8):
    Income from discontinued operations, net of taxes                                                    7,210                4,355
    Gain on disposition, net of taxes                                                                   29,677
-----------------------------------------------------------------------------------------------------------------------------------
Net income (loss)                                                             $   (49,208)         $    32,925          $     3,034
===================================================================================================================================

Basic and diluted per share amounts:

    Loss from continuing operations                                           $     (6.36)         $     (0.48)         $     (0.16)
    Income from discontinued operations                                                                   0.87                 0.53
    Gain on disposition of discontinued operations                                                        3.60
-----------------------------------------------------------------------------------------------------------------------------------
Net income (loss)                                                             $     (6.36)         $      3.99          $      0.37
===================================================================================================================================
Basic and diluted average common shares                                         7,737,000            8,258,000            8,265,000

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

                                                               Page 21

<PAGE>


<TABLE>
                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                           CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

<CAPTION>
                                                                                                             Year Ended December 31
-----------------------------------------------------------------------------------------------------------------------------------
(Dollars in thousands)                                                              1998                  1997                 1996
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                              <C>                  <C>                  <C>     
Net income (loss)                                                                $(49,208)            $ 32,925             $  3,034
-----------------------------------------------------------------------------------------------------------------------------------

Other comprehensive income (loss), net of tax:

    Foreign currency translation adjustments                                       (1,385)                (301)                (294)
    Unrealized holding gains on securities-net
        of taxes of $97                                                               152
-----------------------------------------------------------------------------------------------------------------------------------
    Other comprehensive loss                                                       (1,233)                (301)                (294)
-----------------------------------------------------------------------------------------------------------------------------------

Comprehensive income (loss)                                                      $(50,441)            $ 32,624             $  2,740
===================================================================================================================================

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

                                                               Page 22

<PAGE>


<TABLE>
                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                                     CONSOLIDATED BALANCE SHEETS

<CAPTION>
                                                                                                                        December 31
-----------------------------------------------------------------------------------------------------------------------------------
(Dollars in thousands, except per share amounts)                                                       1998                    1997
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                                <C>                    <C>      
ASSETS

CURRENT ASSETS:
      Cash and equivalents                                                                         $  19,271              $ 134,462
      Short-term investments                                                                          45,353
      Receivables (net of allowance for doubtful accounts
           of $3,354 in 1998 and $3,176 in 1997)                                                      31,942                 45,690
      Inventories:
           Finished goods                                                                              2,960                  9,283
           Work in process                                                                            11,954                 18,519
           Raw materials and parts                                                                     8,456                 18,873
      Deferred income taxes                                                                           32,288                 24,830
      Income taxes receivable                                                                         13,570
      Other                                                                                            6,302                  6,536
-----------------------------------------------------------------------------------------------------------------------------------
      Total current assets                                                                           172,096                258,193
-----------------------------------------------------------------------------------------------------------------------------------

PROPERTY, PLANT AND EQUIPMENT:
      Land                                                                                            10,569                 12,102
      Buildings and improvements                                                                      32,733                 55,155
      Plant facilities, leased                                                                        11,184                 11,012
      Machinery and equipment                                                                         85,738                100,526
-----------------------------------------------------------------------------------------------------------------------------------
                                                                                                     140,224                178,795
      Accumulated depreciation and amortization                                                      (77,585)               (82,382)
-----------------------------------------------------------------------------------------------------------------------------------
      Property, plant and equipment--net                                                              62,639                 96,413
-----------------------------------------------------------------------------------------------------------------------------------

OTHER ASSETS                                                                                          10,743                  3,606
-----------------------------------------------------------------------------------------------------------------------------------
                                                                                                   $ 245,478              $ 358,212
====================================================================================================================================

LIABILITIES AND SHAREOWNERS' EQUITY

CURRENT LIABILITIES:
      Accounts payable                                                                             $  15,704              $  16,188
      Accrued expenses                                                                                31,104                 23,209
      Advances on contracts                                                                            2,074                  1,867
      Provision for warranties and losses on contracts                                                12,066                 15,898
      Payroll and profit sharing                                                                      10,742                 15,825
      Income taxes                                                                                     9,388                 31,599
-----------------------------------------------------------------------------------------------------------------------------------
      Total current liabilities                                                                       81,078                104,586
-----------------------------------------------------------------------------------------------------------------------------------

LONG-TERM OBLIGATIONS                                                                                 32,701                 33,234
-----------------------------------------------------------------------------------------------------------------------------------

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: 1998,
         6,547,687 shares; 1997, 8,261,036 shares                                                     34,454                 40,631
      Retained earnings                                                                               99,073                180,356
      Accumulated other comprehensive income (loss)                                                   (1,828)                  (595)
-----------------------------------------------------------------------------------------------------------------------------------
      Total shareowners' equity                                                                      131,699                220,392
-----------------------------------------------------------------------------------------------------------------------------------
                                                                                                   $ 245,478              $ 358,212
====================================================================================================================================

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

                                                               Page 23

<PAGE>


<TABLE>
                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                           CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY

<CAPTION>
                                                                                                         Other
                                                                                                         Compre-            Total
                                                             Common Stock                                hensive-          Share-
(Dollars in thousands,                               ---------------------------        Retained          Income           owners'
except per share amounts)                              Shares           Dollars         Earnings          (Loss)           Equity
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                   <C>             <C>              <C>              <C>              <C>       
Balance, January 1, 1996                              8,124,055       $   34,307       $  156,946       $        0       $  191,253
    Net income for 1996                                                                     3,034                             3,034
    Dividends declared-$0.48 per share                                                     (3,973)                           (3,973)
    Stock option transactions                           205,193            4,691                                              4,691
    Foreign currency translation adjustment                                                                   (294)            (294)
-----------------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1996                            8,329,248           38,998          156,007             (294)         194,711
    Net income for 1997                                                                    32,925                            32,925
    Dividends declared-$0.48 per share                                                     (3,974)                           (3,974)
    Stock option transactions                           135,988            2,778                                              2,778
    Repurchases of common stock                        (204,200)          (1,145)          (4,602)                           (5,747)
    Foreign currency translation adjustment                                                                   (301)            (301)
-----------------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1997                            8,261,036           40,631          180,356             (595)         220,392
    Net loss for 1998                                                                     (49,208)                          (49,208)
    Dividends declared-$0.48 per share                                                     (3,685)                           (3,685)
    Stock option transactions                            82,451            1,605                                              1,605
    Repurchases of common stock                      (1,795,800)          (7,782)         (28,390)                          (36,172)
    Foreign currency translation adjustment                                                                 (1,385)          (1,385)
    Unrealized holding gains on
        securities-net of taxes of $97                                                                         152              152
-----------------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1998                            6,547,687       $   34,454       $   99,073       $   (1,828)      $  131,699
===================================================================================================================================

