<PAGE>


                                   [PHOTO]



                                               HARMON INDUSTRIES, INC.
-------------------------------------------------------------------------------
                                               1997 ANNUAL REPORT


<PAGE>

CORPORATE PROFILE


Harmon is a leading supplier of sophisticated signal, inspection and train
control products and systems. It serves three railroad markets: domestic
freight, domestic rail transit, and international, which includes both freight
and rail transit.

     Harmon's design focus is microprocessor based and aimed toward systems
and products that improve the operating efficiency and safety performance of
its customers. Products include railroad signal and train control equipment,
train inspection systems, rail/highway grade crossing hardware and related
packaging, installation and maintenance services.

     Harmon emphasizes engineering innovation and rapid response to customer
needs. Many of its products provide sophisticated and timely solutions to
signal and control problems that impact the railroad industry.

     Its technology base was greatly enhanced in 1997 when Harmon obtained
exclusive rail transportation rights to a revolutionary radio technology that
was developed at a cost of several hundred million dollars by Hughes Aircraft
Company for the U.S. Department of Defense. This technology will provide the
basis for a communication-based train control system that will be marketed to
rail systems in North America and throughout most parts of the world.

     Harmon is headquartered in Blue Springs, Missouri, a suburb of Kansas
City. It operates from numerous facilities in the U.S., as well as Canada,
England, Switzerland, and Australia.

     Harmon common stock trades on The Nasdaq Stock Market under the symbol:
HRMN. Its current annual dividend is 11 cents per share, giving effect to a 3-
for-2 stock split and a 10% dividend increase in February, 1998. / /

---------------
    [PHOTO]

[PHOTO CAPTION]

Cover Photo: San Francisco's Bay Area Rapid Transit (BART) system. Harmon
received a contract, including all options, valued at $45 million in February
1998, to design and install a revolutionary communications-based automatic
train control system on BART's highest density lines. The new system will
employ an innovative radio technology that was developed by Hughes Aircraft
Company (now Raytheon Company) for the U.S. military forces to track vehicles
and personnel on the battlefield.
---------------


<PAGE>

FINANCIAL HIGHLIGHTS
(IN THOUSANDS EXCEPT PER SHARE DATA, WHERE APPLICABLE)


<TABLE>
<CAPTION>

OPERATING DATA
Year ended December 31,                        1997        1996      Percent Change
-----------------------------------------------------------------------------------
<S>                                          <C>         <C>         <C>
Net sales                                    $213,530    $175,440       + 21.7 %

Pre-tax income                                 17,583      15,105       + 16.4

Income taxes                                    6,622       5,775       + 14.7

Net earnings                                   10,961       9,330       + 17.5

Earnings per share (basic and diluted) (3)       1.06        0.91       + 16.5

Dividends per share (3)                           .10         .10         -0-

</TABLE>


<TABLE>
<CAPTION>

PERFORMANCE DATA
Year ended December 31,                        1997        1996      Percent Change
-----------------------------------------------------------------------------------
<S>                                            <C>         <C>       <C>
Return on sales (pre-tax)                        8.2%        8.6%       -  4.7 %

Return on year-end equity                       15.7%       16.1%       -  2.5

Return on capital employed (1)                  23.8%       25.9%       -  8.1

</TABLE>


<TABLE>
<CAPTION>

YEAR-END DATA
Year ended December 31,                        1997        1996      Percent Change
-----------------------------------------------------------------------------------
<S>                                           <C>         <C>        <C>
Working capital                               $50,323     $33,629       + 49.6 %

Interest-bearing long-term debt               $15,456     $ 3,412       +353.0

Approximate number of shareholders (2)            596         637       -  6.4

Number of employees                             1,510       1,202       + 25.6

Outstanding shares (000s) (3)                  10,437      10,244       +  1.9

</TABLE>


(1)  Return on capital employed is a measurement that encourages management
     to operate as efficiently as possible. It promotes reduced asset values
     relative to sales, and measures how effective it is (for example) to
     borrow money to purchase capital goods to reduce manufacturing costs.
     The formula is: the sum of pre-tax earnings plus interest expense
     divided by the sum of average total assets minus non-interest bearing
     liabilities.

(2)  Includes only registered shareholders. Since many shareholders hold
     their shares in "street name," the number of individual shareholders is
     larger than the number shown.

(3)  Adjusted for February 1998 3-for-2 stock split.
-------------------------------------------------------------------------------

TABLE OF CONTENTS

<TABLE>
<S>                                                            <C>
Financial Highlights                                            1

Report to Shareholders                                          2

The Year in Review                                              6

Selected Financial Data                                        18

Financial Review                                               20

Consolidated Financial Statements                              26

Notes to Consolidated Financial Statements                     31

Investor Information                                           42

Management, Directors and Corporate Data                       43

Locations                                                      43

</TABLE>

                                                                             1

<PAGE>

REPORT TO SHAREHOLDERS

1997 was an outstanding year for Harmon Industries. Sales surpassed $200 million
for the first time ever, topping out at $214 million, a gain of 21.7% over the
$175 million reported for 1996. Incoming orders increased 22% to a record
$229 million. Pre-tax earnings gained 16.4% to $18 million. Giving effect to
the 3-for-2 stock split in February 1998, diluted earnings per share rose
16.5% to $1.06, compared with $0.91 in 1996. Our order backlog increased
25.5% to $75 million from $59 million a year ago.

     I am very satisfied with our performance in 1997. Even more so because
we produced record earnings while absorbing more than $1 million in
additional capacity-related expenses, chiefly from expanding production
facilities, hiring and training more than 200 new employees, and incurring
certain onetime acquisition expenses. Thus, our day-to-day operations were
even more efficient than our financial results indicate.

     Our record breaking performance in 1997 was due to a combination of
continued prosperity among our freight railroad customers, our technology
leadership and our extensive service capabilities. Railroad mergers also
aided our performance as acquiring railroads seek to increase capacities to
generate additional revenues and reduce their operating ratios in order to
validate their acquisition strategies. Signaling and train control are
instrumental to achieving greater capacity and efficiency. Thus Harmon is in
an excellent position to benefit from the ongoing merger trend among North
American railroads.

GROWTH STRATEGY

     Our three-pronged growth strategy is working well. In brief, it is to
maintain our strong position with our North American freight railroad
customers with new products and expanded services; build a similar solid
position with North American rail transit authorities, and expand
internationally with basically similar products and technology that we
provide to our domestic markets.

     We advanced on all fronts in 1997. Sales to our domestic freight
customers were up 9.1% at $180 million. We had very strong growth among
products and systems related to capacity or efficiency improvements, such as
train control

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

[PHOTO]

Business soared to record levels in 1997. For 1998, I look for further gains,
particularly in our domestic rail transit and international endeavors.

Bjorn E. Olsson, President
and Chief Executive Officer

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

2
<PAGE>

systems, carborne equipment and train inspection systems. We finished 1996
with a successful re-signaling of 150 miles of track at Stampede Pass in
Washington. In 1997 we received the biggest turnkey order in our history,
roughly $40 million, to support a major freight railroad's program to upgrade
and expand its capacity between Greenwich, Ohio and Chicago, Illinois. To our
knowledge this is the largest and most ambitious project of its kind and
enables Harmon to develop its capabilities in total turnkey supply even
further.

NEW TECHNOLOGY

     Shipments to our rail transit customers, which advanced 4.1% to $15 million
in 1997, are expected to increase in 1998 in part because of a license agreement
we signed last fall with Raytheon Company (formerly Hughes Aircraft Company).
The agreement gives Harmon the manufacturing and exclusive rail transportation
marketing rights to a revolutionary new technology that will give us the
opportunity to provide communication-based train control to rail systems in
North America and throughout most other parts of the world.

     Our communication-based train control system is called "Advanced Automatic
Train Control" (AATC). It is a train control technology that is based upon a
very sophisticated wireless data communication network that has the ability to
determine the location, speed and direction of vehicles. AATC will be
implemented in San Francisco on the Bay Area Rapid Transit District (BART) with
whom we signed a $45 million contract, including all options, in February 1998.
The contract calls for the completion and implementation of our AATC system over
the next three years. Our AATC system will enable BART to control increased
train traffic through the most congested portion of its line by allowing trains
to move at 90 second headways, even while operating at speeds of up to 80 miles
per hour.

     The AATC system will be the platform for proposals Harmon makes to other
potential rail transit customers worldwide that intend to use communication-
based train control systems.

     In February 1998, we delivered our technical proposal to New York City
Transit, which intends to

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

[CHART]

GROSS SALES
$ - Millions

/ / Domestic Freight Railroads
/ / Domestic Rail Transit
/ / International


<TABLE>
<S>                        <C>
1993                        98.8
1994                       119.1
1995                       136.1
1996                       183.9
1997                       214.4
</TABLE>


[CHART]

NET EARNINGS
$ - Millions


<TABLE>
<S>                         <C>
1993                         6.9
1994                         7.6
1995                         6.9
1996                         9.3
1997                        11.0
</TABLE>

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


                                                                              3

<PAGE>

upgrade its signal system beginning in 1998. We have already successfully
demonstrated the AATC technology on an operating subway line in New York City
for officials from several transit agencies and consulting firms. We are very
hopeful that we will be among the three suppliers selected to prequalify for
approximately $3 billion in advanced train control systems in New York City over
the next 20 years.

INTERNATIONAL SALES

     Shipments to our international customers rose 233.5% to $18 million, which
largely reflected orders filled by our British subsidiary, Vaughan Harmon
Systems, Ltd. (Vaughan Harmon), for its technologically-advanced train
describers. International bookings rose 20.8% to $17 million. In the fourth
quarter, Vaughan Harmon was awarded a contract for approximately $10 million,
including options, by Railtrack for the replacement of the signaling on the
Cromer Branch line in Norfolk, England. The first phase representing less than
10% of this amount is included in 1997 bookings and year-end backlog. The system
will involve a Vaughan Harmon PC-based signal and control system and the first
use in Europe of our VHLC, an electronic interlocking controller, and HXP-3
level crossing control, both of which are used extensively in North America.
This achievement should be seen in the context of Railtrack having a $4 billion
capital expenditure plan for upgrading the signaling portion of the rail system
in England during the next 10 years. Obviously to become an approved supplier
should open up tremendous opportunities for Harmon.

INVESTMENTS FOR THE FUTURE

     We continued to invest heavily in research and development. In addition, we
also introduced specific cost efficiency improvement teams that continuously
review our existing product program to assure we maintain our competitive
position.

     To meet the increased demand for our products and services, we increased
our capacity dramatically during 1997, expanding our manufacturing spaces, our
plant workforce and our engineering staff.

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

[CHART]

BACKLOG
$ - Millions

<TABLE>
<S>                         <C>
1993                        40.5
1994                        44.6
1995                        49.1
1996                        59.4
1997                        74.5
</TABLE>


[CHART]

RETURN ON CAPITAL EMPLOYED

<TABLE>
<S>                        <C>
1993                       39%
1994                       34%
1995                       22%
1996                       26%
1997                       24%
</TABLE>

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


4

<PAGE>

     We also made a concerted and successful effort to improve our quality, both
at the point of design and in the manufacturing and assembly processes. As a
consequence, two additional Harmon sites became ISO-9000 certified during 1997,
and the Lee's Summit facility received its certification in early 1998.

CONCLUSION

     We are following a successful strategy, which is evident from the dramatic
success we achieved in the three markets where we compete. Our efforts in 1997
not only produced a record performance, they also laid very solid ground for
future expansion. These achievements were the result of a tremendous effort from
our devoted employees, and I wish to thank them for a job well done.

     Looking ahead to 1998 we see both potential problems and material
opportunities. Some railroads are experiencing operating problems, which may
affect certain merger plans and spending budgets. Further, the Congress has not
yet finalized appropriations for highway crossing warning programs or for mass
transit projects. On the other hand, the railroad market in general is
experiencing increased car loadings; two major railroads indicated sizable
increases in their proposed capital expenditures for 1998, and rail transit
projects are expanding materially.

     Regardless, we entered 1998 with a record backlog and an order intake for
the first two months roughly 30% higher than we achieved during the early months
of 1997. Thus, even though it is a bit early to make projections for 1998, we
remain quite confident about our future.

/s/ Bjorn E. Olsson
--------------------
Bjorn E. Olsson
President and Chief Executive Officer

Blue Springs, Missouri
March 19, 1998

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

[CHART]

              STOCK PRICE RANGE*
                 1990-1997

<TABLE>
<CAPTION>
                            High           Low
                            ----           ---
<S>                        <C>            <C>
1990                       $ 4.92         $ 2.33
1991                       $ 4.83         $ 2.33
1992                       $ 8.50         $ 2.25
1993                       $15.50         $ 7.75
1994                       $16.17         $11.00
1995                       $13.67         $ 8.92
1996                       $13.00         $ 8.00
1997                       $19.67         $11.00
</TABLE>

*All restated for Feb. '98 3-for-2 stock split


                                                                              5
<PAGE>

THE YEAR IN REVIEW


Harmon's record performance last year was the result of its continued
implementation of its far-ranging strategy for growth. Implicit to the
overall success of this plan were three vital considerations: continued
development of its core business, the North American freight railroads,
expansion of technology, and building an infrastructure to support these
growth plans. Considerable progress on all three issues was achieved last
year.


/ /  DOMESTIC FREIGHT-NORTH AMERICA

Sales to this core market, which comprised 84.7% of our revenues in 1997,
increased 9.1% to $180 million, up from $165 million in 1996. New orders
booked in 1997 amounted to $198 million, a gain of 31.7% from the previous
year. Our domestic freight railroad backlog at 1997 year-end was $44 million,
up 78.9% from a year ago.

     Our largest customer continued to provide us with sizable orders last
year as it pressed forward with its capacity-enhancing capital expenditure
program. In addition, we experienced increased demand from other railroads,
especially those involved in merger activities.

