<PAGE>



                                    HARMON 
                               INDUSTRIES, INC. 



                                   [GRAPHIC]




                               ANNUAL REPORT 1998


<PAGE>

CORPORATE PROFILE

HARMON is a leading supplier of signal, inspection, train control and 
communication products and systems to freight and transit railroads 
throughout the world.

     Harmon's design focus is 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 systems, voice and data 
communications systems, asset management, installation and maintenance 
services.

     Harmon emphasizes engineering innovation and rapid response to customer 
needs. Its products and services provide sophisticated and timely solutions 
to signaling, communications and train control problems that impact the 
railroad industry.

     Harmon's technology base was greatly enhanced in 1997 when it obtained 
exclusive rail transportation rights to a revolutionary spread spectrum radio 
technology that was developed by the former Hughes Aircraft Company (now 
Raytheon). This technology will provide the basis for a communication-based 
train control system that will be marketed to rail systems in North America 
and world wide.

     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, Mexico, and Australia.

     Harmon common stock trades on The Nasdaq Stock Market under the 
symbol: hrmn. Its current annual dividend is 11 cents per share.

--------------------------------------------
TABLE OF CONTENTS

Financial Highlights                       1
Report to Shareholders                     2
Year in Review                             7
Selected Financial Data                   18
Management's Discussion and              
 Analysis of Financial Condition         
 and Results of Operations                20
Consolidated Financial Statements         28
Notes to Consolidated Financial          
 Statements                               33
Investor Information                      46
Corporate Officers and Directors          47

<PAGE>
                                                                              1


[GRAPHIC]

ABOUT THE COVER

This year's cover illustration depicts Harmon's expanding business 
internationally.

Last year, two of its key systems were certified for use on railroads in 
Great Britain. This was a watershed achievement. It validates Harmon's 
advanced technology, and its U.K. certification is expected to lead to 
greater acceptance of Harmon products throughout Europe.

-------------------------------------------------------------------------------
HARMON POSTED RECORD SALES FOR THE SEVENTH CONSECUTIVE YEAR AND RECORD 
EARNINGS FOR THE THIRD CONSECUTIVE YEAR. THIS IS THE RESULT OF DEVELOPING NEW 
TECHNOLOGY THAT HELPS TO MAKE RAILROADS MORE EFFICIENT, CAPITALIZING ON 
MARKET CHANGES, MAKING COMPLEMENTARY ACQUISITIONS, AND RESPONDING QUICKLY AND 
DECISIVELY TO CUSTOMER NEEDS.


FINANCIAL HIGHLIGHTS
(IN THOUSANDS, EXCEPT PER SHARE ITEMS AND NUMBER OF  EMPLOYEES)

<TABLE>
<CAPTION>
OPERATING DATA
YEAR ENDED DECEMBER 31,                   1998           1997        Change
<S>                                    <C>            <C>            <C>
Net sales                              $  265,219     $ 213,530      + 24.2%
Pretax income                              21,049        17,583      + 19.7
Income taxes                                7,647         6,622      + 15.5
Net earnings                               13,402        10,961      + 22.3
Earnings per share (basic)                   1.27          1.06      + 19.8
Earnings per share (diluted)                 1.25          1.06      + 17.9
Dividends per share                           .11           .10      + 10.0

<CAPTION>
PERFORMANCE DATA
YEAR ENDED DECEMBER 31,                   1998           1997        Change
<S>                                    <C>            <C>            <C>
Return on sales (pretax)                     7.9%          8.2%      -  3.7%
Return on year-end equity                   15.8%         15.7%      +  0.6
Return on capital employed(1)               23.2%         23.8%      -  2.5

<CAPTION>
YEAR-END DATA
AT DECEMBER 31,                           1998           1997        Change
<S>                                    <C>            <C>            <C>
Working capital                        $   55,864     $  50,323      + 11.0%
Interest-bearing long-term debt        $   19,540     $  15,456      + 26.4
Approximate number of shareholders(2)         613           596      +  2.9
Number of employees                         1,662         1,510      + 10.1
Outstanding shares (000s)                  10,662        10,437      +  2.2
</TABLE>

(1) Return on capital employed is a measurement that promotes reduced asset
    values relative to sales. It measures (for example) the efficacy of 
    borrowing money to purchase capital goods to reduce manufacturing costs. 
    The formula is: the sum of pretax 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 amount shown.