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

                                                               Page 24

<PAGE>


<TABLE>
                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                                CONSOLIDATED STATEMENTS OF CASH FLOWS

<CAPTION>
                                                                                                             Year Ended December 31
-----------------------------------------------------------------------------------------------------------------------------------
(Dollars in thousands)                                                                     1998              1997              1996
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                   <C>               <C>               <C>      
OPERATING ACTIVITIES:

      Net income (loss)                                                               $ (49,208)        $  32,925         $   3,034
      Adjustments to reconcile net income (loss) to net cash
        provided (used) by operating activities:
           Depreciation and amortization                                                 15,782            13,112             8,996
           Gain on disposal of property, plant and equipment                            (10,876)           (3,513)
           Deferred income taxes                                                         (8,597)          (10,470)           (3,280)
           Results of discontinued operations and
               gain on disposal                                                                           (36,887)           (4,355)
           Restructuring write-downs                                                     40,489
           Net changes in:
               Receivables                                                               14,266            26,897            (4,506)
               Inventories                                                                6,548             3,364            16,877
               Other assets                                                             (12,737)            1,584            (1,752)
               Accruals and payables                                                    (22,822)           39,635            (4,257)
               Advances on contracts                                                        207               435            (1,114)
               Provision for warranties and losses on contracts                          (3,832)            1,420             6,688
               Environmental remediation                                                   (317)             (198)             (327)
-----------------------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by continuing operating activities                       (31,097)           68,304            16,004
           Net cash used by discontinued operations                                                       (11,180)           (2,181)
-----------------------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by operating activities                                  (31,097)           57,124            13,823
-----------------------------------------------------------------------------------------------------------------------------------

INVESTING ACTIVITIES:

      Additions of property, plant and equipment                                        (15,079)          (22,177)          (48,303)
      Purchase of short-term investments                                               (101,046)
      Proceeds from sale of short-term investments                                       55,943
      Restricted plant construction funds                                                                   3,738            (3,738)
      Proceeds from sale of discontinued operations                                                        77,884
      Proceeds on real estate sales and assets retirements                               16,718             8,475            (1,070)
-----------------------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by investing activities                                  (43,464)           67,920           (53,111)
-----------------------------------------------------------------------------------------------------------------------------------

FINANCING ACTIVITIES:

      Long-term borrowings                                                                                  1,642            20,241
      Payments on long-term borrowings                                                     (544)           (1,132)             (135)
      Proceeds from issuance of common stock                                              1,605             2,778             4,691
      Repurchase of common stock                                                        (36,172)           (5,747)
      Dividends paid                                                                     (3,685)           (3,974)           (3,973)
      Other                                                                                (124)             (531)             (390)
-----------------------------------------------------------------------------------------------------------------------------------
      Net cash provided (used) by financing activities                                  (38,920)           (6,964)           20,434
-----------------------------------------------------------------------------------------------------------------------------------

      Effect of exchange rate changes on cash                                            (1,710)              680
-----------------------------------------------------------------------------------------------------------------------------------

Net increase (decrease) in cash and equivalents                                        (115,191)          118,760           (18,854)
Cash and equivalents at beginning of year                                               134,462            15,702            34,556
-----------------------------------------------------------------------------------------------------------------------------------
Cash and equivalents at end of year                                                   $  19,271         $ 134,462         $  15,702
====================================================================================================================================

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

                                                               Page 25

<PAGE>


<TABLE>
                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                          CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

<CAPTION>
                                                                                                              Year Ended December 31
------------------------------------------------------------------------------------------------------------------------------------
(Dollars in thousands)                                                                      1998              1997              1996
------------------------------------------------------------------------------------------------------------------------------------

<S>                                                                                       <C>               <C>               <C>   
Other cash flow information:
------------------------------------------------------------------------------------------------------------------------------------
Income taxes paid-net of refunds                                                          $9,478            $3,143            $5,700
Interest paid                                                                              1,098             1,389             1,574
------------------------------------------------------------------------------------------------------------------------------------

Noncash investing and financing activities:
------------------------------------------------------------------------------------------------------------------------------------
Reclassification of plant held for sale from
      "Property, Plant and Equipment" to "Other Assets",
      at book value which is below market                                                 $6,422
------------------------------------------------------------------------------------------------------------------------------------

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

                                                               Page 26

<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 and  Investments--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.  Investments  consist of high-grade debt securities (AA rating or better)
with  maturities  greater  than 90 days  from  the date of  acquisition  and are
classified as "available-for-sale." Investments classified as available-for-sale
are reported at fair market value with unrealized  gains or losses excluded from
earnings and reported as a separate  component of stockholders'  equity,  net of
tax, until realized.  The company's investment guidelines limit investments with
a single issuer,  excluding the U.S.  Government or any agency  thereof,  to the
greater of $5.0 million 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  method. 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 ("SFAS") No. 13 "Accounting for Leases."

Revenue Recognition--Revenues, other than from 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 included in other income  (expense).  For the
Japanese  subsidiary,   the  cumulative  translation  adjustments  are  recorded
directly in retained  earnings.  The company  incurred net translation  gains of
approximately $0.1 million in 1998 and net translation losses of $1.4 million in
1997, resulting primarily from its Asia-Pacific subsidiaries.  Translation gains
or losses were not material prior to 1997.

                                     Page 27

<PAGE>


1. SIGNIFICANT ACCOUNTING POLICIES (continued)

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.

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.

Per Share  Information--Basic  earnings per share is computed using the weighted
average number of common shares outstanding for the period. Diluted earnings per
share  reflects the  potential  dilution that could occur if securities or other
contracts  to issue  common  stock (such as stock  options)  were  exercised  or
converted into common stock,  however,  such adjustments are excluded when there
is a loss from continuing operations, as they are considered antidilutive.