     Last year's sales reflected a continuing trend toward systems and away
from individual products. This was especially evident in our highway grade
crossing warning product line. Very strong growth was also realized with
systems that enhance capacity or efficiency, such as train control systems,
carborne equipment and train inspection systems.

     We received our largest individual product order for Harmon
multi-territory Ultra Cab II units. These will be installed in the latest
model AC traction locomotives.

     Ultra Cab II is a microprocessor-based train control unit that enhances
safety and capacity by displaying signal indications continuously in the
engine cab where the track is so equipped, and by enforcing the speeds
authorized by these signals. It is also a key component of our Incremental
Train Control System, which is undergoing final tests on the Michigan
high-speed rail project.

     Demand for our hot box detectors was also particularly strong last year.


/ /  DOMESTIC RAILROAD SERVICES

Our asset management service revenues, which are included in the revenues of
$180 million shown

---------------
     [CHART]

Gross Sales - 1997

<TABLE>

<S>                              <C>
/ / Domestic Freight             70.7%
/ / Domestic Services            14.0%
/ / Domestic Rail Transit         7.1%
/ / International                 8.2%

</TABLE>

[CHART CAPTION]
[TRIANGLE] Every Harmon market experienced higher revenues in 1997. Gross
sales to our domestic freight market increased by 5%; domestic services by
35%; domestic rail transit by 4%, and international by 234%. An order backlog
of $75 million at 1997 year-end provides a strong start for 1998.

[PHOTO CAPTION]
[TRIANGLE] No other transportation system can match the load carrying
capabilities and fuel efficiency of a freight hauling railroad. Supplying
signal and control systems to the North American freight railroads defines
Harmon and its core business. Approximately 85% of Harmon's product and
service revenues were derived from this market in 1997.
---------------


6
<PAGE>


                                   [PHOTO]


<PAGE>

on page 6 under "Domestic Freight-North America," increased 34.6% to $30
million in 1997 compared with $22 million in 1996.

     These services were conceived initially to help our domestic railroad
customers manage their purchasing and warehousing functions for signal
equipment inventories. Later, we added component subassembly and on-site
delivery of signal systems in kit form ready for installation by a railroad
crew. In 1996 we added project management.

     These services have proved timely as they support the railroads' ongoing
drive to increase their operating efficiencies, which has become even more
pressing because of many railroad mergers. These mergers have increased
market demand for services and products as the railroads' operating systems
are consolidated. And having an alternate, on-call source to perform certain
services, particularly those that have grown in complexity and cost in recent
years, has proved to be a cost-effective outsource option for many North
American railroads.

     Last year our service operation was instrumental in helping several
railroads restore their operations quickly after heavy snows and floods wiped
out signal and control systems along many miles of track. By having
components on hand (including those of our competitors) in semi-assembled
form we were able to rush them to damaged sites, sometimes even overnight, to
get their trains rolling safely again. Without having such backup signal
equipment on hand, nature's rampages might have taken weeks to correct, and
the loss of freight revenue in the interim would have been considerable.

     Further, the introduction of full project management in 1996 proved
timely in 1997, as well. Last year we received a $40 million order to improve
and expand a major railroad's capacity on 270 miles of track between
Greenwich, Ohio and Chicago. To our knowledge this is the largest and most
ambitious project of its kind by any Class I railroad. This project, which
enables us to further develop our total turnkey capabilities, is critical to
that railroad's achieving its planned growth objectives in connection with
the acquisition of approximately half of the Conrail system.

     We are responsible for all signaling and train control, including the
supervision of the installation. About half of the job was delivered in 1997,
and we are currently negotiating an expansion of this project.

     We continued to expand our service function. In 1997 we opened a full
service facility in Fort

---------------
    [PHOTO]

[PHOTO CAPTION]
[TRIANGLE] Harmon's outsourcing services are being used increasingly by the
nation's Class I railroads. This component produced service revenues of $30
million last year. In addition it also supplied about $35 million in Harmon
products, incremental volume the Company may not have realized without its
service capability.

[PHOTO CAPTION]
[TRIANGLE] Harmon's innovative service operation has expanded from
warehousing and component subassembly to full project management. Shown at
right is construction underway on a project for which the Harmon project
management team directed the signal system installation for a major Class I
railroad.
---------------


8
<PAGE>


                                   [PHOTO]


<PAGE>

Wayne, Indiana, and in 1998, we launched another such facility in Spokane,
Washington.


/ /  DOMESTIC RAIL TRANSIT

Incoming orders for 1997 were $13 million compared with $22 million the prior
year. The past year was characterized by much quoting activity but few
contract awards for all-new construction, which is our forte.

     In October we were awarded two signal projects from the Utah Transit
Authority (UTA) totaling $5.4 million for grade crossings, interlockings and
block signals. The UTA is building a 15-mile light rail transit line to
prepare for the 2002 Winter Olympic Games. This project illustrates the
validity of Harmon technology. Since 1991, we have been awarded every signal
contract, save one, for new light rail systems in the United States. We also
received our fifth order for our microprocessor-based speed enforcement
system from New York City, which brings our total to 40 such systems to date.

     Last fall we signed a letter of intent with the San Francisco Bay Area
Rapid Transit District (BART) to install our Advanced Automatic Train Control
system (AATC) on BART's highest density lines. In February 1998, that letter
of intent was turned into a contract for approximately $45 million, including
all options. When completed, it will be our largest rail transit contract to
date.

Domestic rail transit billings amounted to $15 million in 1997 compared with
$14 million in 1996. The bulk of 1997 shipments reflected partial completion
of a $17.6 million contract for New Jersey Transit Authority. That contract
is scheduled for completion by the second quarter of 1998. Our year-end order
backlog, which does not include the BART contract, was $20 million compared
with $24 million at December 31, 1996.

Business activity should improve in 1998. We expect to bid on more than ten
projects, which aggregate $400 million.


/ /  INTERNATIONAL

Sales and incoming orders both rose to record levels last year. Billings
amounted to nearly $18 million compared to $5 million in 1996. New orders
were $17 million compared with $14 million in 1996. Our order backlog at
year-end was $11 million, approximately the same as 1996. Most of


---------------
    [PHOTO]

[PHOTO CAPTION]
[TRIANGLE] Although contracts awarded last year for microprocessor-based rail
transit signal and control systems were relatively modest, prospects are well
above average as the industry expects to let bids in the $300 million-$400
million range in 1998.

[PHOTO CAPTION}
[TRIANGLE] Harmon successfully demonstrated its Advanced Automatic Train
Control technology on an operating subway line in New York City for officials
from several transit agencies and consulting firms. New York City Transit is
expected to select three suppliers this year to prequalify for $3 billion in
advanced train control systems, which that agency is expected to award over
the next 20 years. Harmon is one among several competing for this business.
---------------


10
<PAGE>


                                   [PHOTO]


<PAGE>

the impetus relates to our July 1996 acquisition of Vaughan Harmon Systems
Ltd., a British-based manufacturer of train describers, passenger information
systems and modular railway control systems.

     For the second consecutive year, Vaughan Harmon turned in an outstanding
performance, receiving contracts totalling $15 million during 1997.
Additionally, it was recently awarded a $10 million contract to replace
signal systems on Railtrack's Cromer Branch Line in Norfolk, England. Phase 1
of this contract, valued at approximately $500,000, is included in 1997
orders. The system marks the first use in Europe of our VHLC electronic
interlocking controller and HXP-3 level crossing controller, as well as a
Vaughan Harmon PC-based signaling control (office) system. Vaughan Harmon
also received contracts earlier in the year for $5 million to supply its
train describers at two locations in Scotland.

     These contracts are particularly important because they afford us the
opportunity to demonstrate our products and services to Railtrack, which
plans to modernize the entire British rail system. The portion relating to
signals and controls approximates $4 billion and is expected to be let over
the next ten years.

     Vaughan Harmon's solid position in the UK continues to play an important
role in our initiative to expand our business, not only in Britain, but
throughout all of Europe.

     Elsewhere, in Brazil we received two contracts from Cia Vale Do Rio Doce
of Sao Luis, Brazil. The first was for our wayside train control and track
circuits. In August, we received a second contract of $2.3 million for our
Ultra-Cab II system, which reads coded cab signals from the rails to control
speed and braking, and stop a train automatically, if necessary.

     In addition, we are now developing a sizable amount of business in
Mexico, particularly for hot box detectors and other safety-related devices.
We are establishing a subsidiary in Mexico to facilitate our expanding
business there and to form a base for what we hope will be a long-term
service relationship with these railroads.

     At year's end we were also developing additional business in China and
India.


/ /  ACQUISITIONS

In 1997, we acquired Devtronics, Inc., which makes products related to
highway grade crossing


---------------
    [PHOTO]

[PHOTO CAPTION]
[TRIANGLE] Harmon's international reach extends around the globe, which
includes BHP Iron Ore of Australia to whom Harmon supplies a variety of
products, including its advanced hot box detectors.

[PHOTO CAPTION]

[TRIANGLE] A $16 billion project is underway to modernize the entire rail
system in Great Britain. An estimated $4 billion will be invested for new
signal and control systems. Last year, through our British-based subsidiary,
Vaughan Harmon Systems Ltd., we received $15 million in orders from Railtrack
to replace signal systems on the Cromer Line in Norfolk, England, and to
supply train describers in Motherwell, Glasgow and Edinburgh, Scotland.

     Our July 1996 acquisition of Vaughan Harmon is proving invaluable. We
now have a well respected railroad supplier in place at a time when business
opportunities are expanding. The new contracts afford us the opportunity to
demonstrate the combined capabilities of Harmon and Vaughan Harmon and its
advanced signal system technologies to Railtrack and to the continental
European rail community, as well.
---------------


12
<PAGE>


                                   [PHOTO]


<PAGE>

event monitoring and alarm equipment, with central reporting and networking
capabilities. We also acquired the remaining interest in Vale-Harmon
Enterprises, Ltd., which now gives us 100% ownership of that Canadian-based
sales and marketing organization. Early in 1998 we acquired CSS, Inc., a
railroad installation and maintenance company. These acquisitions fit into our
strategy to provide increased services for the railroads.

/ /  TECHNOLOGY

In December, we signed a license agreement with Raytheon Company (formerly
Hughes Aircraft Company) for the manufacturing and exclusive rail transportation
marketing rights to a revolutionary new technology for communication-based train
control applicable to rail and rail transit systems in North America and most
other parts of the world. It is Harmon's most important and far reaching
technology acquisition ever.

     The technology has major advantages over other systems. It is a powerful
data transmission system using radio, which can transmit data very rapidly in
both directions between a controlling ground station and multiple trains,
including through tunnels and zones of radio interference. These capabilities
make it particularly attractive to high density rail transit agencies that
operate rapid transit trains in underground subways. Variations of the system
may be of interest to freight railroads.

     To make this communications-based system operational, Harmon will add its
on-board equipment, wayside computer controls, and relevant software. When
operational, the system will enable transit authorities to run their trains
faster and closer together. This is particularly desired by rail transit
authorities as it will enable them to move substantially more passengers over
their current track systems.

     Our system has a flexible, modular architecture so that it can be adapted
to a wide variety of operational requirements and other systems presently in use
throughout the world. Harmon's Advanced Automatic Train Control (AATC) system,
which will enable BART trains to follow at 90 second intervals at up to 80 miles
per hour, will be the platform for proposals we will make to other transit
systems.

     Last fall, we successfully demonstrated the AATC technology on an operating
subway line in New York to officials of several transit agencies. Later, we
submitted a formal proposal to New York

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

[CHART]

RESEARCH & DEVELOPMENT EXPENDITURES
$ - Millions

<TABLE>
<S>                          <C>
1993                         3.4
1994                         4.6
1995                         5.2
1996                         6.3
1997                         7.7
</TABLE>

[CHART CAPTION]
TRIANGLE  Harmon's investment for research and development has more than
doubled in the past five years, increasing 126 percent from $3.4 million to
$7.7 million. Much of Harmon's increased sales are due from new products
developed by the research and development team.

[PHOTO CAPTION]
--)  Harmon engineers are dedicated to developing products and systems
that enable railroads to operate more safely and efficiently. In brief,
Harmon's signal and control systems allow railroads to safely operate more
trains on a given stretch of track, thereby increasing their operating
efficiency. In addition, Harmon micro-processor-based products are less
costly to install and maintain compared with signal systems that rely on
mechanical relays.

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


14
<PAGE>

                                   [PHOTO]

<PAGE>

City for a radio based control system that utilizes the AATC technology. New
York City Transit has a 20-year plan to upgrade its signal system, which has an
estimated price tag of $3 billion. Three companies will be selected to
demonstrate their systems in 1999, and one will be chosen to upgrade the first
segment of the New York network.

/ /  EXPANDING CAPACITY

Our drive to expand capacity focused on methods to increase output while
limiting the addition of permanent overhead. This centered on three areas:
increasing the agility of our plants to shift work from one to another,
expanding vendor relationships, and product redesign.

     We added 100,000 square feet to our collective manufacturing space and
invested heavily in technologically-advanced incremental production equipment in
1997.

     In addition, we continued to cross train our permanent labor force to
perform multiple tasks.

     We also intensified our partnering relationships with many vendors. Key
suppliers now maintain their inventories in our facilities, invoicing us only
when we use their products. In turn, we share our order input with them. This
gives our vendors a better understanding of our forecasting processes, and
removes inertia from the order/delivery process.

     Finally, we further intensified our quality focus on product design and
build processes, a program which began in earnest in 1990. As new products are
developed, each is more rigorously tested for "designed-in quality" and
simplicity of production than ever before. Further, we increased responsibility
for quality at the production stage rather than having to correct imperfections
at the final inspection process.