<PAGE>

2


[PHOTO]

Bjorn E. Olsson, President & Chief Executive Officer


REPORT TO SHAREHOLDERS

1998 was an outstanding year. It marked the seventh consecutive year of sales 
and booking gains and the third consecutive year of increased net earnings. 
Sales rose 24% last year to $265 million, an increase of nearly $52 million 
over the 1997 level. These higher shipments drove net earnings up 22% to a 
record $13.4 million, or $1.27 per share (basic), up from $1.06 per share for 
1997. 

     Incoming orders rose even faster than sales.  They increased 26% to 
$289 million, $61 million greater than 1997 bookings. Each market's new 
orders were the largest ever received in a single year.

RECEIPT of incoming orders accelerated greatly during the fourth quarter of 
1998. They rose to $105 million, a new record for any quarter, and nearly 
twice the amount we booked in the fourth quarter of 1997. As a result, we 
finished 1998 with a record backlog of $132 million, 77% above the 1997 
year-end level.

FREIGHT RAILROAD MARKET

Business remained exceptionally solid with our principal customers - the 
North American freight railroads. Our sales to them were $221 million last 
year, an increase of 22%. Incoming orders increased 10% over those of 1997 to 
$219 million and comprised 76% of the $289 million we booked in new orders 
last year. 

     The freight railroads continued their drive to improve their capacity 
and efficiency, which our advanced signal and control systems provide. 

     Railroad mergers also helped our sales last year. The participants seek 
products and systems that will help them coordinate their expanded rail 
systems and improve their utilization of capacity. 

     In addition, the railroads continued to increase the amount of work 
they outsource. They are finding that our asset management services component 
materially reduces their total cost of ownership. 

     Last year asset management services billings comprised $35 million of 
our freight sales. This sales figure, however, understates the full 
contribution of this service organization as service project contracts 
typically include additional orders for some Harmon products and systems as 
well. 

     Cost savings are the catalyst for our increased service revenues. This 
same principle now extends to single-source, multi-year supply contracts, 
which the freight railroads are beginning to adopt. Harmon received three 
last year, which will aggregate more than $70 million annually. Multi-year 
contracts will enable us to work in close partnership with these customers to 
uncover 

<PAGE>

                                                                              3


other areas of important cost savings. We plan to introduce this 
partnering concept to other major railroads. 

     Finally, the Transportation Equity Act for the 21st Century (TEA-21), 
which was signed into law last year, is expected to be of major assistance in 
the sale of rail/highway grade crossing systems and products. The new Act 
provides for a 55% increase in government funding of these projects over the 
next six years.

A DECISIVE NEW TREND

The most significant trend affecting Harmon's future became evident last 
year. Our non-freight orders soared. Rail transit bookings were $43 million, 
up 229%; international orders were $27 million, up 60%. Growth of this 
magnitude in a single year highlights the growth potential in these markets.

     The $70 million in orders derived from these two markets is very 
significant. That amount comprised 24% of all orders received by Harmon last 
year, up from 13% in 1997, almost doubling its contribution to total bookings 
in one year.

     Moreover, $70 million is nearly equal to our entire sales for 1991. In 
effect, during the past seven years we have entered two markets largely from 
the ground up and built them to a size that closely matches our total 1991 
output. And we did this without compromising our service to our traditional 
core market, the North American freight railroad community, which tripled 
their business with us since 1991.

VALIDATED STRATEGY

The impressive sales gains on all three fronts confirm that the long-term 
growth strategy we began in 1993 is living up to expectations.

     That strategy was to develop two other markets - rail transit and 
international - while simultaneously continuing to expand our traditional 
business - the North American freight railroads. That strategy has proved 
highly effective.

We needed to do two things simultaneously. We had to build internal capacity 
to have more products and services to offer our present customers, and we had 
to develop new customers. We did this piece by piece over a five-year period 
beginning in early 1994. We nearly doubled our research and development 
efforts and expanded our marketing and sales forces. We hired additional 
engineers, built new engineering offices, added new test equipment, and built 
new manufacturing facilities.

     Each aspect involved a considerable investment. Yet by tight control of 
expenses and insistence on meeting schedules, the cost of those investments 
was absorbed and more than offset by the consistent gains in revenues and 
earnings that followed.

[CHART]

<TABLE>
<CAPTION>

                  Gross Sales
                ($ in millions)
<S>              <C>
94                     119
95                     136
96                     184
97                     214
98                     262
</TABLE>


[CHART]

<TABLE>
<CAPTION>

             Net Earnings
           ($ in millions)
<S>         <C>
94                7.6
95                6.9
96                9.3
97                11.0
98                13.4
</TABLE>

ACQUISITIONS

Acquisitions of companies and products also occupy a pivotal role in our 
strategy. We look for companies with complementary technologies and products 
that add market potential so that in future years we could obtain a larger 
share of freight railroad and transit markets.