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."

Recently  Issued  Accounting  Standard--In  June 1998, the FASB issued SFAS 133,
"Accounting for Derivative  Instruments and Hedging  Activities." This Statement
requires  companies  to record  derivatives  on the  balance  sheet as assets or
liabilities,  measured at fair value. Gains and losses resulting from changes in
the fair market values of those  derivative  instruments  would be accounted for
depending  on the use of the  instrument  and  whether  it  qualifies  for hedge
accounting.  SFAS 133 will be effective for the company's  year ending  December
31,  2000.  The company  enters into forward  exchange  contracts to hedge sales
transactions and firm commitments denominated in foreign currencies.  Management
does not expect this  Statement to have a  significant  impact on the  company's
financial condition or results of operations.

                                     Page 28

<PAGE>


2. FINANCIAL INSTRUMENTS AND SHORT-TERM INVESTMENTS

Financial  instruments that potentially subject the company to concentrations of
credit risk consist principally of cash and equivalents, short-term investments,
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.

The carrying value of cash and equivalents, short-term investments, 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, 1998 and 1997, the company had forward  exchange
contracts  to sell  Japanese  Yen with a market  value  of  approximately  $14.1
million and $12.4 million,  respectively, for a contract amount of $13.8 million
and $12.8 million, respectively. Also at December 31, 1998 and 1997, the company
had forward exchange  contracts to purchase  Japanese Yen with a market value of
approximately $6.0 million and $1.7 million, respectively, for a contract amount
of $5.9 million and $1.8 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.

The fair  value  and the  amortized  cost of  available-for-sale  securities  at
December 31, 1998,  including  unrealized  holding  gains,  are presented in the
table which follows. Fair values are based on quoted market prices obtained from
an independent broker.  Available-for-dale  securities are classified as current
assets and have an average maturity of less than two years.  Gross proceeds from
the sale of marketable  securities  were $55.9 million during 1998.  Gross gains
and losses  realized  on such sales or  maturities  were not  material.  For the
purpose of determining  gross realized gains and losses,  the cost of securities
sold is based upon specific identification.


                                                                      Unrealized
(in thousands)                       Amortized cost  Market value  holding gains
--------------------------------------------------------------------------------
Corporate debt securities                    $45,104       $45,353          $249
================================================================================

                                     Page 29

<PAGE>


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)                                          1998              1997
-------------------------------------------------------------------------------
Long-term borrowings                               $  20,224         $  18,630
Deferred compensation                                    291             1,977
Environmental remediation                              7,120             7,437
Long-term leases                                       5,066             5,190
===============================================================================
Total                                              $  32,701         $  33,234
===============================================================================


The current portion of long-term obligations is included in current liabilities.
The  expected  maturity  amounts  are  as  follows:  1999,   $1,101,000;   2000,
$1,231,000; 2001, $1,167,000;  2002, $1,197,000;  2003, $1,227,000;  thereafter,
$27,879,000.

Long-term  Borrowings--Consists  of three unsecured loans used for the company's
land,  building  and  equipment  located  in  Kawasaki,  Japan.  The  loans  are
denominated   in  Yen.   Approximately   $6.8  million  is  payable  in  monthly
installments through the year 2011, which bears interest at 2.5%.  Approximately
$11.7  million and $1.7 million  require a balloon  payment due in the year 2006
and 2007,  respectively,  which bear  interest  at 3.1% and 2.2%,  respectively,
payable semiannually.

Deferred   Compensation--The   company   has   several   nonqualified   deferred
compensation  and bonus plans  covering  selected  members of management and key
technical  employees.  Substantially  all  these  plans  were  terminated  as of
December 31, 1998, and the balances classified as currently payable.

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.

Leases--Certain  long-term  leases for plant  facilities  are treated as capital
leases for financial statement purposes. 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.

Payment  obligations  under existing capital and operating leases as of December
31, 1998 are as follows:

                                                       Capital       Operating
(in thousands)                                          Leases        Leases
----------------------------------------------------------------- -----------
Lease payments:
      1999                                            $    635        $1,657
      2000                                                 635         1,326
      2001                                                 635           894
      2002                                                 635           311
      2003                                                 635            24
      Remaining years                                    6,822            13
-----------------------------------------------------------------------------
Total                                                    9,997        $4,225
                                                                  ===========
Imputed interest                                        (4,795)
-----------------------------------------------------------------
 Present value of lease payments
      (including current portion of $136)             $  5,202
=================================================================

                                     Page 30

<PAGE>


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

The company sub-leases a portion of its of its Palo Alto,  California,  facility
under a short-term  operating  lease  expiring  October 2000.  In addition,  the
company leases a portion of its facility in Kawasaki,  Japan, under a short-term
operating lease. Included in other income for 1998 is approximately $1.2 million
of income after  expenses  from these rental  agreements.  Rental income was not
material prior to 1998.

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

<CAPTION>
(in thousands)                                               1998              1997             1996
------------------------------------------------------------------------------------------------------
<S>                                                       <C>               <C>              <C>    
Real property                                             $ 1,129           $ 2,446          $ 2,384
Equipment                                                     864             1,041              782
------------------------------------------------------------------------------------------------------
Total                                                     $ 1,993           $ 3,487          $ 3,166
======================================================================================================
</TABLE>

Credit Facility  Termination--The  company  previously had arranged with several
banks to provide a $50.0 million  unsecured  credit facility which was scheduled
to expire on March 31, 1999.  During 1998, the company did not borrow under this
credit  facility.  Due to the operating  loss reported in 1998,  the company was
technically not in compliance with certain terms under this credit facility. The
company  evaluated  the  proposed  revised  terms and elected to  terminate  the
facility based on the company's cash balances and short-term investments.

The  Company  has  letters of credit of $2.1  million of which $0.9  million was
outstanding at December 31, 1998, with approximately $0.6 million collateralized
by specific cash balances.

4. SHAREOWNERS' EQUITY

Stock  Repurchase  Program--During  1998,  the Board of Directors  increased its
common stock repurchase  authorization  from 2,500,000 to 3,500,000  shares.  By
December  31,  1998,  all  3,500,000  shares  have  been  repurchased,  of which
1,795,800 and 204,200 were repurchased in 1998 and 1997, respectively. No shares
were repurchased in 1996.