     As a result, our innovative programs for non-traditional labor, cross
training of our permanent labor force, and attention to quality issues all
combined to enable us to invoice $74 million in products and services in the
final quarter of 1997, which is a strong indication of the productive capacity
that Harmon now possesses.  / /

---------------
                                   [PHOTO]

[PHOTO CAPTION]
TRIANGLE  Harmon invested approximately $4 million for plant expansion in
1997, adding 100,000 square feet to our collective manufacturing spaces at
three locations. These investments were made to handle the sizable increases
in business Harmon expects will occur in 1998 and 1999.

[PHOTO CAPTION]
--)  Harmon's production floor in Grain Valley, MO. Shown at right is a new
automatic insertion machine, which was part of $2 million invested in new
production equipment last year. This state-of-the-art unit is approximately
five times faster than predecessor models.


16
<PAGE>

                                   [PHOTO]

<PAGE>

SELECTED CONSOLIDATED FINANCIAL DATA (UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>



Years ended December 31                            1997       1996        1995         1994
--------------------------------------------------------------------------------------------------
<S>                                             <C>         <C>        <C>          <C>
OPERATIONS
Net sales                                       $ 213,530   $175,440   $ 136,780    $ 119,703
Cost of sales                                     156,224    126,997      96,094       81,023
Research and development expenditures               7,664      6,331       5,218        4,561
                                               ---------------------------------------------------
Gross profit                                       49,642     42,112      35,468       34,119
Selling, general and administrative expenses       30,298     25,990      23,200       21,176
Other operating expenses (income)                     964        544         481           44
                                               ---------------------------------------------------
Operating income                                   18,380     15,578      11,787       12,899
Other expenses                                        797        473         607          214
                                               ---------------------------------------------------
Pre-tax earnings (continuing operations)           17,583     15,105      11,180       12,685
Income taxes                                        6,622      5,775       4,294        5,046
                                               ---------------------------------------------------
Earnings from continuing operations                10,961      9,330       6,886        7,639
Gain (loss) from discontinued operations                -          -           -            -
Use of net operating loss carryforward                  -          -           -            -
                                               ---------------------------------------------------
Net earnings (loss)                             $  10,961   $  9,330   $   6,886    $   7,639
                                               ---------------------------------------------------
                                               ---------------------------------------------------

Effective tax rate - continuing operations          37.7%      38.2%       38.4%        39.8%
Return on sales - continuing operations              5.1%       5.3%        5.0%         6.4%
Return on equity - continuing operations            15.7%      16.1%       14.0%        17.7%
Return on equity - total                            15.7%      16.1%       14.0%        17.7%
Weighted average shares (000s) - basic*            10,313     10,217      10,187        9,649

PER SHARE DATA*
Earnings from continuing operations - basic     $    1.06   $    .91   $     .68    $     .79
Net earnings (loss) - basic                          1.06        .91         .68          .79
Cash dividends                                        .10        .10         .10          .10
Book value                                           6.68       5.66        4.82         4.27
Price/earnings ratio range - basic              10.3-18.5   8.8-14.2   13.2-20.2    13.9-20.4

OTHER DATA AT YEAR-END
Working capital                                 $  50,323   $ 33,629   $  35,014    $  21,670
Total assets                                      135,769    104,677      86,845       68,395
Long-term debt                                     15,456      3,412      12,090          733
Stockholders' equity                               69,762     57,939      49,232       43,063
Current ratio                                      2.09:1     1.85:1      2.60:1       2.03:1
Quick assets ratio                                 1.12:1     1.01:1      1.16:1       1.03:1
Liabilities to equity ratio                         .95:1      .81:1       .76:1        .59:1
Capital additions (continuing operations)          10,475      6,371       5,532        3,242
Capital additions (total)                          10,475      6,371       5,532        3,242
Depreciation & amortization
  (continuing operations)                           5,639      5,004       3,906        2,621
Depreciation & amortization (total)                 5,639      5,004       3,906        2,621
Outstanding shares (000s)*                         10,437     10,244      10,208       10,092

</TABLE>
* Adjusted for three-for-two stock split in February 1998.


18

<PAGE>

SELECTED CONSOLIDATED FINANCIAL DATA (UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>

                                                                                                                  Five-Year Ten-Year
                                                                                                                  Compound  Compound
Years ended December 31                     1993      1992       1991     1990       1989       1988     1987      Growth    Growth
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                      <C>        <C>       <C>        <C>       <C>        <C>       <C>       <C>       <C>
OPERATIONS
Net sales                                  $99,295   $81,899    $70,934  $ 72,707    $70,154   $64,558    $57,068   +21%      +14%
Cost of sales                               65,716    54,271     45,536    47,478     46,377    42,044     37,995
Research and development expenditures        3,442     3,541      4,000     3,414      3,200     3,669      3,318
-----------------------------------------------------------------------------------------------------------------
Gross profit                                30,137    24,087     21,398    21,815     20,577    18,845     15,755   +16%      +12%
Selling, general and administrative
  expenses                                  18,558    15,646     13,550    14,427     13,186    11,965     10,671
Other operating expenses (income)              114       137      1,122       762       (263)      (27)        43
-----------------------------------------------------------------------------------------------------------------
Operating income                            11,465     8,304      6,726     6,626      7,654     6,907      5,041   +17%      +14%
Other expenses                                 388     1,228      2,118     1,504      1,244     1,301      1,519
-----------------------------------------------------------------------------------------------------------------
Pre-tax earnings (continuing operations)    11,077     7,076      4,608     5,122      6,410     5,606      3,522   +20%      +17%
Income taxes                                 4,193     2,498      1,688     2,022      2,506     2,100      1,613
-----------------------------------------------------------------------------------------------------------------
Earnings from continuing operations          6,884     4,578      2,920     3,100      3,904     3,506      1,909   +19%      +19%
Gain (loss) from discontinued operations         -       165     (2,492)  (12,306)    (2,744)   (1,020)      (217)
Use of net operating loss carryforward           -       273        395         -          -         -          -
-----------------------------------------------------------------------------------------------------------------
Net earnings (loss)                        $ 6,884   $ 5,016    $   823  $ (9,206)   $ 1,160   $ 2,486    $ 1,692   +17%      +21%
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------

Effective tax rate - continuing
  operations                                 37.9%     35.3%      36.6%     39.5%      39.1%     37.5%      45.8%
Return on sales - continuing operations       6.9%      5.6%       4.1%      4.3%       5.6%      5.4%       3.3%
Return on equity - continuing operations     20.8%     30.1%      39.6%     53.9%      26.5%     25.9%      16.5%
Return on equity - total                     20.8%     33.0%      11.2%   (160.2%)      7.9%     18.3%      14.6%
Weighted average shares (000s) - basic*      8,948     7,672      7,490     7,084      6,948     6,720      6,708

PER SHARE DATA*
Earnings from continuing operations -
  basic                                    $   .77   $   .60    $   .39  $    .44    $   .56   $   .52    $   .28   +12%      +14%
Net earnings (loss) - basic                    .77       .65        .11     (1.30)       .17       .37        .25   +10%      +16%
Cash dividends                                   -         -          -      .042       .083      .083       .083
Book value                                    3.49      1.88        .98       .80       2.13      2.02       1.73   +29%      +14%
Price/earnings ratio range - basic       10.1-20.1  3.4-13.0  21.2-44.0       N/A  23.0-34.9  9.5-14.6  13.2-22.5

OTHER DATA AT YEAR-END
Working capital                            $20,790   $10,740    $ 9,660  $  7,955    $14,444   $ 7,037    $11,870   +36%      +16%
Total assets                                53,000    38,488     36,575    41,408     48,082    42,948     37,984   +29%      +14%
Long-term debt                                 439     4,898     11,915    17,220     17,688    12,139     14,621
Stockholders' equity                        33,086    15,197      7,377     5,747     14,756    13,557     11,604   +36%      +20%
Current ratio                               2.28:1    1.72:1     1.71:1    1.49:1     2.08:1    1.45:1     2.17:1
Quick assets ratio                          1.32:1     .87:1      .76:1     .66:1      .84:1     .60:1     1.09:1
Liabilities to equity ratio                  .60:1    1.53:1     3.96:1    6.21:1     2.26:1    2.17:1     2.27:1
Capital additions (continuing operations     3,189     2,154      1,098     2,187      2,236     1,830      1,504
Capital additions (total)                    3,189     2,154      1,098     4,521      4,589     9,886      3,552
Depreciation & amortization
  (continuing operations)                    2,121     1,936      2,022     2,410      2,373     2,541      2,481
Depreciation & amortization (total)          2,121     1,936      2,022     3,511      3,185     2,834      2,531
Outstanding shares (000s)*                   9,493     8,075      7,497     7,185      6,942     6,717      6,707

</TABLE>

* Adjusted for three-for-two stock split in February 1998.

                                                                             19
<PAGE>

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


OVERVIEW
-------------------------------------------------------------------------------

Harmon's business has been on an upward trend for the past several years. It
continues to increase its sales with its principal customers, the Class I and
Short-Line Railroads. Demand for Harmon's purchasing, materials management,
pre-assembly and project management services is growing rapidly as these
services fill an increasing need in the railroad industry, which continues to
downsize and outsource functions it previously did internally. Because of
Harmon's advanced technology and service, Harmon now occupies a strong
position within the new construction portion of the rail transit market,
securing every domestic microprocessor-based signal and control contract
awarded since 1991, save one. Harmon's international operations are growing
rapidly as evidenced by a 234% gain in international sales to $17.5 million
in 1997 from $5.2 million in 1996.

     Harmon's growth has been aided also by acquisitions of businesses and/or
product lines that fit its core business. Last November it acquired
Devtronics, Inc., which makes recorders and remote maintenance monitoring
equipment that offer substantial savings to railroads. In 1997 it also
acquired a remaining majority interest in Vale-Harmon Enterprises, Ltd. (Vale
Harmon), a Canadian-based railroad sales and marketing company. In 1996
Harmon acquired United Kingdom-based Vaughan Systems Ltd. (since renamed
Vaughan Harmon Systems Ltd.). It was a strategic acquisition to increase
Harmon's sales in Europe. Vaughan Harmon Systems Ltd. designs signal and
control software and is a leading manufacturer of train describers, passenger
information and modular railway control systems, which complement Harmon's
existing product line. It has proved to be a most promising acquisition,
producing the bulk of Harmon's international sales and new orders last year.
Harmon also acquired two railroad contract-engineering firms in 1996, which
provided a significant gain in engineering resources. In 1995 Harmon acquired
the assets of Atlanta-based Serrmi Services, Inc. It provides signal design
engineering and wiring and highway grade crossing services to freight
railroads.


PROFILE OF CURRENT OPERATIONS
-------------------------------------------------------------------------------

The Company's sales are summarized by product category in the table on page
21. The table also breaks out gross sales and percentages of total sales for
each of the past three years. Sales of Harmon crossing and control products
by its asset management services operation are included in those separate
descriptive categories. The value-added services supplied with those products
are included in the asset management services category.

     TRAIN CONTROL SYSTEMS include products related to the control of train
movement. These include signal control track circuits (Electro Code);
interlocking control equipment such as Electro Logic, the Harmon Logic
Controller (hlc) and the Vital Harmon Logic Controller (vhlc); carborne
equipment (Ultra Cab); computer-based control systems; train describers; and
the design, wiring and installation of packages and systems comprised of these
products.

     CROSSING SYSTEMS include all products related to rail/highway crossing
warning systems. The products include train detection devices (the Company's
pmd and hxp, among others); flashing lights and cantilevers; and the design,
wiring and installation of packages and systems comprised of these products.

     ASSET MANAGEMENT SERVICES is a single-source, rapid delivery service of
railroad components for railroad customers. It involves warehousing commonly-
used parts and equipment that are manufactured by the Company and by other
vendors. Service functions continue to expand. They now include asset and
materials management, and kitting of various components, which are delivered as
a complete unit, ready for installation. Total project management was added in
1996 and has since grown rapidly.

     TRAIN INSPECTION SYSTEMS include products that monitor the condition of
trains when they pass a train inspection site, and the design, wiring and
installation of packages and systems comprised of these products. The hot box
detector is the principal product, which is installed beside the track to
detect overheating bearings in passing rail cars, a serious condition that
could lead to derailments. Other products include a sensor to identify high
or wide loads and a device that detects foreign objects being dragged under a
rail car.

     PRINTED WIRING BOARDS include production of customer designed printed
wiring boards for shipment to other electronics manufacturers.

     OTHER sales include communication equipment and products that do not fit
readily into the other five categories.


20
<PAGE>

SALES BY PRODUCT OR SERVICE FUNCTION*

<TABLE>
<CAPTION>
                                                           Years ended December 31,
                                              1997                   1996                    1995
                                      ------------------------------------------------------------------
     (Dollars in thousands)            Amount        %        Amount         %        Amount        %
     ---------------------------------------------------------------------------------------------------
     <S>                              <C>         <C>        <C>          <C>        <C>          <C>
     Train Control Systems            $101,624     47.4%     $ 87,080      47.3%     $ 55,437      40.7%
     Crossing Systems                   55,598     25.9%       48,927      26.6%       42,375      31.1%
     Asset Management Services          29,913     14.0%       22,217      12.1%       14,194      10.4%
     Train Inspection Systems           13,407      6.2%       12,906       7.0%       11,360       8.4%
     Printed Wiring Boards               5,772      2.7%        5,249       2.9%        6,752       5.0%
     Other                               8,113      3.8%        7,489       4.1%        5,999       4.4%
                                      ------------------------------------------------------------------
      Total                           $214,427    100.0%     $183,868     100.0%     $136,117     100.0%
     ---------------------------------------------------------------------------------------------------
</TABLE>

     * Sales volumes shown above are gross totals and do not include cash
       discounts or deferred contract revenue. As a result, there are
       differences between the amounts in this table and those presented in
       the Consolidated Statements of Earnings. The differences do not affect
       the validity of the discussion and analysis.


RESULTS OF OPERATIONS
-------------------------------------------------------------------------------

YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995.