     To that end, we acquired 11 companies in the past five years as 

<PAGE>

4


well as several exciting technologies. For example, in 1997 we secured a 
license for the rail transportation application of a very sophisticated 
wireless data communication network from Raytheon, which it had built for the 
military. This radio is key to our revolutionary Advanced Automatic Train 
Control (AATC) system, which we believe is the most advanced in the world.

     We redesigned the military version radio last year to one using 
commercially available components. It is now far less costly to build, which 
enhances its potential for commercial use.

     In 1996, we acquired Vaughan Harmon Systems, Ltd. It is a premier railroad
software developer in the U.K., and it is also a market leader in the
manufacture of train describers, passenger information and modular control
systems that control many passenger and commuter trains in the U.K. To date,
this acquisition has produced substantial new business, chiefly with Railtrack,
which is aggressively seeking new technology for its planned upgrades. Vaughan
Harmon provides us entry into Britain and the European continent. Through them,
we were able to gain major exposure of our products and systems to the British
rail market last year. In December, 1998, Railtrack awarded us a $12 million
contract for our micro-processor based interlocking and level control systems.

     This contract has great significance. Ours was the first new technology to
receive initial approval from Railtrack. Permanent approval is pending. Not only
did our products pass rigorous safety and operating tests, it was also confirmed
that our technology is highly cost effective, which is a growing requirement in
most of Europe. The demonstration and test phase is over. With Railtrack's
initial adoption of our technology, other railroads will undoubtedly now take a
much closer look at our technology.

     We made three acquisitions in 1998. The largest was SES CO. It provides 
complete communications, security and dispatching systems for the 
transportation industry. Its forte is an ability to integrate communication 
systems used in transportation and other commercial operations into 
efficient, reliable functioning systems. In essence, SES CO enables us to 
bring added value to our customers, which should help us become even more 
competitive.

     Acquisitions continue. On March 2, 1999, we signed a letter of intent 
to acquire the majority control of Angiolo Siliani S.p.A. and Siliani 
Elettronica ed Impianti S.p.A. of Florence, Italy (Siliani). Siliani makes 
equipment and systems for signaling, train control and rolling stock. It is a 
leader in switch point machines for both standard and high-speed lines, 
equipment, interlockings, and electromechanical devices for locomotives 
serving the Italian rail market.

     Taken as a whole, each acquisition added a service, product or 
technology that we previously had to purchase elsewhere, or opens a new 
market area. Collectively, we are now able to offer a more complete line of 
products and services to our customers.

[CHART]

<TABLE>
<CAPTION>

                Backlog
             (in millions)
<S>          <C>
94                44.6
95                49.1
96                59.4
97                74.5
98                131.8
</TABLE>


[CHART]

<TABLE>
<CAPTION>

          Return on Capital 
              Employed
<S>       <C>
94                34%
95                22%
96                26%
97                24%
98                23%
</TABLE>


[CHART]

<TABLE>
<CAPTION>

              Price Range of Stock
<S>           <C>
94                $11.00-$16.17
95                $8.92-$13.67
96                $8.00-$13.00
97                $11.00-$19.67
98                $16.83-$26.50
</TABLE>


<PAGE>

                                                                              5


RAIL TRANSIT EXPANSION

In 1993, rail transit sales were $5 million. Five years later they totaled 
$25 million. Even more important, new orders in 1998 amounted to $43 million. 
They comprised major contracts with five rail transit authorities - one new 
customer and four for which we did prior work. At 1998 year-end our rail 
transit backlog was $71 million versus $16 million at the end of 1993. This 
backlog is expected to increase further as we submitted the best bid on 
several other projects, amounting to $23 million.

RAIL TRANSIT is experiencing a major renewal in the U.S. There are more 
projects now in planning than at any other time in this decade. Many are 
expected to be let for bids in 1999.

      Most important, government funding has increased substantially. Last 
year, the same tea-21 bill that provided increased funding for rail/highway 
grade crossings allocated even more funds for the rail transit industry. It 
provided for a minimum 50% (and potentially 75%) increase in funding for 
transit projects over the next six years. We anticipate this will be the 
catalyst that moves many pending projects from the drawing boards and 
planning stages to bids that lead to construction contracts.

INTERNATIONAL GROWTH

INTERNATIONALLY, we began to gain momentum in 1995 when we booked orders for 
$6.5 million that year. By 1998, orders had swelled to $27 million, and we 
were doing sizable business in Britain, Brazil, China and Australia.

      Being a player on the international rail scene is critical to the 
long-term prosperity of Harmon. This is where our greatest opportunities will 
be found.