Common Share Purchase  Rights--During  1998, the Board of Directors  amended the
company's  Common  Share  Purchase  Rights Plan to decrease  from 15% to 10% the
threshold level of common stock ownership that would trigger the  exercisability
of common share purchase rights under the Rights Plan. 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  $0.01  per  Right at any  time  prior  to 10 days  after a person  or group
acquires  10%  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 10% 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
10% 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 a person or group not  previously  approved  by the Board of
Directors  acquires  10% 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  10% 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 10% 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.

                                     Page 31

<PAGE>


4. SHAREOWNERS' EQUITY (Continued)

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.  Options are typically  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.  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, 1998.

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 six months after the date of grant. 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 $26.50 in
1998,  21,000  option  shares were  granted at $26.88 in 1997 and 21,000  option
shares were granted at $34.63 in 1996.

Stock  option   transactions   included  in  the   Consolidated   Statements  of
Shareowners' Equity are shown net of retirement of mature shares used in payment
for options  exercised  and include  tax  benefits  related to sales under stock
option  plans of  $217,000,  $719,000 and  $1,161,000  for 1998,  1997 and 1996,
respectively.

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


<CAPTION>
                                                                                                   Weighted Average
1998                                                                      Shares                     Exercise Price
--------------------------------------------------------------------------------------------------------------------
<S>                                                                    <C>                                 <C>   
Granted                                                                  242,000                           $25.72
Exercised                                                                 82,451                           $16.84
Terminated                                                               151,427                           $29.67
At December 31:
      Outstanding                                                      1,452,062                           $27.41
      Exercisable                                                        858,765                           $26.57
      Reserved for future grants                                       1,056,709

1997
--------------------------------------------------------------------------------------------------------------------
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

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
</TABLE>

                                                       Page 32

<PAGE>


4. SHAREOWNERS' EQUITY (continued)

<TABLE>
The following table summarizes  information concerning currently outstanding and
exercisable options at December 31, 1998:

<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         319,946                  5.3             $15.57             233,608            $13.61
      $22.75 to $22.75         263,502                  5.2             $22.75             263,502            $22.75
      $22.81 to $26.88         395,000                  8.7             $25.87              49,666            $26.66
      $27.00 to $35.88          84,493                  7.2             $32.88              52,326            $33.52
      $36.75 to $36.75         259,415                  6.2             $36.75             174,482            $36.75
      $39.50 to $55.00         129,706                  6.7             $48.55              85,181            $48.77
----------------------- --------------- -------------------- ------------------    ---------------- -----------------
      $10.00 to $55.00       1,452,062                  6.6             $27.41             858,765            $26.57
======================= =============== ==================== ==================    ================ =================
</TABLE>


<TABLE>
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
SFAS 123, "Accounting for Stock-Based Compensation," the company's pro forma net
income (loss) for 1998, 1997 and 1996 would have been $(50,420,000), $31,724,000
and $1,256,000,  respectively, or $(6.52), $3.84 and $0.15 per basic and 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 1998, 1997 and 1996 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 calculated
on the date of grant using the Black-Scholes option-pricing model along with the
weighted average assumptions used are as follows:

<CAPTION>
                                                                              1998           1997           1996
--------------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>            <C>            <C>  
Fair value                                                                   $7.70          $8.02          $7.96
Dividend yield                                                                 2.1%           1.2%           1.5%
Volatility                                                                    41.7%          38.1%          37.5%
Risk free interest rate at the time of grant                                   5.4%           6.1%           6.2%
Expected term to exercise (in months from the vest date)                       4.9            4.5            3.5
</TABLE>


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 33

<PAGE>


5. INCOME TAXES

<TABLE>
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:

<CAPTION>
(in thousands)                                                              1998             1997              1996
-------------------------------------------------------------------------------------------------------------------
<S>                                                                    <C>              <C>               <C>       
U.S.                                                                   $ (67,995)       $ (10,330)        $  (4,662)
Foreign                                                                   (5,013)           3,368             2,566
--------------------------------------------------------------------------------------------------------------------
Total                                                                  $ (73,008)       $  (6,962)        $  (2,096)
====================================================================================================================


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

(in thousands)                                                              1998             1997              1996
-------------------------------------------------------------------------------------------------------------------
Current:
    U.S.                                                                $(16,092)       $     425         $   1,928
    State                                                                    286            1,275              (152)
    Foreign                                                                  506            1,870             1,264
--------------------------------------------------------------------------------------------------------------------
Total current                                                            (15,300)           3,570             3,040
--------------------------------------------------------------------------------------------------------------------
Deferred:
    U.S.                                                                  (6,273)          (4,385)           (3,497)
    State                                                                 (2,227)          (2,185)             (318)
--------------------------------------------------------------------------------------------------------------------
Total                                                                  $ (23,800)       $  (3,000)        $    (775)
====================================================================================================================

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

(in thousands)                                                              1998             1997              1996
-------------------------------------------------------------------------------------------------------------------
Deferred compensation                                                  $   2,073        $   2,556         $   1,915
Loss accruals                                                             20,147           18,041            10,495
Environmental remediation                                                  3,172            3,274             3,147
Uniform capitalization                                                       135            1,212             1,007
Vacation accrual                                                           1,199            1,663             1,580
Net operating loss and tax credits carried forward                         8,653
Other                                                                        782            3,334             2,111
--------------------------------------------------------------------------------------------------------------------
      Gross deferred tax assets                                           36,161           30,080            20,255
--------------------------------------------------------------------------------------------------------------------
Depreciation                                                                (191)          (2,610)           (3,197)
Other                                                                                                           (58)
--------------------------------------------------------------------------------------------------------------------
      Gross deferred tax liabilities                                        (191)          (2,610)           (3,255)
--------------------------------------------------------------------------------------------------------------------
Net deferred tax asset                                                 $  35,970        $  27,470         $  17,000
====================================================================================================================
</TABLE>


The company has federal and state operating loss  carryforwards of approximately
$10.0 million and $12.3  million,  respectively,  which expire  through the year
2019. In addition,  the company has federal and state tax credit  carryforwards,
related primarily to research credits,  totaling  approximately $3.7 million and
$0.9  million,  respectively.  These tax  credit  carryforward  benefits  expire
through the year 2019.