Harmon achieved record sales and earnings in 1997. Net sales increased 22% to
a record $213.5 million compared with $175.4 million for 1996 and $136.8
million for 1995. Net earnings increased 17% to a record $11.0 million ($1.06
per share-diluted) compared with $9.3 million in 1996 ($0.91 per
share-diluted) and $6.9 million in 1995 ($0.67 per share-diluted). The
increase in earnings from 1996 to 1997 and from 1995 to 1996 was due chiefly
to substantially higher sales levels in 1997 and 1996. Return on equity was
15.7% for 1997 compared with 16.1% for 1996 and 14.0% for 1995. Return on
capital employed was 23.8% in 1997 compared with 25.9% in 1996 and 21.7% in
1995. The backlog at 1997 year-end was $75 million, an increase of 26% from
one year earlier.

SALES ANALYSIS. Throughout 1997, the railroad industry continued its move
toward the purchase of entire systems and away from the purchase of
individual components. This trend reflects the railroads' desires to fix
operational responsibility on one supplier and to place orders with large
suppliers, which have broad-based product lines, meaningful research and
engineering support, and strong service capabilities. This trend has played
to Harmon's strengths in 1997, wherein every product line experienced higher
sales. Sales of train control systems increased $14.5 million to $101.6
million; sales of crossing systems were up $6.7 million to $55.6 million;
sales of asset management services were up $7.7 million to $29.9 million; and
sales of train inspection systems, printed wiring boards and other
miscellaneous products each recorded gains in excess of $500,000. The
increase in train control system sales is chiefly the result of increased
orders from recently-merged railroad companies and continued strong sales of
Harmon's Ultra Cab units. The increase in crossing system sales primarily
reflects higher levels of business with recently-merged railroad companies.
The sales gain in asset management services reflects a continuation toward
outsourcing among domestic freight railroads, which enables them to complete
specific upgrade projects more quickly. Train inspection sales, which are
principally made to domestic railroads, increased 3.9% in 1997. Sales of
printed wiring boards were up 10%, which reversed the trend of the previous
year.

     Harmon's strengths in train control and crossing systems and asset
management services were the principal reasons its 1997 sales reached a
record $213.5 million, which was $38.1 million greater, or 21.7%, than those
of 1996. Net sales of $175.4 million in 1996 were 28.3% ahead of those of
1995. Incoming orders for 1997 were also a record at $228.6 million, which
despite record shipments that year, resulted in a backlog of $75 million.
Approximately 59% ($44 million) of the backlog was domestic freight related;
15% ($11 million) related to international business, chiefly in Great Britain
and Brazil, and 26% ($20 million) related to domestic rail transit. The rail
transit backlog increased by approximately $8 million in February, 1998,
following reception of the first phase of a $45 million communications-based
train control contract with BART, which involves the use of the
newly-acquired wireless data communication technology.


                                                                             21
<PAGE>

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


OPERATING SUMMARY

<TABLE>
                                         Percentage of Net Sales                 Percentage of Change
                                       ----------------------------          -----------------------------
                                         Years ended December 31,            1997       1996         1995
                                                                             over       over         over
                                        1997       1996       1995           1996       1995         1994
     --------------------------------------------------------------          -----------------------------
     <S>                               <C>        <C>        <C>             <C>       <C>         <C>
     Net sales                         100.0%     100.0%     100.0%          21.7%      28.3 %      14.3 %
     Cost of sales                      73.2%      72.4%      70.3%          23.0%      32.2 %      18.6 %
     Research and development            3.6%       3.6%       3.8%          21.1%      21.3 %      14.4 %
                                       ----------------------------          -----------------------------
     Gross profit                       23.2%      24.0%      25.9%          17.9%      18.7 %       4.0 %
     Selling, general
      and administrative expenses       14.2%      14.8%      17.0%          16.6%      12.0 %       9.6 %
     Other operating expenses, net       0.4%       0.3%       0.4%          77.2%      13.1 %     993.2 %
                                       ----------------------------          -----------------------------
     Operating income                    8.6%       8.9%       8.5%          18.0%      32.2 %      (8.6)%
     Other expenses                      0.4%       0.3%       0.4%          68.5%     (22.1)%     183.6 %
                                       ----------------------------          -----------------------------
     Earnings before income taxes        8.2%       8.6%       8.1%          16.4%      35.1 %     (11.9)%
     Income taxes                        3.1%       3.3%       3.1%          14.7%      34.5 %     (14.9)%
                                       ----------------------------          -----------------------------
     Net earnings                        5.1%       5.3%       5.0%          17.5%      35.5 %      (9.9)%
     --------------------------------------------------------------          -----------------------------
     --------------------------------------------------------------          -----------------------------
</TABLE>


     The table above illustrates the percentage relationship to net sales for
certain items reflected in the Company's Consolidated Statements of Earnings
and the percentage increase or decrease in the dollar amounts of such items
year-to-year.

     Sales of the Company's signal and control systems are influenced by
various factors. They include the financial condition of the railroad
industry, the railroads' budgets for planned equipment expenditures and the
level of activity in authorizing grade crossing warning system improvements.
These improvements receive up to 80% federal support, with an aggregate limit
of $160 million per year. Authorization for the current funding program
expires in March, 1998, and the Congress is presently working on an extension
of this funding. It is expected that appropriations will be authorized later
this year, and spending levels will be comparable for rail-highway crossing
warning systems and increased for rail transit projects.

     The market for the remainder of the Company's products is largely
dependent on the financial condition of the railroad industry, the trend of
the general economy, and individual railroads' budgets for capital
expenditures and repairs and maintenance. At year-end 1997, the freight
railroad industry was enjoying good market conditions with increased revenues
in most segments of their business, particularly intermodal traffic. Its
estimated 1998 capital expenditure budgets will be at or above 1997 levels.
The industry continues to look for ways to improve profits, which includes
the purchase of more efficient operating systems, the use of outsourced
services, and better utilization of current capital equipment. The industry
was also merger minded, which historically has reduced capital spending while
mergers were pending and increased spending after they were completed.

GROSS PROFIT. Gross profit as a percent of sales declined to 23.2% for 1997
compared with 24.0% for 1996 and 25.9% in 1995. The incremental declines in
1997 and 1996 reflect the shift away from individual product sales to those
of entire systems and outsourced services, both of which deliver
substantially higher sales but with reduced profit margins. For example, the
$40 million upgrade project, which commenced in 1997 for a Class I railroad,
added substantially to the sale of Harmon products and systems, but it also
contained sizable amounts of "pass-through" business, which provide only
modest profit margins. In addition, profit margins were under additional
pressure during the past two years because of capacity expansions in 1997 and
product upgrades in 1996.

     Traditionally, declining profit margins have negative connotations.
Harmon's experience is otherwise. Management's primary focus is on net
earnings, and less so on margins. It takes on additional lower margin
business when overall increased profits are likely to occur. Its asset
management service business illustrates this business concept. Standing
alone, it is a low margin, but profitable business. But when linked to
Harmon's total business strategy, it makes a healthy profit contribution
because its function begets additional sales of Harmon products and systems,
and it performs a service few others in the railroad industry can match.
Moreover, the Company is confident its service business will increase as the
railroads continue to outsource their asset management, maintenance and line
upgrade projects.


22
<PAGE>

RESEARCH AND DEVELOPMENT. Research and development expenditures increased
$1.3 million in 1997 following a $1.1 million increase in 1996, which
illustrates Harmon's ongoing commitment to incorporating new technology into
its products. The principal reasons for the increase in 1997 relate to
continued development of our Incremental Train Control System (ITCS),
development of next-generation products, and costs related to demonstrating
our Advanced Automatic Train Control (AATC) system in New York City to
several prospective buyers.

     Although R&D expenditures were up in absolute terms in 1997 and 1996, as
a percent of sales they remained the same at 3.6% because of the sales
increase in 1997. Expenditures in 1995 were 3.8%.

SELLING, GENERAL & ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses (SG&A) for 1997 were $30.3 million, roughly $4.3
million higher than those of 1996. The 1997 increase relates principally to
the 21.7% sales increase for 1997, which naturally generated more sales
expense and increased profit-based incentive compensation. While SG&A
expenses increased in absolute dollar terms last year their costs relative to
net sales declined for the fourth consecutive year--to 14.2% of sales from
14.8% in 1996, 17.0% in 1995 and 17.7% in 1994. This downward trend as a
percentage of net sales reflects improvements in cost controls and the fixed
nature of certain costs. The absolute increase in dollars each year basically
reflects the result of inflation, commissions incident to higher sales
volume, and additions to SG&A expenses incident to acquisitions made in 1997,
1996 and 1995. These expenses were offset somewhat in 1995 by lower
profit-based bonuses.

     Apart from higher SG&A expenses incurred due to higher sales in 1997,
certain other expenses (chiefly, costs related to employee recruiting as well
as legal and outside computer consulting services) approximated $1.5 million
last year, resulting in operating cost increases. Conversely, a $7.7 million
increase in service revenues in 1997 helped reduce SG&A expenses as a percent
of sales because the service operation incurs proportionally less SG&A
expenses per dollar of revenue than Harmon's other revenue producing
products. This illustrates the beneficial effect on profits when otherwise
low-margin business is added to an already profitable enterprise.

AMORTIZATION EXPENSES. Amortization expenses increased 18.7% from 1996 to
1997 and 7.3% from 1995 to 1996. The increases are the result of acquisitions
made during 1997 and 1996.

OTHER OPERATING EXPENSES. The increase in other operating expenses in 1997
reflects the Company's equity in the net loss of Vale Harmon prior to the
acquisition. Changes between 1996 and 1995 were insignificant.

INTEREST INCOME AND EXPENSE. Interest expense was $1,219,000 in 1997,
$724,000 in 1996 and $741,000 in 1995. The increase in 1997 was the result of
a January, 1997 private placement of $15 million in senior unsecured notes.
The decrease in 1996 reflected lower average borrowings in 1996 compared with
1995. Interest income was greater in 1997 than in the two previous years
because the proceeds from the private placement were invested during the
first half of 1997. During the second half of 1997, those same funds were
redeployed to support greater working capital needs and for capital expansion
programs to increase the Company's manufacturing capacity.

INCOME TAXES. The Company's effective income tax rate was 37.7% in 1997
compared with 38.2% in 1996 and 38.4% in 1995. The tax rate in 1997 was lower
because of United Kingdom net operating loss usage.


INFLATION
-------------------------------------------------------------------------------

Inflation has been modest in the past three years. Wage increases have been
about 4% in each of the past three years. Raw material cost increases were
about 3% in 1995 and 1996, and negligible in 1997. Competitive pressure has
required the Company to maintain or reduce sales prices to sustain market
share. Management believes that competitive pricing pressures will remain for
the foreseeable future. Its program to combat this is to continue to increase
productivity, adopt emerging lower-cost technological advances into its
products, expand its available products through internal development and
acquire products or companies in the railroad supply industry that will
expand Harmon's product or service offerings.

                                                                             23
<PAGE>

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


LIQUIDITY, CASH FLOW AND CAPITAL RESOURCES
-------------------------------------------------------------------------------

The Company concluded 1997 with a very strong balance sheet. Total assets
were $135.8 million, up $31.1 million. Stockholders' equity rose to $69.8
million ($6.68 per share) from $57.9 million ($5.66 per share). Working
capital was $50.3 million, which produced a current ratio of 2.09:1 compared
to 1.85:1 a year earlier. Interest-bearing debt was up $12.5 million. This
chiefly reflects a $15 million private debt placement of unsecured 10-year
senior notes, which Harmon completed in January, 1997. Cash was used to fund
capital expenditures of $10.5 million chiefly for plant expansions and
purchases of additional production equipment, increased receivables and
contract costs of $5.3 million (largely because of the $17.8 million sales
increase in the 1997 fourth quarter), and to support an $11.7 million
increase in year-end inventories, offset by cash provided by an increase in
trade payables of $5.2 million.

     At December 31, 1997, availability under the Company's primary bank
lines of credit amounted to $31 million, with no borrowings against it.
Capital expenditures for 1998 are budgeted at $14.5 million, roughly $4.0
million higher than the capital expenditures for 1997. Traditionally, the
Company spends less on capital expenditures than it actually budgets.

1998 OUTLOOK
-------------------------------------------------------------------------------

On balance, the outlook for 1998 is bright. The Company began 1998 with a
backlog of $74.5 million, up $15.1 million from its year earlier backlog of
$59.4 million. Its principal Class I railroad customers indicate they will
increase expenditures for capacity enhancements, which include purchases of
products, systems and services of a type that Harmon provides. Harmon's
recent addition of wireless radio technology for railroad application is
expected to be major factor in Harmon's future sales of its
communication-based automatic train control systems. Other positive factors
include: (1) continued upgrading and privatization of railroads in Mexico;
(2), a trend toward increased outsourcing among Class I railroads; (3),
greater sales opportunities internationally, particularly because of the
expanding business relationship between Harmon's British-based subsidiary
(Vaughan Harmon Systems Ltd.) and British Railtrack; (4), a sizable increase
in the number of bids expected to be let in 1998 by domestic rail transit
authorities; and (5), continuing mergers between Class I railroads, which
upon completion, generally lead to signal and train control upgrades across
the newly-combined systems.

     Despite the many positives for Harmon, there are two potential negatives
as well. The first relates to the potential for a heightened competitive
environment. The parent of a significant competitor was recently sold to a
European company, which is a world giant in railroad equipment and systems.
Another domestic railroad supplier has become a sizable force in railroading
in recent years, and there are rumors that the parent company of a third
railroad equipment supplier may be sold. The second issue relates to the fact
that the Congress has not yet authorized funds for rail-highway grade
crossing upgrades or rail-transit projects. What effect these factors will
have on Harmon is uncertain.