      First, the international market is estimated to be eight times larger 
than the North American freight and rail transit markets combined - roughly 
$4 to $5 billion annually.

      Second, our technology is very cost effective. It delivers greater 
usage per rail mile and a lower cost of operation than older, traditional 
systems. With railroad privatization waves presently sweeping Europe, the 
incentive to operate rail systems more efficiently has increased markedly.

      Third, there are more, massive upgrade projects underway or in the 
planning stages in Europe, Asia and South America than anything we have ever 
seen before. And we now have the technology, systems and products that make 
our participation a distinct possibility.

      U.K.-based Railtrack, for example, has a $4 billion, 10-year program to 
invest in signal and train control products and systems. In addition, the 
London underground will be privatized in about a year. Estimated capital 
expenditures for upgrades to its signal and train control system are in 
excess of $11 billion. The London project is particularly interesting because 
communication-based train control may well be the best solution, and our AATC 
is the most advanced in the world.

      The Italian railroads recently proposed a ten-year capital expenditure 
plan of $44 billion - half for a high speed train system, and half to upgrade 
their existing systems, which makes our pending acquisition of the majority 
control of Siliani especially timely.

      Again, privatizations are the catalyst for railroad refurbishments 
throughout Mexico. As a result, we opened a subsidiary there last year to 
handle the sizable increases in business we are now experiencing in that 
country. Also, we signed an agreement with Japan's Nippon Signal Co. Ltd. to 
collaborate on the worldwide implementation of our revolutionary AATC System. 
We will sublicense our AATC technology to Nippon Signal for installations in 
Asia. Nippon Signal and Harmon will join together to build a common AATC 
platform that will be marketed world wide.

CONCLUSION

I am delighted with our 1998 performance and excited about the prospects for 
1999. The economy is very strong. Our year-end record backlog of $132 million 
has been subsequently strengthened by the receipt of several significant 
contracts. Domestic mergers, which drive the sales of many products, continue 
at a rapid pace. Rail transit and international business offer promise of 
substantially increased business in 1999.

/s/ Bjorn E. Olsson

Bjorn E. Olsson
President & Chief Executive Officer
Blue Springs, MO
March 9, 1999

<PAGE>

6


[PHOTO]

Burlington Northern Santa Fe Railway Co. awarded Harmon a three-year contract 
to provide materials integration services. These services will be interfaced 
with BNSF's engineering offices and construction forces in the field. Harmon 
will purchase materials, coordinate material movement logistics and ship to 
job sites on a just-in-time basis from its three warehouses in the U.S. 
Harmon will be the exclusive provider of its VHLC interlockings for the next 
three years and its Electro Code track circuit equipment through 1999.

<PAGE>

                                                                              7

-------------------------------------------------------------------------------
SALES TO NORTH AMERICAN FREIGHT RAILROADS ROSE 22% IN 1998 - THE COMBINATION OF
A STRONG ECONOMY AND THE STRENGTH OF HARMON'S PRODUCTS.

[CHART]

<TABLE>
<CAPTION>

                                    Gross Sales - 1998
                                      $ in millions
<S>                                 <C>
North American Freight                 $220.6 (84.2%)
North American Transit                 $25.5 (9.7%)
International                          $15.9 (6.1%)
                                       ------------
                                       $262.0
</TABLE>

                               YEAR IN REVIEW
                               NORTH AMERICAN 
                                   FREIGHT
                                   -------

HARMON CONTINUED ITS MARKET PENETRATION OF THE SIGNAL AND CONTROL SECTOR OF 
THE FREIGHT RAILROAD INDUSTRY DURING 1998. THE PAST YEAR'S RECORD SALES AND 
NEW ORDERS REFLECT A VIBRANT ECONOMY THAT FOSTERED INCREASED CAPITAL GOODS 
PURCHASES BY FREIGHT CARRIERS AND HARMON'S CONTINUED DEVELOPMENT OF 
TECHNOLOGICALLY-ADVANCED SYSTEMS, PRODUCTS, AND SERVICES.


BUSINESS from our North American freight railroad customers was excellent in 
1998. Sales gained 22% to $221 million from $180 million in 1997. New orders 
booked in 1998 rose some $20 million to $219 million from $199 million in 
1997.

The overall strength of the economy last year aided our sales to freight 
carriers. Many enjoyed record car loadings. This general prosperity enabled 
them to press forward with their sizable capital investment programs, many of 
which are dedicated to increasing operating efficiency, particularly among 
merged railroads as they seek to optimize capacity on their combined rail 
systems. We continued to benefit from their programs as so many of our 
systems, products and services help provide major increases in efficiency and 
capacity.