                                     Page 34

<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>
                                                                            1998             1997              1996
--------------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>               <C>               <C>    
Statutory federal tax (benefit) rate                                      (35.0)%           (35.0)%           (34.0)%
      Export sales benefit                                                 (0.1)             (6.5)            (10.0)
      Research credit                                                      (0.7)             (8.5)            (14.6)
      Effect of foreign operations taxed at various rates                   3.1               9.8              18.7
      State taxes (benefit) net of federal tax                             (1.2)             (8.4)             (4.8)
      Other                                                                 1.3               5.5               7.7
====================================================================================================================
Effective tax (benefit) rate                                              (32.6)%           (43.1)%           (37.0)%
====================================================================================================================
</TABLE>


6. ENVIRONMENTAL REMEDIATION AND OTHER CONTINGENCIES

In 1991 the company  recorded a $15.0 million  charge for estimated  remediation
actions and cleanup costs.  The company  remains in compliance with the remedial
action plans being monitored by various regulatory agencies at its Scotts Valley
and Palo Alto sites and no additional  provision  has been recorded  since 1991.
Expenditures  charged  against the  provision  totaled  $317,000,  $198,000  and
$327,000 for the years 1998, 1997 and 1996,  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. 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 35

<PAGE>


7. EMPLOYEE BENEFIT PLANS

Employees'  Investment  Plan--The  Watkins-Johnson  Employees'  Investment  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 continuing  operations  was  $1,903,000,  $2,001,000  and
$1,920,000 in 1998, 1997 and 1996, 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 and is  allocated  as a  percentage  of
eligible  employee  base  compensation.  All  U.S.  employees  are  eligible  to
participate  in the  plan  and  vesting  is  immediate.  The  Board  approved  a
contribution  equal to 1% of eligible employee  compensation for 1998, 1997, and
1996, which resulted in charges to continuing  operations of $378,000,  $657,000
and $639,000,  respectively.  The ESOP held 181,624 and 229,231 shares of common
stock at December 31, 1998 and 1997, respectively,  and there are no unallocated
or unearned shares held by the plan. 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.

8. BUSINESS SEGMENT REPORTING

In 1997  the  company  adopted  SFAS  131,  "Disclosures  about  Segments  of an
Enterprise and Related Information." 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.  Operations  in the  Wireless  Communications  segment  involve the
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.   Operations  in  the  Semiconductor  Equipment  segment  involve  the
development,   manufacture,   sale  and  service  of   chemical-vapor-deposition
equipment used in the manufacture of semiconductor products.

                                     Page 36

<PAGE>


8. BUSINESS SEGMENT REPORTING (continued)

On October 31, 1997 the company completed the sale of its Government Electronics
segment  to  Stellex  Industries,   Inc.  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 development, manufacture and sale of advanced microwave devices and
tactical  electronic systems and devices for  guided-missile  programs and other
government applications.

<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, 1998
-------------------------------------------------------------------------------------------------------------------
                                                           Pre-tax          Year-
                                                            Income            End        Capital
                                                Sales       (Loss)         Assets       Additions      Depreciation
--------------------------------------------------------------------------------------------------------------------
<S>                                        <C>            <C>          <C>              <C>               <C>      
Wireless Communications                    $  115,219     $(13,697)    $  50,778        $   7,324         $   3,655
Semiconductor Equipment                        96,981      (80,996)       67,496            7,742            11,664
Corporate                                                                127,204               13               463
--------------------------------------------------------------------------------------------------------------------
Loss from operations                                       (94,693)
Other income (expense)--net                                 21,685
--------------------------------------------------------------------------------------------------------------------
Total                                      $  212,200     $(73,008)    $ 245,478        $  15,079         $  15,782
====================================================================================================================

                                                                                       Year Ended December 31, 1997
--------------------------------------------------------------------------------------------------------------------
Wireless Communications                    $  104,817     $   (954)    $  54,408        $   6,881         $   2,510
Semiconductor Equipment                       186,454      (13,328)      132,528           15,152            10,144
Corporate                                                                171,276              144               458
--------------------------------------------------------------------------------------------------------------------
Loss from 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
--------------------------------------------------------------------------------------------------------------------
Wireless Communications                    $   76,683     $ (8,511)    $  50,754        $   1,941         $   1,252
Semiconductor Equipment                       272,436        7,212       174,549           46,122             7,231
Corporate                                                                 68,441              240               513
--------------------------------------------------------------------------------------------------------------------
Loss from operations                                        (1,299)
Other income (expense)--net                                   (797)
--------------------------------------------------------------------------------------------------------------------
Total                                      $  349,119     $ (2,096)    $ 293,744        $  48,303         $   8,996
====================================================================================================================
</TABLE>


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

                                     Page 37

<PAGE>


8. BUSINESS SEGMENT REPORTING (continued)

<TABLE>
Sales  to  individual  customers   representing  greater  than  10%  of  company
consolidated sales during at least one of the past three years are as follows:

<CAPTION>
(in thousands)                                                              1998             1997              1996
--------------------------------------------------------------------------------------------------------------------
<S>                                                                   <C>              <C>               <C>       
Wireless Communications:
        Lucent Technologies, Inc.                                     $   33,000       $   20,000        $   11,000
        United States Government                                          26,000           36,000            28,000
Semiconductor Equipment:
        Hyundai Electronics Industries Co., Ltd.
           (and affiliates)                                               11,000           15,000            37,000
        Marubeni Hytech (a Japanese distributor)                           5,000           21,000            47,000

Sales to unaffiliated customers by geographic area are as follows:

(in thousands)                                                              1998             1997              1996
--------------------------------------------------------------------------------------------------------------------
United States                                                         $  135,692       $  169,001        $  143,510
Export sales from United States:
      Europe                                                               6,479            8,924            29,759
      Japan                                                               10,770           23,035            65,952
      Korea                                                                5,095           29,531            52,572
      Other Asia-Pacific countries                                        12,368           13,955            35,767
      Other                                                                9,753            3,307             3,728
Europe                                                                    21,429           34,701             9,759
Japan                                                                      4,510            2,742             3,312
Other Asia-Pacific countries                                               6,104            6,075             4,760
--------------------------------------------------------------------------------------------------------------------
Total                                                                 $  212,200       $  291,271        $  349,119
====================================================================================================================
</TABLE>


Intercompany  transfers of products and services between geographic regions were
$43.2  million,  $59.0 million and $37.5 million in fiscal years 1998,  1997 and
1996,  respectively,  and are accounted for at prices the company believes to be
arm's length.