     The Company's goal is to achieve an annual order rate of approximately
$300 million by the year 2000. This goal is predicated upon maintaining our
current product and systems sales levels and increasing our service business
to the domestic freight railroad market. It also assumes we will book a
representative share of the mass transit projects that are presently
contemplated for release in 1998 and 1999, and that our aggressive pursuit of
business in the international market will result in material sales gains. It
does not depend on acquisitions. It should be recognized that these are
goals, not forecasts. Much depends on the future trends of domestic and
international economies, which are uncertain.


OTHER
-------------------------------------------------------------------------------

The Company streamlined its organizational structure during 1996, merging its
domestic operating subsidiaries into the parent company effective January 1,
1997. This realignment has improved customer service and streamlined overall
operations.

     There are no recently issued accounting pronouncements which have not
been implemented that would have a significant effect on the Company's
financial statements.


24
<PAGE>

YEAR 2000 ISSUE
-------------------------------------------------------------------------------

Management is presently conducting a formal Year 2000 survey with its
suppliers of critical inventory items. To date it has uncovered nothing
significant in its supply chain that would cause Harmon Year 2000 problems.
Simultaneously, management is conducting a review of its products that
contain imbedded software. Only small issues have been discovered, and
management expects to resolve these during 1998 at minimal cost. In addition,
the Company is in the midst of a multi-year project to upgrade its operating
systems, which includes a review of all its computer systems and applications
at all its locations to assess the impact of the Year 2000 date change. As
part of its overall systems upgrade to accommodate its recent and expected
future growth, Harmon has been working the past year to bring all its
information systems, including manufacturing controls, on line with a common
operating software. The Company has been advised that the new software, which
is expected to be implemented during 1998-1999, is Year 2000 compliant. The
cost to bring all the Company's operating systems onto one platform is
approximately $2.5 million.


FOURTH QUARTER RESULTS
-------------------------------------------------------------------------------

Sales for Harmon's 1997 fourth quarter were a record $73.8 million, 31.8%
greater than its 1996 fourth quarter sales of $56.0 million. Cost of sales as
a percentage of sales was 74.4% compared with 78.5% in 1996. The positive
difference between the two years reflects greater shipments of higher margin
products in 1997. In 1996, a sizable portion of Harmon's fourth quarter
revenues were comprised of asset management service billings, which carry
smaller markups than Harmon-manufactured goods and often include pass-through
business--products not manufactured by Harmon but which are purchased by
Harmon to complete a turnkey project.

     Net earnings for the 1997 fourth quarter were $3.9 million, or $0.37 per
share - diluted, compared with $2.1 million, or $0.20 per share - diluted,
for the 1996 fourth quarter.


QUARTERLY CONSOLIDATED STATEMENTS OF EARNINGS (UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
-------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                              1997                                             1996
Quarters ended             March 31    June 30   Sept. 30    Dec. 31         March 31    June 30   Sept. 30    Dec. 31
----------------------------------------------------------------------------------------------------------------------
<S>                        <C>         <C>       <C>        <C>              <C>         <C>       <C>         <C>
Net sales                   $35,988    $47,621    $56,125    $73,796          $38,397    $39,111    $41,957    $55,975
Cost of sales                26,196     33,607     41,512     54,909           27,224     26,141     29,721     43,911
R&D expenditures              1,602      1,809      1,758      2,496            1,458      1,726      1,492      1,656
                           -------------------------------------------------------------------------------------------
Gross profit                  8,190     12,205     12,855     16,391            9,715     11,244     10,744     10,408
Selling, general and
 administrative expenses      5,847      6,687      8,228      9,534            6,164      6,560      6,491      6,774
Amortization                    160        166        178        192              137        137        154        159
Miscellaneous (income)
 expense-net                    (23)       281         (4)        13              (16)       (14)       (14)         2
                           -------------------------------------------------------------------------------------------
Operating income              2,206      5,071      4,453      6,652            3,430      4,561      4,113      3,473
Investment income               138        176         67         41              169         29         28         25
Interest expense                124        428        333        334              255        234        123        112
                           -------------------------------------------------------------------------------------------
Pre-tax earnings              2,220      4,819      4,187      6,359            3,344      4,356      4,018      3,386
Income taxes                    772      1,832      1,548      2,470            1,269      1,699      1,530      1,278
                           -------------------------------------------------------------------------------------------
Net earnings                $ 1,448    $ 2,987    $ 2,639    $ 3,889          $ 2,075    $ 2,657    $ 2,488    $ 2,108
                           -------------------------------------------------------------------------------------------
                           -------------------------------------------------------------------------------------------
Earnings per common
 share-diluted              $  0.14    $  0.29    $  0.25    $  0.37          $  0.20    $  0.26    $  0.24    $  0.20
                           -------------------------------------------------------------------------------------------
                           -------------------------------------------------------------------------------------------
Weighted average
 shares-diluted (000s)       10,304     10,335     10,392     10,467           10,244     10,262     10,266     10,296
                           -------------------------------------------------------------------------------------------
                           -------------------------------------------------------------------------------------------
</TABLE>

Quarterly per share amounts may not add to annual amounts due to the timing
of net earnings and changes in common stock equivalents during each year.


STOCK SPLIT
-------------------------------------------------------------------------------

Effective February 27, 1998, the Company's common stock was split on a
three-for-two basis. Per share information included herein reflects the
effect of that stock split.


                                                                             25
<PAGE>

CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)


<TABLE>
<CAPTION>

At December 31,                                                                1997          1996
---------------------------------------------------------------------------------------------------
<S>                                                                          <C>           <C>
ASSETS
Current assets:
  Cash and cash equivalents                                                  $  6,748      $      -
  Trade receivables, less allowance for doubtful accounts
    of $318 in 1997 and $307 in 1996                                           45,001        39,656
  Costs and estimated earnings in excess of billings on
    uncompleted contracts (note 2)                                              2,850         1,665
  Inventories:
    Work in process                                                             6,171         4,145
    Raw materials and supplies                                                 32,894        23,076
                                                                             ----------------------
                                                                               39,065        27,221
  Deferred tax asset (note 4)                                                   2,215         1,637
  Prepaid expenses and other current assets                                       473         2,851
                                                                             ----------------------
    Total current assets                                                       96,352        73,030
                                                                             ----------------------

Property, plant and equipment, at cost (note 3):
  Land                                                                            465           356
  Buildings                                                                    11,363         9,010
  Machinery and equipment                                                      16,319        14,292
  Office furniture and equipment                                               20,671        16,032
  Transportation equipment                                                      1,393         1,236
  Leasehold improvements                                                        3,120         2,395
                                                                             ----------------------
                                                                               53,331        43,321
  Less accumulated depreciation and amortization                               29,302        25,389
                                                                             ----------------------
    Net property, plant and equipment                                          24,029        17,932

Deferred tax asset (note 4)                                                       414           738
Cost in excess of fair value of net assets acquired, net of accumulated
  amortization of $3,180 in 1997 and $2,483 in 1996 (note 11)                   8,766         7,606
Deferred compensation asset (note 6)                                            5,807         4,998
Other assets                                                                      401           373
                                                                             ----------------------
                                                                             $135,769      $104,677
                                                                             ----------------------
                                                                             ----------------------
</TABLE>


See accompanying notes to consolidated financial statements.

<PAGE>

<TABLE>
<CAPTION>

At December 31,                                                          1997       1996
------------------------------------------------------------------------------------------
<S>                                                                    <C>         <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Current debt installments (note 3)                                   $  1,162    $   737
  Accounts payable                                                       21,554     15,119
  Accrued payroll, bonus and employee
    benefit plan contributions (note 6)                                  11,893     10,892
  Billings in excess of costs and estimated earnings on
    uncompleted contracts (note 2)                                        5,677      5,926
  Other accrued liabilities                                               5,177      6,235
  Current tax liability                                                     566        492
                                                                       -------------------
      Total current liabilities                                          46,029     39,401
                                                                       -------------------

Deferred compensation liability (note 6)                                  4,522      3,925
Long-term debt (note 3)                                                  15,456      3,412
                                                                       -------------------
      Total liabilities                                                  66,007     46,738

Stockholders' equity (notes 3, 6, 7 and 11):
  Common stock of $.25 par value; authorized 20,000,000 shares,
    issued 10,437,369 shares in 1997 and 10,243,910 shares in 1996     $  2,609      2,561
  Additional paid-in capital                                             24,514     22,340
  Foreign currency translation                                              104        203
  Unearned compensation                                                    (224)         -
  Retained earnings                                                      42,759     32,835
                                                                       -------------------
      Total stockholders' equity                                         69,762     57,939

Commitments and contingencies (notes 6 and 10)


                                                                       -------------------
                                                                       $135,769   $104,677
                                                                       -------------------
                                                                       -------------------

</TABLE>
<PAGE>

CONSOLIDATED STATEMENTS OF EARNINGS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>

Years ended December 31,                                  1997           1996         1995
--------------------------------------------------------------------------------------------
<S>                                                     <C>           <C>           <C>
Net sales                                               $213,530       $175,440     $136,780
Cost of sales                                            156,224        126,997       96,094
Research and development expenditures                      7,664          6,331        5,218
                                                        ------------------------------------
      Gross profit                                        49,642         42,112       35,468
                                                        ------------------------------------

Selling, general and administrative expenses              30,298         25,990       23,200
Amortization of cost in excess of fair value
  of net assets acquired (note 11)                           697            587          547
Equity in net loss of affiliate (note 8)                     330              -            -
Miscellaneous income - net                                    63             43           66
                                                        ------------------------------------
      Operating income                                    18,380         15,578       11,787

Interest expense                                           1,219            724          741
Investment income                                            422            251          134
                                                        ------------------------------------
      Earnings before income taxes                        17,583         15,105       11,180

Income tax expense (benefit) (note 4):
  Current                                                  6,876          6,945        4,413
  Deferred                                                  (254)        (1,170)        (119)
                                                        ------------------------------------
                                                           6,622          5,775        4,294
                                                        ------------------------------------
      Net earnings                                      $ 10,961       $  9,330     $  6,886
                                                        ------------------------------------
                                                        ------------------------------------

Basic earnings per common share*                        $   1.06       $   0.91     $   0.68
Diluted earnings per common share*                      $   1.06       $   0.91     $   0.67
                                                        ------------------------------------
                                                        ------------------------------------

Weighted average shares used in computation (000s)*
  Basic earnings per common share                         10,313         10,217       10,187
  Diluted earnings per common share                       10,374         10,268       10,242
                                                        ------------------------------------
                                                        ------------------------------------

</TABLE>

* Adjusted for three-for-two stock split in February 1998.

See accompanying notes to consolidated financial statements.
<PAGE>

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
                                                     Additional     Foreign                                       Total
                                           Common     Paid-in       Currency        Unearned      Retained    Stockholders'
                                           Stock      Capital      Translation    Compensation    Earnings       Equity
---------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>       <C>           <C>            <C>             <C>         <C>
BALANCE AT DECEMBER 31, 1994*              $2,523      $21,878        $  -            $  -         $18,662        $43,063
Net earnings                                    -            -           -               -           6,886          6,886
Cash dividends paid ($0.10 per share)           -            -           -               -          (1,021)        (1,021)
Common stock issued (note 7):
  Stock options and other                      30          274           -               -               -            304
                                           --------------------------------------------------------------------------------

BALANCE AT DECEMBER 31, 1995*               2,553       22,152           -               -          24,527         49,232
Net earnings                                    -            -           -               -           9,330          9,330
Cash dividends paid ($0.10 per share)           -            -           -               -          (1,022)        (1,022)
Common stock issued (notes 7 and 11):
  Acquisitions of businesses                    6          144           -               -             -              150
  Stock options and other                       2           44           -               -             -               46
Foreign currency translation                    -            -         203               -             -              203
                                           --------------------------------------------------------------------------------

BALANCE AT DECEMBER 31, 1996*               2,561       22,340         203               -          32,835         57,939
Net earnings                                    -            -           -               -          10,961         10,961
Cash dividends paid ($0.10 per share)           -            -           -               -          (1,037)        (1,037)
Common stock issued (notes 6, 7 and 11):
  Acquisition of business                      23        1,337           -               -               -          1,360
  Deferred compensation                         6          355           -            (224)              -            137
  Stock options and other                      19          482           -               -               -            501
Foreign currency translation                    -            -         (99)              -               -            (99)
                                           --------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1997*              $2,609      $24,514        $104           $(224)        $42,759        $69,762
                                           --------------------------------------------------------------------------------
                                           --------------------------------------------------------------------------------

</TABLE>

* Adjusted for three-for-two stock split in February 1998.

See accompanying notes to consolidated financial statements.