Included among product sales was a two-year agreement for Ultra Cab II 
equipment for installation on the latest models of ac traction locomotives. 
Several other railroads have sections of line equipped for cab signal 
operation, which requires compatible equipment on their locomotives.

Sales of rail/highway grade crossing equipment and systems declined 4.6% last 
year to $53.0 million. Sales of these products, which include our hxp-3 
detection and control equipment, should increase in 1999 largely because of 
the 1998 enactment of the Transportation Equity Act for the 21st Century 
(TEA-21). The new bill increased the level of federal funding over the next 
five years by 55% for warning systems at rail/highway grade crossings. Thus, 
the opportunity for increased sales from these markets is substantial.

Our business in Mexico continues to grow. As a consequence, we created a 
Mexican subsidiary, Industrias Harmon de Mexico, S.A. de C.V. to increase our 
share of the expanding Mexican rail market. Based in Monterrey, this Harmon 
subsidiary will handle sales and support of our growing Mexican customer base.

<PAGE>

8


[PHOTO]

1. Upon completion of a $58 million two-year project for CSX Corporation last 
year, Harmon received a five-year contract to supply its VHLC racks as part 
of CSX's program to eliminate its pole lines, replacing them with Harmon 
coded track equipment and a radio-based supervisory control system.

[PHOTO]

2. Conrail is scheduled to be merged into two other railroads this June, which 
should spur additional sales of Harmon's efficiency- and capacity-enhancing 
signal and control systems.

[PHOTO]

3. Harmon's asset management services group increased its revenues from $10.2 
million in 1993 to $34.9 million in 1998 principally by expanding its 
services from chiefly an alternate customer warehousing operation in 1993 to 
total project management by 1998.

<PAGE>

                                                                              9

-------------------------------------------------------------------------------
OVERALL BOOKINGS IN 1998 RAN 26.5% AHEAD OF 1997 AT $289 MILLION VERSUS $229 
MILLION, RAISING THE CORPORATE YEAR-END BACKLOG 77% TO $132 MILLION.

[CHART]

<TABLE>
<CAPTION>

                                  ORDER BOOKINGS - 1998
                                       $ IN MILLIONS
<S>                               <C>          <C>
North American Freight                 $219.3  (75.8%)
North American Transit                  $42.5  (14.7%)
International                           $27.4   (9.5%)
                                       ------
                                       $289.2
</TABLE>

Our timing was excellent. Last July we booked an $8 million order from 
Mexico's TFM railroad to install a centralized traffic control system for 
freight rail traffic between Monterrey and Nuevo Laredo, Mexico. The project 
will use many Harmon products, including its VHLC and Electro Code track 
circuits.

Of the $221 million in sales to North American freight carriers last year, 
service revenues comprised $34.9 million, up 17% from the previous year. A 
major factor driving our growth within the freight sector is the growing 
acceptance of our service concept, which has expanded greatly since inception 
in 1991 as an alternate warehouse facility. In addition to warehousing, we 
now provide inventory control, materials management, subassemblies, equipment 
maintenance, delivery of containerized, pre-assembled components, on-site 
construction and project management. Customers are discovering that these 
services materially lower their total costs of ownership, thereby reducing 
their overall costs - a major goal of every railroad.

SHORTLY after the close of 1998, we signed a three-year contract with the 
Burlington Northern Santa Fe Railway Co. to provide materials integration 
services. These services will include interfacing with that railroad's 
engineering offices and construction forces in the field. Harmon will 
purchase materials, coordinate material movement logistics and ship to job 
sites on a just-in-time basis from its three warehouses in the U.S. Harmon 
will be the exclusive provider of its VHLC interlockings for the next three 
years and its Electro Code track circuit equipment throughout 1999.

Further, superior on-time and on-budget performance brought us even more 
business. Upon completion of a $58 million turnkey project last year to 
expand CSX Transportation, Inc.'s capacity in the Midwest, the largest and 
most extensive project ever undertaken by Harmon, we were awarded a five-year 
contract from that same railroad to supply our VHLC racks as part of that 
railroad's program to eliminate its pole lines, substituting our coded track 
equipment and a radio-based supervisory control system in their place.

RAILROADS are now seeking single-source, multi-year contracts as a way to 
reduce costs. Three of these contracts we signed last year should yield more 
than $70 million in annual sales over the next several years. We expect to 
build on our multi-year service contracts by providing similar services to 
other railroads -in effect, providing a cost-effective labor and materials 
management source we believe will become commonplace in the years ahead.