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

<CAPTION>
                                                                                                          Operating
                                                                                                      Profit (Loss)
(in thousands)                                                                     1998          1997          1996
--------------------------------------------------------------------------------------------------------------------
<S>                                                                            <C>           <C>            <C>     
United States                                                                  $(89,302)     $(19,385)      $(4,231)
Europe                                                                              300         3,640           700
Japan                                                                            (6,376)          185           952
Other Asia-Pacific countries                                                        685         1,278         1,280
--------------------------------------------------------------------------------------------------------------------
Total                                                                          $(94,693)     $(14,282)      $(1,299)
====================================================================================================================

                                                                                                           Year-End
                                                                                                  Long-Lived Assets
(in thousands)                                                                     1998          1997          1996
--------------------------------------------------------------------------------------------------------------------
United States                                                                   $72,168      $118,606      $121,483
Europe                                                                            1,290         1,729         2,290
Japan                                                                            21,915        26,493        30,076
Other Asia-Pacific countries                                                      3,999         3,762         4,159
--------------------------------------------------------------------------------------------------------------------
Total                                                                           $99,372      $150,590      $158,008
====================================================================================================================
</TABLE>


Long-lived assets exclude financial  instruments,  deferred tax assets,  and for
1996 exclude the net assets of discontinued operations totaling $29.8 million.

                                     Page 38

<PAGE>


8. BUSINESS SEGMENT REPORTING (continued)

Summarized  below  are  operating   results  of  the   discontinued   government
electronics  business through its sale on October 31, 1997.  Intersegment  sales
were transferred based on negotiated prices.

                                                         Year Ended December 31
(in thousands)                                            1997             1996
--------------------------------------------------------------------------------
Net sales                                             $75,700           $89,200
================================================================================

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

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


9. EARNINGS PER SHARE

Basic and diluted  earnings per share were computed based solely on the weighted
average shares outstanding for each period.

For 1998,  1997 and 1996 the  incremental  shares from the  assumed  exercise of
120,000,  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  887,000,  564,000 and 685,000
shares of common stock were not included in the computation of diluted per share
amounts in 1998,  1997 and 1996,  respectively,  because  the  weighted  average
exercise  prices  were  greater  than the  average  market  prices of the common
shares.  Weighted average exercise prices of $33.50 in 1998,  $39.61 in 1997 and
$39.62 in 1996 exceeded the average market prices of $23.28,  $29.75 and $28.62,
respectively.

10. REAL ESTATE TRANSACTIONS

In 1998 the company sold  approximately 15 acres of undeveloped land adjacent to
its San  Jose,  California,  facility  for a net  sales  price of $16.0  million
realizing a pre-tax gain of $15.0 million.  Due to the  downsizing  described in
Note 11, the balance of the San Jose facility was vacated and its carrying value
of $6.4 million  (which  management  believes to be less than market  value) was
reclassified as held for sale and included in "Other Assets"  (long-term) in the
December 31, 1998  Consolidated  Balance Sheet. The company expects to sell this
property in 1999. Any future gain associated with the sale of this property will
be treated as from the sale of a corporate asset for segment reporting purposes.

In 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 pre-tax gain of $7.6 million.

                                     Page 39

<PAGE>


11. DISCONTINUED PRODUCT LINES AND RELATED RESTRUCTURING CHARGES

<TABLE>
During the third quarter of 1998,  the company  restructured  its  operations to
focus  on  its  core  atmospheric-pressure   chemical-vapor-deposition   (APCVD)
operations in its Semiconductor  Equipment  segment by discontinuing  efforts on
its high-density-Plasma  initiative. Also, the company's Wireless Communications
segment evaluated its Base2(TM)  base-station product,  reassessing key customer
needs and market conditions.  Inventory,  demo equipment,  and specialized fixed
assets  associated  with these  discontinued  products  were written down in the
restructuring.  As a result,  the  company  reduced  its  global  work force and
downsized its operations.  The company recorded charges of $44.4 million related
to  facilities  and fixed assets,  inventory,  severance and other exit costs as
follows:

<CAPTION>
                                                            Accrued
                                                          Severance,         Write Down of
                                                       Benefits, and        Facilities and           Write Down
(in thousands)                                           Other Costs          Fixed Assets         of Inventory
----------------------------------------------------------------------------------------------------------------
<S>                                                           <C>                  <C>                  <C>    
Restructuring provision                                       $3,921               $23,370              $17,119
                                                                      ===================== ====================

Amounts paid                                                   2,210
---------------------------------------------------------------------
Balance at December 31, 1998                                  $1,711
=====================================================================
</TABLE>


Included in the third-quarter  1998 asset  write-downs is an approximately  $6.0
million  charge related to the  Semiconductor  Equipment  segment's  facility in
Japan,  which was written down to fair market value in accordance  with SFAS No.
121,  "Accounting for Impairment of Long-Lived  Assets and for Long-Lived Assets
to be Disposed  Of." A portion of this facility is being leased to a tenant (see
Note 3).

The company anticipates substantially all accrued severance and benefits will be
paid within a year.

12. SUBSEQUENT EVENTS

On March 1, 1999,  Watkins-Johnson  announced  that,  after a  strategic  review
performed by its investment banking firm, it would pursue a sale of the company,
either in its entirety or through sales of its individual business segments.  On
March 4, 1999, Watkins-Johnson announced that it had signed a non-binding letter
of  intent  to  sell  its  Semiconductor   Equipment  Group,  exclusive  of  its
discontinued  high-density-plasma  and certain other assets,  to Silicon  Valley
Group, Inc. (SVG). The sale is subject to customary due diligence,  execution of
a definitive acquisition  agreement,  Hart Scot Rodino filings, and the approval
of the boards of directors of Watkins-Johnson and SVG. There can be no assurance
that the sale of the Semiconductor Equipment Group to SVG will be completed, nor
can there be any  assurance  that  Watkins-Johnson  will be able to complete its
strategy for the sale of the entire company.