<PAGE>

CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>

Years ended December 31,                                                        1997              1996                 1995
-----------------------------------------------------------------------------------------------------------------------------
<S>                                                                          <C>                <C>                  <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings                                                                 $  10,961          $  9,330             $  6,886
Adjustments to reconcile net earnings to net cash
 provided by (used in) operating activities:
 Depreciation and amortization                                                   5,639             5,004                3,906
 Loss (gain) on sale of property, plant and equipment                               45                (5)                 (34)
 Deferred tax expense (benefit)                                                   (254)           (1,170)                (119)
 Earned stock compensation                                                         137                 -                    -
 Equity in net loss of affiliate                                                   330                 -                    -
Changes in assets and liabilities, net of acquisitions of businesses:
 Trade receivables                                                              (3,900)          (13,740)              (3,860)
 Inventories                                                                   (11,677)           (1,060)              (7,830)
 Estimated costs, earnings and billings on contracts                            (1,371)            7,381               (2,873)
 Prepaid expenses and other current assets                                       2,454              (360)                 131
 Accounts payable                                                                5,209             3,345                3,052
 Accrued payroll and benefits                                                      911             4,000                 (651)
 Other liabilities                                                               (995)             5,007                 (478)
 Other deferred liabilities                                                        597               371                  157
                                                                             ----------         ---------            ---------
  Total adjustments                                                             (2,875)            8,773               (8,599)
                                                                             ----------         ---------            ---------
   Net cash provided by (used in) operating activities                           8,086            18,103               (1,713)
                                                                             ----------         ---------            ---------

CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures                                                           (10,475)           (6,371)              (5,532)
Acquisitions of businesses                                                        (196)           (2,146)              (1,182)
Proceeds from sale of property, plant and equipment                                 29                46                   84
Deferred compensation, net                                                        (809)           (1,339)                (429)
Other investing activities                                                        (358)            1,584                 (974)
                                                                             ----------         ---------            ---------
   Net cash used in investing activities                                       (11,809)           (8,226)              (8,033)
                                                                             ----------         ---------            ---------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock                                             501                46                  292
Cash dividends                                                                  (1,037)           (1,022)              (1,021)
Proceeds from issuance of long-term debt                                        15,000                 -                    -
Borrowings under line of credit agreements                                      52,370            46,530               31,152
Repayments under line of credit agreements                                     (55,293)          (55,165)             (20,491)
Principal payments of long-term debt                                              (971)             (469)                (436)
                                                                             ----------         ---------            ---------
   Net cash provided by (used in) financing activities                          10,570           (10,080)               9,496
Foreign currency translation                                                       (99)              203                    -
Net increase (decrease) in cash and cash equivalents                             6,748                 -                 (250)
                                                                             ----------         ---------            ---------
Cash and cash equivalents at beginning of year                                       -                 -                  250
                                                                             ----------         ---------            ---------
Cash and cash equivalents at end of year                                     $   6,748          $      -             $      -
                                                                             ----------         ---------            ---------
                                                                             ----------         ---------            ---------

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
 Interest                                                                    $     884          $    690             $    661
 Income taxes                                                                $   6,635          $  6,019             $  4,167

</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES
------------------------------------------------------------------------------

PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION.  The consolidated
financial statements of the Company include the accounts of Harmon Industries,
Inc., and its wholly-owned subsidiaries, Vaughan Harmon Systems Limited
(Vaughan Harmon), Vale-Harmon Enterprises, Ltd. (Vale Harmon), Devtronics, Inc.
(Devtronics) and Harmon Railway Systems International (HRSI). Effective January
1, 1997 the Company's former subsidiaries Harmon Electronics, Inc. (HEI),
Electro Pneumatic Corporation (EPC) and Consolidated Asset Management Company,
Inc. (CAMCO), were merged with and into Harmon Industries, Inc. such that
Harmon Industries was the surviving corporation.

     Significant intercompany accounts and transactions have been eliminated
in consolidation. Management of the Company has made estimates and
assumptions relating to the reporting of assets and liabilities and
disclosure of contingent liabilities to prepare these financial statements in
conformity with generally accepted accounting principles. Actual results
could differ from those estimates.

NATURE OF BUSINESS.  The Company is a major supplier of signal and train
control products to railroads throughout North America and the world. It
manufactures an extensive line of railroad signal and communication
equipment, traffic control systems, rail/highway grade crossing hardware and
related components. The Company also provides a single-source, rapid delivery
service for urgently needed railroad components by warehousing commonly-used
parts and equipment, which are manufactured both by Harmon and other vendors.

INVENTORY VALUATION.  Inventories are valued primarily at the lower of cost
(first-in, first-out) or market (net realizable value). The components of cost
are labor, materials and an allocation of manufacturing overhead.

PROPERTY, PLANT AND EQUIPMENT.  Buildings, machinery and equipment, office
furniture and equipment, transportation equipment and leasehold improvements
are being depreciated or amortized using the straight-line method over the
estimated useful lives of the assets, which range from two to thirty-three
years. Maintenance and repairs are charged to operations as incurred. Renewals
and betterments are capitalized as additions to the appropriate asset accounts.
Upon sale or retirement of assets, the cost and related accumulated
depreciation applicable to such assets are removed from the accounts, and any
resulting gain or loss is reflected in operations.

INCOME TAXES.  Income taxes are accounted for in accordance with Statement of
Financial Accounting Standards No. 109, Accounting for Income Taxes. Under the
asset and liability method of Statement 109, deferred tax assets and
liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.

LONG-TERM CONTRACTS.  Profits on long-term contracts are recorded on the basis
of the Company's estimates of the percentage of completion of individual
contracts. That portion of the total contract price is accrued which is
allocable, on the basis of the Company's engineering estimates of the
percentage of completion, to contract expenditures incurred. Profits are not
recorded during the start-up phase of the contract. All losses are recognized
in the period during which they become evident.

COST IN EXCESS OF FAIR VALUE OF NET ASSETS ACQUIRED.  Cost in excess of the fair
value of net assets acquired is amortized on a straight-line basis generally
over five to fifteen years. The Company assesses the recoverability and
measures impairment, if any, of such cost by determining whether the
amortization of the cost in excess of the fair value of net assets acquired
over its remaining life can be recovered through undiscounted future operating
cash flows.

STATEMENT OF CASH FLOWS.  For purposes of the statement of cash flows, the
Company considers all investments purchased with a maturity of three months or
less to be cash equivalents.

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

RESEARCH AND DEVELOPMENT.  Costs incurred in the creation of new products or in
changing existing products are charged to expense as incurred.

STOCK SPLIT.  On February 3, 1998, the Company declared a three-for-two stock
split, payable on February 27, 1998 in the form of a stock dividend to
stockholders of record on February 13, 1998. Share and per share data for all
periods presented have been adjusted to give retroactive effect to this stock
split.

EARNINGS PER COMMON SHARE.  Prior to December 31, 1997 the Company computed
earnings per share (EPS) in accordance with the provisions of Accounting
Principles Board ("APB") Opinion No. 15, Earnings per Share and related
interpretations. As such, primary earnings per common share was based on the
weighted average number of common shares outstanding, giving effect to common
stock equivalents (stock options), if dilutive. On December 31, 1997 the
Company adopted SFAS No. 128, Earnings per Share, which replaces the
presentation of primary and fully diluted EPS with a presentation of basic and
diluted EPS. Previously reported EPS information has been restated to reflect
the adoption of SFAS No. 128.

     Basic EPS excludes dilution and is computed by dividing income available to
common stockholders by the weighted-average number of common shares outstanding
for the period. Diluted EPS reflects the potential dilution that could occur if
securities or other contracts to issue stock were exercised or converted into
common stock or resulted in the issuance of common stock that then shared in
the earnings of the entity.

     For the years ended December 31, 1997, 1996 and 1995 there are no
differences between the numerator used in computing basic and diluted
earnings per share which represents the net earnings of the Company. For the
years ended December 31, 1997, 1996 and 1995 the denominator used in
computing basic earnings per share represents the weighted average number of
common shares outstanding (10,319,000 shares-1997, 10,217,000 shares-1996,
10,187,000 shares-1995), reduced, in the case of 1997, by the weighted
average number of shares of nonvested stock (6,000 shares) issued pursuant to
employee benefit plans. The denominator used in computing diluted earnings
per share represents the weighted average number of common shares outstanding
used for purposes of the basic earnings per share computation (10,313,000
shares-1997, 10,217,000 shares-1996, 10,187,000 shares-1995) increased to
reflect the potential dilution under the treasury stock method of the
outstanding stock options and nonvested stock under the Company's employee
benefit plans and stock option programs (61,000 shares-1997, 51,000
shares-1996, 55,000 shares-1995).

FAIR VALUE OF FINANCIAL INSTRUMENTS.  Estimates of fair values are subjective in
nature and involve uncertainties and matters of significant judgment and
therefore cannot be determined with precision. Changes in assumptions could
affect the estimates. The fair market value of the Company's financial
instruments approximates the carrying value.

STOCK OPTION PLANS.  Prior to January 1, 1996 the Company accounted for its
stock option plan in accordance with the provisions of Accounting Principles
Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. As such, compensation expense would be recorded on the
date of grant only if the current market price of underlying stock exceeded the
exercise price. On January 1, 1996, the Company adopted SFAS No. 123,
Accounting for Stock-Based Compensation, which permits entities to recognize as
expense over the vesting period the fair value of all stock-based awards on the
date of grant. Alternatively, SFAS No. 123 also allows entities to continue to
apply the provisions of APB Opinion No. 25 and provide pro forma net income and
pro forma earnings per share disclosures for employee stock option grants made
in 1995 and subsequent years as if the fair-value-based method defined in SFAS
No. 123 had been applied. The Company has elected to continue to apply the
provisions of APB Opinion No. 25 and provide the pro forma disclosure
provisions of SFAS No. 123.

ENVIRONMENTAL REMEDIATION LIABILITIES.  In October 1996 the American Institute
of Certified Public Accountants issued Statement of Position ("SOP") 96-1,
Environmental Remediation Liabilities. SOP 96-1 was adopted by the Company on
January 1, 1997 and requires, among other things, environmental remediation
liabilities to be accrued when the criteria of SFAS No. 5, Accounting for
Contingencies, have been met. The guidance provided by the SOP is consistent
with the Company's current method of accounting for environmental remediation
costs and, therefore, adoption of this new Statement did not have a material
impact on the Company's financial position or results of operations.

<PAGE>

NOTE 2. CONTRACTS IN PROGRESS
-------------------------------------------------------------------------------

Contract costs on uncompleted contracts are as follows:

<TABLE>
<CAPTION>
                                      Costs and    Billings in
                                      estimated     excess of
                                       earnings     costs and
                                      in excess     estimated
     (Dollars in thousands)          of billings    earnings       Total
     ---------------------------------------------------------------------
     <S>                             <C>           <C>           <C>
     December 31, 1997:
     Costs and estimated earnings       $13,850     $110,836     $124,686
     Billings                            11,000      116,513      127,513
                                     -------------------------------------
                                        $ 2,850     $ (5,677)    $ (2,827)
                                     -------------------------------------
                                     -------------------------------------
     December 31, 1996:
     Costs and estimated earnings       $ 7,796     $ 73,397     $ 81,193
     Billings                             6,131       79,323       85,454
                                     -------------------------------------
                                        $ 1,665     $ (5,926)    $ (4,261)
                                     -------------------------------------
                                     -------------------------------------
</TABLE>

Balances billed, but not paid by customers under retainage provisions in
contracts amounted to $798,000 and $1,165,000 at December 31, 1997 and 1996,
respectively. All receivables on contracts in progress are considered to be
collectible within twelve months.


NOTE 3. INDEBTEDNESS
-------------------------------------------------------------------------------

<TABLE>
<CAPTION>

     (Dollars in thousands)                           1997          1996
     --------------------------------------------------------------------
     <S>                                             <C>           <C>
     Revolving credit agreements                     $     -       $2,826
     Senior unsecured notes payable                   15,000            -
     Lines of credit                                     583            -
     Bank loans                                          336          273
     Note payable                                          -          198
     Capitalized lease obligations                       699          852
                                                     --------------------
       Total indebtedness                             16,618        4,149
     Less current installments                         1,162          737
                                                     --------------------
       Long-term debt                                $15,456       $3,412
                                                     --------------------
                                                     --------------------
</TABLE>


REVOLVING CREDIT AGREEMENTS. The Company has an unsecured $20,000,000
revolving credit agreement which expires August 1999. At December 31, 1997,
there are no outstanding borrowings. Outstanding borrowings bear interest at
a base rate established by the bank plus a variable component depending on
the Company's funded debt to capitalization percentage and fixed charges
coverage ratio.

     The Company has an unsecured reducing revolving credit agreement with
original total credit availability of $15,000,000 reducing by $536,000 as of
the last day of each quarter beginning September 30, 1996. The Company has
remaining total credit availability of $11,784,000 at December 31, 1997
against which there are no outstanding borrowings at December 31, 1997.
Outstanding borrowings are due on August 15, 2001 and bear interest at a base
rate established by the bank plus a variable component depending on the
Company's funded debt to capitalization percentage and fixed charges coverage
ratio.  The Company pays commitment fees of 110 of 1% annually on the unused
portion of the revolving credit agreements.

SENIOR UNSECURED NOTES PAYABLE. On January 24, 1997 the Company issued
$15,000,000 of senior unsecured notes. The notes bear interest at 6.87% and
are payable in equal annual installments of $2,142,857 commencing in 2001
with the final payment due in 2007.


<PAGE>

LINES OF CREDIT. A subsidiary company has a line of credit with total
availability of $457,000 against which there are outstanding borrowings of
$457,000 at December 31, 1997. The line of credit does not have a stated
expiration date as all amounts are payable upon demand of the lender and
accordingly the entire balance outstanding has been classified as current in
the Consolidated Balance Sheets. The line of credit bears interest at the
lender's prime lending rate plus 1% (6.5% at December 31, 1997), payable
monthly. The line of credit is collateralized by liens against certain real
and personal property.

     A subsidiary company has a line of credit with total availability of
$500,000 against which there are outstanding borrowings of $126,000 at
December 31, 1997. The line of credit expires May 29, 2001. All amounts are
payable upon demand, and if not sooner demanded, May 29, 2001 and accordingly
the entire balance outstanding has been classified as current in the
Consolidated Balance Sheets. The line of credit bears interest at the prime
interest rate as published in the Wall Street Journal rate plus 1% (9.5% at
December 31, 1997), adjusted and payable monthly. The line of credit is
collateralized by liens against certain personal property.

BANK LOANS. A subsidiary company has a $211,000 bank loan which is a term note
payable in monthly installments including interest through April 2002. The note
bears interest at a base rate established by the bank plus 2.1% (9.3% at
December 31, 1997). The note is collateralized by liens against certain real
and personal property.

     A subsidiary company has a $125,000 bank loan which is a term note
payable in monthly installments including interest through December, 2000.
The note bears interest at a base rate established by the bank plus 3.0%
(11.00% at December 31, 1997). The note is collateralized by liens against
certain real and personal property.

CAPITALIZED LEASE OBLIGATIONS. The Company entered into various computer
hardware and software capital lease agreements totaling $312,000 and $330,000
in 1997 and 1996, respectively. Monthly installments are due through
November, 2000. The implied interest rates in the lease agreements range from
7.0% to 9.0%.