<PAGE>

10


[PHOTO]

1. We are presently in the development phase of a contract to provide our 
Advanced Automatic Train Control system for BART, the transit authority 
serving the San Francisco Bay Area. If successful, the value of the 
implementation phase will be around $45 million.

[PHOTO]

2. Rail transit is a major source of passenger transportation in New Jersey. 
Last year we completed a $17.6 million contract for the New Jersey Transit 
Authority and were the low bidder on an $11.6 million contract for the Newark 
City Subway.

[PHOTO]

3. The Denver Light Rail System  awarded us a $3.5 million  contract last 
year to furnish and install a signal system on its line extension to 
Littleton, co.

[PHOTO]

4. Our subsidiary, SES CO, presently is working on a $6.5 million subcontract 
with the Dallas dart light rail system.

<PAGE>

                                                                             11

-------------------------------------------------------------------------------
HARMON'S NORTH AMERICAN RAIL TRANSIT  BUSINESS LAST YEAR WAS ITS BEST TO 
DATE - $25.5  MILLION IN BILLINGS AND $42.5 MILLION IN NEW CONTRACTS.


                                YEAR IN REVIEW
                                NORTH AMERICAN 
                                 RAIL TRANSIT
                                 ------------

NORTH American rail transit revenues increased 70% to $25.5 million in 1998. 
Incoming orders rose 229% to $42.5 million from $12.9 million booked in 1997. 
In 1999, the industry is contemplating more new projects and upgrades to 
existing properties than at any other time in the previous ten years. These 
new projects encompass signaling, communications and train control 
requirements with an estimated value of over $200 million.

These new projects are particularly timely as the TEA-21 federal 
appropriations bill authorized a funding increase for transit projects that 
is 50% to 75% greater than the previous funding bill, which expired last year.

During 1998, our billings were primarily from contracts awarded in 1996-1998. 
They included signal and train control installations for the New Jersey 
Transit Authority, grade crossings, interlockings and block signals for the 
Utah Transit Authority, which is expanding its line for the upcoming Winter 
Olympic Games, and the first phase of a major project with the Bay Area Rapid 
Transit District (BART) in San Francisco.

The BART project involves implementation of a revolutionary, highly 
cost-effective, advanced automatic train control system (AATC). AATC is based 
on an extremely reliable and completely wireless data radio network, which 
was originally developed for the U.S. military by the former Hughes Aircraft 
Corporation (now Raytheon).

The radio can accurately determine the position of trains without using 
conventional track circuitry. When completed in 2001, AATC will enable BART 
to substantially increase system capacity by reducing headways between trains 
to less than 90 seconds. It will also help eliminate the potential need for 
another tunnel under San Francisco Bay.

Sales of communication products and systems soared to $6.6 million in 1998 
from $655,000 in 1997. The gain was due primarily to our acquisition of SES 
CO last year. Its ability to link a variety of communication devices into 
reliable functioning systems obtained several contracts for us in 1998. The 
SES CO acquisition greatly expands our range of communication products for 
transit applications.

WE received a $13.6 million contract for a signal and control system for a 
17.5-mile extension of the St. Louis Metrolink. We also received a separate 
contract to supply our carborne equipment for new vehicles needed for this 
project. SES CO, which we acquired last year, received a $4.7 million award 
from SEPTA for audio/visual PA systems and passenger information 
improvements. We were awarded a $4.2 million contract to furnish and install 
grade crossing warnings systems on a new commuter rail line that will restore 
passenger service between Charlotte and Burlington, VT. Denver's Light Rail 
system awarded us a $3.5 million contract to furnish and install a signal 
system on its line extension to Littleton, CO.

IN addition, Harmon and SES CO were the apparent low bidders on two projects 
with the Newark City Subway (NCS). We bid $11.6 million to install our 
Automatic Train Control (ATC) system over a 4.2-mile, 11-station NCS network. 
The ATC system is comprised of our VHLC vital processor interlockings, 
electronic audio frequency track circuits and highway crossing warnings 
systems. Our subsidiary, SES CO, will provide a fiber optic communications 
network for this project. Also, SES CO submitted the lowest bid of $6.9 
million to install multi-disciplined communications and controls for the St. 
Louis Metrolink extension.

Harmon's share of the rail transit business continues to expand - in part 
because of its advanced technology but also because its reputation for 
superior performance continues to grow.

<PAGE>

12


[PHOTO]
1. Brazilian mining railroad CVRD last year awarded us a $2.5 million order 
in U.S. funds to replace the on-board portion of its automatic train control 
system with our Ultra Cab II.

[PHOTO]
2. Last July we booked an $8 million order from Mexico's TFM railroad to 
install a centralized traffic control system for freight rail traffic between 
Monterrey and Nuevo Laredo, Mexico.