                                     Page 40

<PAGE>


13. QUARTERLY FINANCIAL DATA--UNAUDITED

<TABLE>
Unaudited quarterly financial data are as follows:

<CAPTION>
(in thousands, except per share amounts)                                                                           
------------------------------------------------------------------------------------------------------------------------------------
1998 Quarters                                                             1st               2nd               3rd               4th
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                  <C>               <C>               <C>               <C>     
Sales                                                                $ 68,722          $ 53,739          $ 26,257          $ 63,482
Gross profit (loss)                                                    26,176            16,659           (30,638)           21,236
Net income (loss)                                                       9,701            (6,207)          (54,414)            1,712
Basic net income (loss) per share                                        1.17             (0.75)            (6.93)             0.26
Diluted net income (loss) per share                                  $   1.15          $  (0.75)         $  (6.93)         $   0.25


------------------------------------------------------------------------------------------------------------------------------------
1997 Quarters                                                             1st               2nd               3rd               4th
------------------------------------------------------------------------------------------------------------------------------------
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                                               (0.04)             0.11              0.21             (0.76)
Diluted income (loss) per share from
    continuing operations                                               (0.04)             0.10              0.21             (0.76)
Basic net income per share                                               0.30              0.37              0.44              2.88
Diluted net income per share                                         $   0.30          $   0.36          $   0.42          $   2.88
</TABLE>


The first  quarter of 1998  includes a pre-tax  gain on the sale of  undeveloped
land totaling about $15.0 million.

The third  quarter of 1998 includes  pre-tax  charges for  discontinued  product
lines and related restructuring totaling $44.4 million, as described in Note 11.

In  the  fourth  quarter  1997,  due  to  the  continued   overcapacity  in  the
semiconductor  memory market and the Asian  financial  crisis,  the company took
certain  actions 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  was 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 $17.0 million during the fourth quarter.

The total of  quarterly  amounts for basic and diluted net income per share does
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 41

<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 42
<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,  1998 and 1997,  and the related
consolidated  statements  of  operations,   comprehensive  income,  shareowners'
equity,  and cash flows for each of the three years in the period ended December
31, 1998.  These financial  statements are the  responsibility  of the company's
management.  Our  responsibility  is to express  an  opinion on these  financial
statements based on our audits.

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

In our opinion,  such consolidated  financial  statements present fairly, in all
material  respects,  the  financial  position  of  Watkins-Johnson  Company  and
subsidiaries at December 31, 1998 and 1997, and the results of their  operations
and their cash flows for each of the three  years in the period  ended  December
31, 1998 in conformity with generally accepted accounting principles.


Deloitte & Touche LLP
San Jose, California
February 5, 1999
(March 4, 1999 as to Note 12)

                                     Page 43

<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, 1998, 1997 and 1996                21

         Consolidated Statements of Comprehensive Income
         For the Years Ended December 31, 1998, 1997 and 1996                22

         Consolidated Balance Sheets
         December 31, 1998 and 1997                                          23

         Consolidated Statements of Shareowners' Equity
         For the Years Ended December 31, 1998, 1997 and 1996                24

         Consolidated Statements of Cash Flows
         For the Years Ended December 31, 1998, 1997 and 1996             25-26

         Notes to Consolidated Financial Statements                       27-41

         Report of Management                                                42

         Independent Auditors' Report                                        43

                                     Page 44

<PAGE>


     2.  Financial Statement Schedules                                     Page
                                                                           ----
         Independent Auditors' Report                                        48

         II     Valuation and Qualifying Accounts and Reserves
                For the Years Ended December 31, 1998, 1997 and 1996         49


         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-A/A  were filed on  December  14,  1998.  The
         reports  are   referenced   as  Exhibit   10.16  and   Exhibit   10.17,
         respectively, in the Exhibit Index. The report 8-K contains disclosures
         regarding  the  December  10,  1998  Board  of  Director  approval  and
         execution  of an  amendment  to the  company  by-laws and to the Rights
         Agreement,   dated   September  30,  1996,   between  the  company  and
         ChaseMellon.  Form  8-A/A  was filed for  registration  of the  amended
         common  stock  purchase  rights.  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 45

<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 8, 1999                                     By  /s/  Dean A. Watkins
      --------------                                       ---------------------
                                                                Dean A. Watkins
                                                                Chairman of the
                                                                Board

            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.


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

Principal Executive Officer:


/s/  W. Keith Kennedy, Jr.                President and           March 8, 1999
----------------------------         Chief Executive Officer      --------------
     W. Keith Kennedy, Jr.  


Principal Financial and Accounting Officer:


/s/  Scott G. Buchanan                   Vice President,          March 8, 1999
----------------------------        Chief Financial Officer       --------------
     Scott G. Buchanan                   and Treasurer

                                     Page 46

<PAGE>


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

/s/  H. Richard Johnson                       Director            March 8, 1999
----------------------------                                      --------------
     H. Richard Johnson


/s/  John J. Hartmann                         Director            March 11, 1999
----------------------------                                      --------------
     John J. Hartmann


/s/  Raymond F. O'Brien                       Director            March 11, 1999
----------------------------                                      --------------
     Raymond F. O'Brien


/s/  William R. Graham                        Director            March 11, 1999
----------------------------                                      --------------
     William R. Graham


/s/  Robert L. Prestel                        Director            March 11, 1999
----------------------------                                      --------------
     Robert L. Prestel


/s/  Gary M. Cusumano                         Director            March 11, 1999
----------------------------                                      --------------
     Gary M. Cusumano

                                     Page 47

<PAGE>


INDEPENDENT AUDITORS' REPORT


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

We have audited the consolidated financial statements of Watkins-Johnson Company
and  subsidiaries  as of December  31, 1998 and 1997,  and for each of the three
years in the period ended  December 31, 1998, and have issued our report thereon
dated  February  5,  1999  (March  4,  1999 as to Note  12);  such  consolidated
financial  statements and report are included elsewhere in 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(a)2.
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 5, 1999
(March 4, 1999 as to Note 12 of the
Consolidated Financial Statements)