COVENANTS. The various indebtedness agreements contain, among other things,
covenants relating to: maintenance of certain levels of consolidated net
worth and limitations of total liabilities; maintenance of certain ratios of
debt to equity and current assets to current liabilities; and certain
limitations on the payment of cash dividends. At December 31, 1997, the
Company is in compliance with all covenants under its indebtedness agreements
and has retained earnings available for dividends of $8,087,000.

MATURITIES. At December 31, 1997, long-term debt maturities for 1998 and
thereafter are:


<TABLE>
<CAPTION>

     Years ended December 31          (Dollars in thousands)
     -------------------------------------------------------
     <S>                                             <C>
     1998                                            $ 1,162
     1999                                                212
     2000                                                180
     2001                                              2,192
     2002 and thereafter                              12,872
                                                     -------
                                                     $16,618
                                                     -------
                                                     -------
</TABLE>


<PAGE>

NOTE 4. INCOME TAXES
-------------------------------------------------------------------------------

     Income tax expense consisted of the following:

     <TABLE>
     <CAPTION>

     (Dollars in thousands)                     1997       1996       1995
     ------------------------------------------------------------------------
     <S>                                       <C>        <C>         <C>
     Current:
       Federal                                 $4,992     $ 5,741     $3,664
       Foreign                                  1,002           -          -
       State                                      882       1,204        749
                                               ------------------------------
         Total current                          6,876       6,945      4,413

     Deferred:
       Federal                                   (223)       (976)       (99)
       State                                      (31)       (194)       (20)
                                               ------------------------------
         Total deferred                          (254)     (1,170)      (119)
                                               ------------------------------
         Total income tax expense              $6,622     $ 5,775     $4,294
                                               ------------------------------
                                               ------------------------------
</TABLE>

Income tax expense for the years ended December 31, 1997, 1996, and 1995,
respectively, differed from the amounts computed by applying the U.S. federal
income tax rate of 35 percent to pretax income as a result of the following:

     <TABLE>
     <CAPTION>

     (Dollars in thousands)                     1997       1996       1995
     ------------------------------------------------------------------------
     <S>                                       <C>        <C>         <C>
     Computed expected tax expense             $6,154     $5,287      $3,913
     Increase (reduction) in income
       taxes resulting from:
        State and local income taxes, net of
          federal income tax benefit              553        657         473
        Other, net                                (85)      (169)        (92)
                                               ------------------------------
                                               $6,622     $5,775      $4,294
                                               ------------------------------
                                               ------------------------------
</TABLE>

The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at December
31, 1997 and 1996 are presented below:

     <TABLE>
     <CAPTION>

     (Dollars in thousands)                                1997       1996
     ------------------------------------------------------------------------
     <S>                                                 <C>          <C>
     Deferred tax assets:
       Deferred compensation                             $ 1,805      $1,531
       Compensated absences                                  425         353
       Inventories                                           481         490
       Allowance for doubtful accounts                       117         120
       Various other reserves                              1,561       1,043
                                                         --------------------
         Total gross deferred tax assets                   4,389       3,537
         Less valuation allowance                            369         369
                                                         --------------------
                                                           4,020       3,168
      Deferred tax liabilities:
        Plant and equipment                               (1,391)       (793)
                                                         --------------------
        Net deferred tax assets                          $ 2,629      $2,375
                                                         --------------------
                                                         --------------------
</TABLE>


There were no net changes in the total valuation allowance for the years
ended December 31, 1997 and 1996. Management believes it is more likely than
not that the results of future operations will generate sufficient taxable
income to realize the deferred tax assets as reduced by the valuation
allowance.

     During 1995, the Internal Revenue Service completed examinations of the
Company's federal income tax returns for the years ended December 31, 1992,
1993 and 1994. The results of the examinations did not have a material effect
on the Company's financial statements.

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. BUSINESS SEGMENT INFORMATION
-------------------------------------------------------------------------------

The Company and its subsidiaries operate in one reportable segment of railroad
electronics and related products.

     Two customers accounted for net sales of approximately $66,340,000 and
$17,406,000 for the year ended December 31, 1997, net sales of approximately
$77,302,000 and $16,126,000 for the year ended December 31, 1996 and net sales
of approximately $19,091,000 and $15,532,000 for the year ended December 31,
1995. At December 31, 1997, the Company had significant receivable balances
from five customers totaling approximately $18,360,000. The Company has no
other unusual credit risks or concentrations.


NOTE 6. COMMITMENTS
-------------------------------------------------------------------------------

The Company has also entered into various operating lease arrangements covering
the use of manufacturing facilities, administrative offices and equipment.
Rental expense related to these leases amounted to $2,122,000, $1,661,000 and
$1,581,000 for the years ended December 31, 1997, 1996 and 1995, respectively.

     A summary of non-cancelable long-term operating lease commitments follows
(Dollars in thousands):

<TABLE>
<CAPTION>
                                              Real          Total
    Years ended December 31,  Equipment     property     commitments
    ----------------------------------------------------------------
    <S>                       <C>           <C>          <C>
    1998                       $  11         $  752        $  763
    1999                           4            689           693
    2000                           -            498           498
    2001                           -            341           341

</TABLE>

It is expected that in the normal course of business, leases that expire will
be renewed or replaced by leases on other properties; thus, it is anticipated
that future minimum lease commitments will not be less than the amounts shown
for 1998.

EMPLOYEE BENEFITS.  In 1985, the Company formed an Employee Stock Ownership Plan
and Trust (ESOP), which includes all employees. The ESOP held 746,358 shares
and 755,246 shares of Company common stock which had been allocated to plan
participants at December 31, 1997 and 1996, respectively. Company contributions
to the ESOP are normally based on a percentage of pretax earnings. Dividends on
common shares held by the ESOP are reflected as a reduction in retained
earnings.

     ESOP contributions charged to operating expense were $3,874,000, $3,815,000
and $2,785,000 for the years ended December 31, 1997, 1996 and 1995,
respectively.

     The Company and its subsidiaries have various bonus plans based primarily
on Company performance. Accrued and unpaid bonuses at December 31, 1997 and 1996
were $2,776,000 and $2,505,000, respectively.

     The Company has a nonqualified, unfunded deferred compensation plan for
certain key executives providing for payments upon retirement, death or
disability. Under the plan, certain employees receive retirement payments equal
to a portion of the three highest continuous years' average compensation. These
payments are to be made for the remainder of the employees' life with a minimum
payment of ten years' benefits to either the employee or his or her
beneficiary. The plan also provides for reduced benefits upon early retirement,
disability or termination of employment. The cost (gain) related to this plan
was $573,000, $(365,000) and $491,000 for the years ended December 31, 1997,
1996 and 1995, respectively.

     In 1997 the Company established a nonqualified, unfunded deferred
compensation plan for certain key executives providing for payments upon
termination, retirement, death or disability. This plan is available to new
officers of the Company in lieu of participation in the plan described above.
Under the plan, contributions are based on a formula which is expected to
result in a target benefit for the participant and vest on a graded basis. The
amount of a participant's benefit is based solely on the participant's vested
account balance except in the case of death prior to termination in which case
the participant's

<PAGE>

benefit is the greater of the participant's vested account balance or the
lesser of eight times the participant's base annual compensation which would
have been paid for the calendar year of death or $1,400,000. Plan
contributions are made in the form of stock and cash to a grantor trust. The
cost related to this plan was $27,000 in 1997.

     In 1997 the Company also established a supplemental executive retirement
plan which is a nonqualified, unfunded deferred compensation plan for certain
key employees providing for payments upon termination, retirement, death or
disability. This plan is available to key employees of the Company exclusive
of members of the Executive staff. Under the plan Company contributions equal
to three percent of each participant's annual compensation are made if the
Company's earnings per share are at least 75% of the Company's earnings per
share for the prior calendar year with such contributions vesting on a graded
basis. The plan also allows for participant deferrals of compensation and
bonus awards to be contributed to the plan. The amount of a participant's
benefit is based solely on the participant's vested account balance. Plan
contributions are made in the form of cash to a grantor trust. The cost
related to the plan was $108,000 in 1997.

     The Company also has employment agreements with certain key executives.
Under the terms of these agreements the Company contributed 24,150 shares of
common stock of the Company to a grantor trust. Stock prices as of the dates
of grant ranged from $13.92 to $16.50. These contributions vest on a graded
basis with the unvested portion shown in the Consolidated Balance Sheets and
Statements of Stockholders' Equity as "Unearned Compensation".

     The Company has recorded the assets and liabilities for the deferred
compensation plans and employment agreements at gross amounts in the
Consolidated Balance Sheets because such assets and liabilities belong to the
Company.

     The Company does not provide other post-retirement benefits.

NOTE 7. STOCKHOLDERS' EQUITY
-------------------------------------------------------------------------------

Share and per share information reflected herein has been adjusted for the
three-for-two stock split in February 1998.

     A summary of stock options granted, exercised and expired follows:

<TABLE>
<CAPTION>
                                   Shares       Price Per Share
-------------------------------------------------------------------------------
<S>                              <C>            <C>
Balance at January 1, 1995         284,475      $ 6.96       Average Price
Granted                             42,000        9.33-11.83
Exercised                         (124,725)       2.59-8.92
Expired                            (15,000)       8.92
Balance at December 31, 1995       186,750       10.13       Average Price

Granted                            151,500        9.00-11.33
Exercised                           (9,000)       3.67-5.50
Expired                            (38,250)      11.00-13.75
Balance at December 31, 1996       291,000        9.79       Average Price

Granted                            132,000       12.17-13.00
Exercised                          (76,253)       3.67-13.75
Expired                            (35,647)      11.00-13.75
BALANCE AT DECEMBER 31, 1997       311,100      $11.51       AVERAGE PRICE

</TABLE>

The Company has outstanding stock options for 311,100 shares of common stock at
prices ranging from $9.33 to $15.17 with a weighted-average remaining
contractual life of 4.7 years of which 181,320 shares are exercisable as of
December 31, 1997. In May 1997 the Company granted stock options for up to
1,500 common shares to each of the

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Company's nine non-employee directors which expire on May 31, 2004. In May
1996 the Company granted stock options for up to 1,500 common shares to each
of the Company's nine non-employee directors which expire on May 31, 2003. In
May 1995, the Company granted stock options for up to 3,000 common shares to
each of the Company's eleven directors which were exercisable through May 31,
1997.

     The Company issued 92,307 shares of unregistered common stock in connection
with a 1997 acquisition (See Note 11). The Company issued 26,471 shares of
unregistered common stock in connection with the 1996 acquisitions of
businesses (See Note 11).


NOTE 8. AFFILIATES
-------------------------------------------------------------------------------

The Company has an investment of 20% in an unconsolidated affiliate which is
accounted for under the equity method. Equity in earnings (losses) of this
affiliate was not significant for the years ended December 31, 1997, 1996 and
1995. The Company had sales to this related entity totaling $253,000, $559,000
and $934,000 for 1997, 1996 and 1995, respectively. The Company had receivables
due from this entity of $69,000 and $144,000 as of December 31, 1997 and 1996,
respectively.

    As of December 31, 1996 the Company also had an investment of 38% in a
formerly unconsolidated affiliate, Vale Harmon, which was accounted for under
the equity method. During 1997 the Company acquired the remaining interest in
this subsidiary company (See note 11). Equity in losses of this affiliate prior
to acquisition amounted to $330,000 in 1997. Equity in earnings (losses) of
this affiliate was not significant for the years ended December 31, 1996 and
1995. The Company had sales to this related entity totaling $27,000 in 1997
prior to acquisition and $282,000 and $543,000 in 1996 and 1995, respectively.
The Company had receivables due from this entity of $79,000 as of December 31,
1996.


NOTE 9. OTHER FINANCIAL INFORMATION
-------------------------------------------------------------------------------

The Company has classified certain environmental compliance expenses as cost of
sales in the accompanying statements of operations. These expenses amounted to
$150,000, $283,000 and $215,000 for the years ended December 31, 1997, 1996 and
1995, respectively.


NOTE 10. LITIGATION
-------------------------------------------------------------------------------

ENVIRONMENTAL MATTER.  On September 30, 1991, the United States Environmental
Protection Agency (EPA) issued a complaint against the Company alleging
violations of the Resource Conservation and Recovery Act (RCRA) and RCRA
regulations in the disposal of solvents at the Company's Grain Valley,
Missouri, plant. The complaint sought penalties in the amount of $2,344,000 and
proposed certain compliance actions. In January 1994 the administrative hearing
on the penalty assessment was heard. The decision from that hearing reduced the
penalties to $586,000. On January 9, 1995 the Company filed a Notice of Appeal
of the initial decision with the Environmental Appeals Board (EAB) and on May
1, 1996, the EAB heard oral arguments. The EAB ruled and affirmed the penalty
of the administrative law judge. On June 6, 1997 the Company filed a complaint
in the Federal District Court for the Western District of Missouri seeking
judicial review of the EAB's decision.

    Based on the Company's cooperation with the Missouri Department of Natural
Resources (MDNR), which had the original jurisdiction of the matters complained
by the EPA, in voluntarily disclosing the alleged violations and in promptly
undertaking all remedial actions specified by the MDNR, the penalties appear to
the Company's legal counsel to be excessive. However, because so few cases have
been disposed of by settlement, or by administrative or judicial proceedings
since the new penalty guidelines were adopted, legal counsel cannot express an
opinion as to the ultimate amount, if any, of the Company's liability.

<PAGE>

    The Company has recorded a total of $2,382,000 of environmental compliance
expenses to date relating to this matter. The Company has recorded a liability
for its best estimates of the costs to be incurred relative to the compliance
actions in other accrued liabilities. Since the amount of the penalty cannot be
reasonably determined at this time, no liability has been accrued in the
financial statements.