[MAP]
3. Major upgrades to rail systems in Mexico are occurring following 
privatization of railroads in that country.

<PAGE>

                                                                             13


-------------------------------------------------------------------------------
Harmon's international business gained momentum last year as important 
contracts were secured in England and Brazil.

                                YEAR IN REVIEW
                                INTERNATIONAL
                                -------------

OUR INTERNATIONAL business showed a marked improvement last year. Although 
revenues were down 9% on the year at $15.9 million, incoming orders more than 
made up for that shortfall, which was more a matter of contract delays than 
an actual downturn in business. New orders rose 60% last year to a record 
$27.4 million, a gain of more than $10 million.

We completed the first phase of a multi-million dollar signal and train 
control project in England with Railtrack last December. Our subsidiary, 
Vaughan Harmon, was then awarded a $12.5 million contract to replace the 
signal system on the Cromer Branch Line in Norfolk, England. This is the 
breakthrough we have long awaited. It introduces our microprocessor-based 
interlocking and level crossing control systems into Europe for the first 
time.

Vaughan Harmon also received a second award from Railtrack last year to 
replace its train describer at Clapham Junction, which controls all train 
movements from London's Victoria Station for trains bound for Brighton and 
the southeast coast, including part of the route used by Eurostar trains to 
Belgium and France. This is the largest train describer yet installed for 
Railtrack by Vaughan Harmon. Coupled with earlier installations at London 
Bridge and Dartford by this subsidiary, our systems now form the heart of 
London's railway control.

Vaughan Harmon was also awarded a contract to supply a modular signaling 
control system for Irish Rail. The new system is part of a mini-centralized 
traffic control project to resignal a number of important branch lines 
throughout Ireland. It will run alongside the current system, which presently 
controls Dublin suburban traffic. Upon completion, all suburban lines will be 
able to be controlled by a single signalman.

In Brazil we received a contract last October for $2.5 million (in U.S. 
funds) to replace the on-board portion of Cia Vale Do Rio Doce's (CVRD) 
automatic train control system with our Ultra Cab II. Our system will enable 
CVRD to add a communications-based operation system at a later date, thereby 
expanding its usefulness when its needs dictate.

We also see greater opportunities developing in Australia and Asia. It was 
for this reason that we purchased the assets of our former sales affiliate 
and created our own sales and service subsidiary, Harmon Industries 
Australia, Pty. Ltd. in Bayswater, Australia.

Having a Harmon-owned and operated company in Australia enables us to provide 
a higher level of sales support and service than previously. It also gives a 
broader base from which to deepen and expand our business in that part of the 
world.

<PAGE>

14


[PHOTO]
1. Final inspection of Harmon's Hot Box Detector system at Riverside.

[PHOTO]
2. Harmon's new Electro Code V provides many new features including easier 
setup procedures.

[PHOTO]
3. Hot Box Detector systems are subjected to complete system set up and 
calibration before shipment to customer sites.

<PAGE>

                                                                             15


-------------------------------------------------------------------------------
HARMON INVESTED $32 MILLION IN THE PAST FIVE YEARS TO DEVELOP NEW PRODUCTS AND
SYSTEMS. THEY ACCOUNTED FOR A SUBSTANTIAL PORTION OF THE NEW ORDERS BOOKED LAST
YEAR, WHICH ILLUSTRATES THE IMPORTANCE OF DEVELOPING NEW PRODUCTS AND THE
RETURNS R&D DOLLARS PROVIDE.

                              YEAR IN REVIEW
                          RESEARCH & DEVELOPMENT

[CHART]

<TABLE>
<CAPTION>
            R&D EXPENDITURES
             $ IN MILLIONS
<S>         <C>
96                $6.33
97                $7.66
98                $8.45
</TABLE>

In 1998, the development of new products and systems continued to be a 
primary focus of Harmon's R&D efforts. Several new products completed 
development and there was considerable effort expended to increase Harmon's 
systems development capability.

Work was substantially completed on our new Electro Code V track circuit 
product, which offers many performance advantages over our predecessor 
Electro Code IV model. Surface mount technology was used in this upgrade 
which provides reduced installation and maintenance costs for the user. 
Earlier Electro Code versions required two technicians for field installation 
while the Electro Code V requires only a single technician. Sales of Electro 
Code V will begin in early 1999.

We also made substantial progress in our next generation hot box detector 
system. This next generation system was also designed using surface mount 
technology which enabled Harmon to significantly increase the reliability of 
the system while at the same time reducing the cost of ownership for the 
user. Sales of these next generation hot box detector systems will also begin 
in 1999.