                                     Page 48

<PAGE>


<TABLE>
                                                                                                                         Schedule II


                                              WATKINS-JOHNSON COMPANY AND SUBSIDIARIES

                                           VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
                                        FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 and 1996


<CAPTION>
                                                          Balance at           Charged to                               Balance at
                                                          Beginning            Costs and                                   End of
Description                                               of Period             Expenses            Deductions(1)          Period
-----------                                               -----------          -----------          ------------         -----------
<S>                                                       <C>                  <C>                  <C>                  <C>        
1998
Allowance for doubtful accounts                           $ 3,175,923          $ 1,731,422          $ 1,553,090          $ 3,354,255
Product warranty reserve                                   13,423,700            6,168,000           13,299,600            6,292,100

1997
Allowance for doubtful accounts                               746,720            2,467,656               38,453            3,175,923
Product warranty reserve                                   14,825,300           10,134,000           11,535,600           13,423,700

1996
Allowance for doubtful accounts                               633,798              119,649                6,727              746,720
Product warranty reserve                                    7,193,500           20,095,300           12,463,500           14,825,300


<FN>
(1) With respect to the allowance for doubtful  accounts,  deductions  represent
write-off of  uncollectible  accounts  receivables.  With respect to the product
warranty reserve,  deductions represent costs incurred for warranty repairs plus
adjustments for expiring warranties.
</FN>
</TABLE>

                                                               Page 49

<PAGE>


                                  EXHIBIT INDEX


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

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

3.2               *By-Laws of Watkins-Johnson  Company,  as amended and restated
                   on  December  10, 1998  (Exhibit  3(ii) to Form 8-K  filed on
                   December 14, 1998, Commission File No. 1-5631).

4.1               *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).

4.2               *Amendment No. 1 to Rights Agreement, dated as of December 10,
                   1998,  to Rights  Agreement,  dated as of September 30, 1996,
                   between the Watkins-Johnson  Company ChaseMellon  Shareholder
                   Services,  L.L.C., as Rights  Agent. (Filed as Exhibit 4.1 to
                   Form 8-K filed on  December  14,  1998,  Commission  File No.
                   1-5631).

10                 Material Contracts

10.1              *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).

10.2              *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).

10.3              *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).

10.4              *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).

10.5              *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).

10.6              *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).

10.7              *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).

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<PAGE>


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

10.8              *Loan   Agreement   dated  as  of  June  12,   1996   (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).

10.9              *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).

10.10             *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).

10.1l             *Stock  Purchase  Agreement dated 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).

10.12             *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 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,  Commission  File No.
                   1-5631).

10.13             *Asset Purchase Agreement between  Watkins-Johnson Company And
                   Samsung  Semiconductor,  Inc.  dated as of December 31, 1997.
                   (Filed as Exhibit 10-y to the 1997 Form 10-K, Commission File
                   No. 1-5631).

10.14             *Assignment  of Lease  Agreement by and between Taylor Woodrow
                   Property  Company,   Inc.  ("Assignor")  and  Watkins-Johnson
                   Company ("Assignee") dated as of December 30, 1997. (Filed as
                   Exhibit  10-z to the  1997  Form  10-K,  Commission  File No.
                   1-5631).

10.15             *Form 8-K filed on  September  10, 1998.  The report  contains
                   disclosures   regarding   the   company's   announcement   of
                   restructuring  plans and related  third quarter 1998 charges.
                   (Commission File No. 1-5631).

10.16             *Form 8-K filed on  December  14,  1998.  The report  contains
                   disclosures regarding the December 10, 1998 Board of Director
                   approval  to amend and  restate  the  company  By-Laws and to
                   amend the Rights Agreement, dated September 30, 1996, between
                   the company and ChaseMellon.(Commission File No. 1-5631).

10.17             *Form 8-A/A filed on December 14,  1998.  Form 8-A/A was filed
                   for the  registration  of the amended  common stock  purchase
                   rights  approved by the Board of  Directors  on December  10,
                   1998 (Commission File No. 1-5631).

                                     Page 51

<PAGE>


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

10.18              Purchase and Sale Agreement,  dated May 2, 1997, by and among
                   Watkins-Johnson  Company and  CarrAmerica  Realty for sale of
                   undeveloped  land  in San  Jose,  California,  including  the
                   August  15,  1997 First  Amendment  to and  Reaffirmation  of
                   Purchase and Sale Agreement.

10.19              Resolution  of the  Board of  Directors  of  Watkins-Johnson,
                   effective  December  31,  1998,  for the  termination  of the
                   company's 1994 Top Management Deferred  Compensation Plan and
                   the company's Annual Top Management Incentive Bonus Plan.

10.20              Form of Severance Agreement, dated September 28, 1998, by and
                   between Watkins-Johnson Company and the following officers of
                   the company: Dr. Patrick J. Brady, Malcolm J. Caraballo,  and
                   Robert G. Hiller.

10.21              Amended and Restated Employment Agreement made as of March 2,
                   1998 and amended and restated in its entirety effective as of
                   January  25,  1999  by  and  between  W.  Keith  Kennedy  and
                   Watkins-Johnson Company.

10.22              Form of employment Agreement, dated February 22, 1999, by and
                   between Watkins-Johnson Company and the following officers of
                   the company: Scott G. Buchanan, Dr. Frank E. Emery, Darryl T.
                   Quan and Claudia D. Kelly.

10.23              Form of Amended and Restated Severance  Agreement  originally
                   dated  September  28, 1998 and  amended  and  restated in its
                   entirety  effective  as of January  25,  1999 by and  between
                   Watkins-Johnson  Company  and the  following  officers of the
                   company:  Dr.  Frank E. Emery,  Darryl T. Quan and Claudia D.
                   Kelly.

10.24              Amended and Restated  Severance  Agreement  originally  dated
                   September  28, 1998 and amended and  restated in its entirety
                   effective   as  of   January   25,   1999   by  and   between
                   Watkins-Johnson Company and Scott G. Buchanan.

10.25              Terms of Employee Retention Program dated March 1, 1999.

21                 Subsidiaries of Watkins-Johnson Company.

23                 Consent of Independent Auditors.

27                 Financial Data Schedule.

* Incorporated by reference to exhibit indicated for each item.


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