OTHER LITIGATION.  The Company has been named as a defendant in several other
lawsuits in the normal course of its business. In the opinion of management,
after consulting with legal counsel, the liabilities, if any, resulting from
these matters will not have a material effect on the consolidated financial
statements of the Company.


NOTE 11. ACQUISITIONS OF BUSINESSES
-------------------------------------------------------------------------------

On November 10, 1997 the Company acquired the stock of a railroad industry
equipment and services supplier. This acquisition was made with the issuance of
92,307 (post-split) shares of unregistered common stock valued at $14.73 (post-
split) per share. This acquisition has been accounted for by the purchase
method of accounting and accordingly, the operating results have been included
in the Company's consolidated results of operations from the date of
acquisition. The excess of the consideration given over the fair value of net
assets acquired has been recorded as goodwill of $591,000.

    On June 12, 1997 the Company acquired the remaining 62% of the outstanding
stock of Vale Harmon for $167,000 in cash. Prior to this transaction the
Company held a 38% ownership interest in Vale Harmon and accounted for the
investment under the equity method. This acquisition has been accounted for by
the purchase method of accounting and accordingly, the operating results have
been included in the Company's consolidated results of operations from the date
of acquisition. The excess of the consideration given over the fair value of
net assets acquired has been recorded as goodwill of $1,083,000.

    The pro forma effects of the 1997 acquisitions on the consolidated financial
statements are not significant.

    On July 1, 1996 the Company acquired the stock of Vaughan Systems Limited
for an initial purchase price of $2,003,000 in cash. In addition to the
initial purchase price, the purchase agreement provides for contingent
payments. These payments are based on the average after-tax earnings of
Vaughan Harmon over the three year period ending June 30, 1999 as well as the
utilization of certain tax net operating loss carryforwards. Any additional
consideration paid will be recorded as goodwill. The acquisition has been
accounted for by the purchase method of accounting and accordingly, the
operating results have been included in the Company's consolidated results of
operations from the date of acquisition. The excess of the cash paid over the
fair value of net assets acquired has been recorded as goodwill of $156,000.
In 1997 the Company recorded an additional $131,000 in goodwill relating to
the use of certain tax net operating loss carryforwards.

    In 1996 the Company acquired the assets of two contract engineering firms.
These acquisitions were made with the issuance of 26,201 (post-split) shares of
unregistered common stock valued at $5.67 (post-split) per share, a $198,000
note payable and $145,000 in cash. These acquisitions have been accounted for
by the purchase method of accounting and accordingly, the operating results
have been included in the Company's consolidated results of operations from the
dates of acquisition. The excess of the consideration given over the fair value
of net assets acquired has been recorded as goodwill of $363,000.

    The pro forma effects of the 1996 acquisitions on the consolidated financial
statements are not significant.

    On February 24, 1995, the Company acquired certain assets of Serrmi
Services, Inc. (Serrmi) for approximately $1,182,000 in cash. The acquisition
has been accounted for by the purchase method of accounting and accordingly,
the operating results have been included in the Company's consolidated
results of operations from the date of acquisition. The excess of the cash
paid over the fair value of net assets acquired has been recorded as goodwill
of $139,000. The pro forma effects of the Serrmi acquisition on the
consolidated financial statements are not significant.

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 12. ACCOUNTING FOR STOCK-BASED COMPENSATION
-------------------------------------------------------------------------------

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 other than for restricted stock and performance-based
awards. Had compensation cost for the Company's other stock option plans been
determined based upon the fair value at the grant date for 1997, 1996 and 1995
awards under these plans consistent with the methodology presented in Statement
of Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation, the Company's net income and basic earnings per share would have
been reduced by approximately $280,000 in 1997, $325,000 in 1996 and $88,000 in
1995, or $.03 per share in 1997, $.03 per share in 1996 and $.01 per share in
1995. The fair value of the options granted is estimated at values ranging from
$3.91 to $5.93 in 1997 and $3.92 to $5.91 in 1996, on the dates of grant using
the Black-Scholes option-pricing model with the following assumptions: dividend
rate of .10 per share in 1997 and 1996, volatility ranging between 46% and 48%
in 1997 and between 41% and 70% in 1996, risk-free interest rate ranging
between 5.90% and 6.40% in 1997 and 5.25% and 7.01% in 1996, assumed forfeiture
rate of 0% in 1997 and 1996, and an expected life ranging between 1.9 and 3.75
years in 1997 and 1996.

    Pro forma net income reflects only options granted since December 31, 1994.
Therefore, the full impact of calculating compensation cost for stock options
under SFAS No. 123 is not reflected in the pro forma net income amounts
presented above because compensation cost is reflected over the options vesting
period and compensation cost for options granted prior to January 1, 1995 is
not considered.


-------------------------------------------------------------------------------
FORWARD LOOKING INFORMATION

This annual report contains forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995, which may include
statements concerning projection of revenues, income or loss, capital
expenditures, capital structure, or other financial items, statements regarding
the plans and objectives of management for future operations, statements of
future economic performance, statements of the assumptions underlying or
relating to any of the foregoing statements, and other statements which are
other than statements of historical fact.

    These statements appear in a number of places in this annual report and
include statements regarding the intent, belief, or current expectations of
the Company's management with respect to (i) the demand and price for the
Company's products and services, (ii) the Company's competitive position,
(iii) the supply and price of materials used by the Company, (iv) the cost
and timing of the completion of new or expanded facilities, or (v) other
trends affecting the Company's financial condition or results of operations.

    Statements made throughout this report are based on current estimates of
future events, and the Company has no obligation to update or correct these
estimates.

    Readers are cautioned that any such forward-looking statements are not
guarantees of future performance and involve risks and uncertainties, and that
actual results may differ materially as a result of these various factors.

<PAGE>

REPORT OF MANAGEMENT

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

TO THE STOCKHOLDERS OF HARMON INDUSTRIES, INC.:

The management of Harmon Industries, Inc., is responsible for the
preparation, presentation, and integrity of the consolidated financial
statements and other information included in this annual report. The
financial statements have been prepared by the Company in accordance with
generally accepted accounting principles and, as such, include amounts based
on management's best estimates and judgments.

     The financial statements have been audited by KPMG Peat Marwick LLP,
independent public accountants. Their audits were made in accordance with
generally accepted auditing standards and included such reviews and tests of
the Company's internal accounting controls as they considered necessary.

     The Company maintains a system of internal accounting controls designed
to provide reasonable assurance at reasonable cost that Company assets are
protected against loss or unauthorized use and that transactions and events
are properly recorded.

     The Board of Directors, through its Audit Committee, comprised solely of
directors who are not employees of the Company, meets with management and the
independent public accountants to assure that each is properly discharging
its respective responsibilities. The independent accountants have free access
to the Audit Committee, without management present, to discuss the results of
their work and their assessment of the adequacy of internal accounting
controls and the quality of financial reporting.

/s/ Bjorn E. Olsson                    /s/ Charles M. Foudree

Bjorn E. Olsson                        Charles M. Foudree
President and                          Executive Vice President - Finance,
Chief Executive Officer                Treasurer and Secretary

February 10, 1998


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

REPORT OF INDEPENDENT AUDITORS

THE BOARD OF DIRECTORS AND STOCKHOLDERS OF HARMON INDUSTRIES, INC. AND
SUBSIDIARIES:

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

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Harmon
Industries, Inc. and subsidiaries at December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the years in the
three year period ended December 31, 1997, in conformity with generally
accepted accounting principles.

KPMG Peat Marwick LLP

Kansas City, Missouri
February 10, 1998
<PAGE>

INVESTOR INFORMATION

FORM 10-K
-------------------------------------------------------------------------------

Shareholders may receive a copy of the Corporation's 1997 Annual Report to the
Securities and Exchange Commission on Form 10-K free of charge by writing:
Mr. Charles M. Foudree
Executive Vice President-Finance
at the Corporation's headquarters.
e-mail: cfoudree@harmonind.com


ANNUAL MEETING
-------------------------------------------------------------------------------

Shareholders are cordially invited to attend the Annual Meeting of
Shareholders, which will be held at 2:00 p.m. on Tuesday, May 12, 1998, at
the Country Club of Blue Springs, Blue Springs, Missouri.

     Management urges all shareholders to vote their proxies and thus
participate in the decisions that will be made at this meeting.


REGISTRAR & TRANSFER AGENT
-------------------------------------------------------------------------------

UMB Bank, n.a.
P.O. Box 419226
Kansas City, Missouri 64141-6226
816/860-7000

For change of name, address, or to replace lost stock certificates, write or
call the Securities Transfer Division.


SECURITIES ANALYST CONTACT
-------------------------------------------------------------------------------

Securities analyst inquiries are welcome.
Please direct them to:
Mr. Charles M. Foudree
Executive Vice President-Finance
816/229-3345
e-mail: cfoudree@harmonind.com


INDEPENDENT AUDITORS
-------------------------------------------------------------------------------

KPMG Peat Marwick LLP
1600 Commerce Bank Building
Kansas City, Missouri 64106


OUTSIDE COUNSEL
-------------------------------------------------------------------------------

Morrison & Hecker LLP
2600 Grand Avenue
Kansas City, Missouri 64108-4606
816/691-2600


CORPORATE HEADQUARTERS
-------------------------------------------------------------------------------

1300 Jefferson Court
Blue Springs, Missouri 64015
816/229-3345
Telefax: 816/229-0556


COMMON STOCK PRICE RANGE AND
DIVIDEND INFORMATION
-------------------------------------------------------------------------------

At December 31, 1997, there were 10,437,369 shares outstanding and
approximately 596 shareholders of record. Cash dividends are 11 cents per
share per year, paid semi-annually at 5 1/2 cents per share.

     The range of high and low prices for the past eight quarters ended
December 31, 1997 is shown below. Per share prices and cash dividends have
been adjusted for all stock splits and stock dividends.

<TABLE>
<CAPTION>

Calendar                         Price Range
Quarter Ended              1997                 1996
-----------------------------------------------------------
<S>                 <C>                   <C>
March 31            $12 2/3 - $11         $10 1/2 - $ 8
June 30              16     -  11 1/6      12 1/2 -   9 1/6
September 30         18 1/3 -  12 5/6      12     -  10 1/3
December 31          19 2/3 -  15 1/3      13     -  10

</TABLE>

STOCK TRADING
-------------------------------------------------------------------------------

The Company's common stock trades on The Nasdaq Stock Market under the
symbol: HRMN. Stock price quotations can be found in major daily newspapers
and in THE WALL STREET JOURNAL.

     At March 9, 1998, the following securities firms were making a dual
auction market in the common stock of the Company:

George K. Baum & Company
Piper Jaffray Companies Inc.
PaineWebber Inc.
C.L. King & Associates


HARMON ON THE WORLD WIDE WEB
-------------------------------------------------------------------------------

Information on Harmon Industries, Inc. is available on the Company's World Wide
Web site at:
http://www.harmonind.com
<PAGE>

MANAGEMENT, DIRECTORS AND CORPORATE DATA

BOARD OF DIRECTORS
-------------------------------------------------------------------------------

Robert E. Harmon (58)
Chairman of the Board

Bruce M. Flohr (59)
Chairman & CEO
RailTex, Inc.
San Antonio, Texas

Charles M. Foudree (53)
Executive Vice President-
Finance, Treasurer and Secretary

Rodney L. Gray (45)
Executive Vice President-
Finance
Enron International, Inc.
Houston, Texas

John W. Johnson* (50)
Vice President
Domestic Sales

Herbert M. Kohn (59)
Attorney-at-Law
Bryan Cave LLP
Kansas City, Missouri

Douglass Wm. List (42)
Management Consultant
Baltimore, Maryland

Gerald E. Myers (56)
Management Consultant
Tempe, Arizona

Bjorn E. Olsson (52)
President & CEO

Judith C. Whittaker (59)
Vice President, General
Counsel/Secretary
Hallmark Cards, Inc.
Kansas City, Missouri

---------------------
* Denotes Advisory Director
( ) Indicates Age of Director


MANAGEMENT
-------------------------------------------------------------------------------

Bjorn E. Olsson
President & CEO

Charles M. Foudree
Executive Vice President-
Finance, Treasurer and Secretary

Lloyd T. Kaiser
Executive Vice President-
Domestic Sales and Service

Ronald G. Breshears
Vice President-
Human Resources

William L. Bush
Vice President-Research &
Development Engineering

Richard A. Daniels
Vice President-Transit and
International Systems Sales

Robert E. Heggestad
Vice President-Technology

J. Randall John
Vice President-Services

John W. Johnson
Vice President-
Domestic Sales

Raymond A. Rosewall
Vice President-Manufacturing

William J. Scheerer
Vice President-
Applications Engineering

Stephen L. Schmitz
Vice President-Controller

Jeffery J. Utterback
Assistant Vice President-
Quality Systems


DOMESTIC LOCATIONS
-------------------------------------------------------------------------------

Riverside, California
Torrance, California
Atlantic Beach, Florida
Jacksonville, Florida
Atlanta, Georgia
Delphi, Indiana
Fort Wayne, Indiana
Louisville, Kentucky
Blue Springs, Missouri
Grain Valley, Missouri (3) +
Lee's Summit, Missouri
Warrensburg, Missouri (3) +
Omaha, Nebraska
Hauppauge, New York
Spokane, Washington

---------------------
+ Denotes number of plants and locations


INTERNATIONAL LOCATIONS
-------------------------------------------------------------------------------

Harmon Industries
Lausanne, Switzerland

Henkes-Harmon Industries,
Pty. Ltd.
Mooroolbark, Victoria, Australia

Vale-Harmon Enterprises, Ltd.
Saint-Laurent, Quebec, Canada

Vaughan Harmon Systems Ltd.
Ware, England
<PAGE>

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

                                     [LOGO]

                              Harmon Industries, Inc.

                              1300 Jefferson Court

                              Blue Springs, MO 64015

                              816-229-3345

                              Fax: 816-229-0556

                              www.harmonind.com

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