As part of our efforts to expand into the international market, Harmon began 
a series of upgrades of its standard products to make them suitable for use 
in that market. Among these was an upgrade to the Vital Harmon Logic 
Controller (VHLC) to enable it to control railroad signal lamps with higher 
voltage AC power as well as traditional low volt DC. This upgrade will be 
implemented in the Cromer project in the United Kingdom in 1999 and should 
have application in many other countries as well. We also obtained CE Mark 
certification for our VHLC and HXP-3. This is a European Community product 
certification roughly comparable to a UL designation in the U.S. and is 
expected to materially increase the acceptance of our products throughout 
Europe.

As Harmon has engaged in larger systems projects like the BART project, we 
have seen the need to improve the processes we use to develop our products 
and systems. In 1998 we began a multi-year effort to improve our hardware, 
software and systems development processes. Our software process is being 
modified to meet the stringent demands of the industry recognized Software 
Capability Maturity Model developed by the Software Engineering Institute. We 
believe these changes will substantially decrease the cost and time needed to 
develop the software used in Harmon products and systems. Similar efforts are 
underway in the hardware and systems areas and will continue in 1999.

Investments for research and development are budgeted at $12.0 million for 
1999 versus $8.5 million expended in 1998 and $7.7 million in 1997. With 
these investments, Harmon will be in an even better position to meet the 
needs of its existing customers and to gain new ones.

<PAGE>

16


[PHOTO]
The traffic control center at the Dallas Area Rapid Transit (DART) system. 
The lighted display, which shows the operation of all dart trains, was 
designed by SES CO, which Harmon acquired in 1998.

<PAGE>
                                                                           17


-------------------------------------------------------------------------------
HARMON MADE THREE ACQUISITIONS LAST YEAR. ALL WERE COMPLEMENTARY TO ITS 
PRINCIPAL BUSINESS, EXPANDING ITS CAPABILITIES AND INCREASING ITS COMPETITIVE 
POSITION.


                                YEAR IN REVIEW
                                 ACQUISITIONS
                                 ------------

HARMON acquired three companies last year. In January, 1998, we purchased 
CSS, Inc. of Delphi, Indiana. CSS operates in a seven-state area throughout 
the Midwest and Florida. CSS installs and maintains products and equipment 
used by railroads, primarily at grade crossings on short-line and regional 
railroads. This acquisition adds equipment maintenance as well as additional 
installation capabilities to Harmon's railroad service operation.

Last October we finalized the purchase of SES CO., inc. and a related 
company, which are headquartered in Hingham, Massachusetts. SES CO is a 
leader in railroad communications, particularly in rail transit applications. 
It integrates communication, detection and monitoring equipment of many 
manufacturers into functional systems. Its capabilities extend to fiber optic 
networks, tunnel and above-ground radio systems, vehicle radio systems, 
passenger emergency telephone systems, audio/visual passenger information 
systems, fire alarm systems, closed circuit tv, local area networks and 
Supervisory Control and Data Acquisition (SCADA) systems.

SES CO provides Harmon with a broader range of systems design, manufacturing 
and construction capabilities, which will increase Harmon's competitive 
position whenever contracts are put up for bid.

When SES CO was acquired it brought with it several important rail transit 
contracts. Subsequent to its acquisition, SES CO has been the successful 
bidder on contracts totalling nearly $18 million in Dallas, St. Louis and 
Philadelphia.

We also established a wholly-owned sales and service subsidiary last year in 
Bayswater, Australia, by purchasing the assets of a former affiliate.  Harmon 
Industries Australia, Pty. Ltd. strengthens our position in Australia and 
increases our ability to expand our business in that part of the world.

Our March 2, 1999, letter of intent to acquire the majority control of 
Angiolo Siliani S.p.A. and Siliani Elettronica ed Impianti S.p.A. of 
Florence, Italy (Siliani) is expected to be of substantial assistance in 
acquiring European business. Siliani makes equipment and systems for 
signaling, train control and rolling stock. It is a leader in switch point 
machines for both standard and high-speed lines, equipment, interlockings, 
and electromechanical devices for locomotives serving the Italian rail market.

The pending Siliani acquisition may also prove very timely as the Italian 
railroads recently proposed a ten-year capital expenditure plan of $44 
billion -half for a high speed train system, and half to upgrade their 
existing systems.

Harmon is presently evaluating several additional acquisition opportunities. 
Each would expand and complement our core business.


<PAGE>

18                                                                            19


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

<TABLE>
<CAPTION>
                                                                                                                                
                                                                                                                                
YEARS ENDED DECEMBER 31                                  1998       1997       1996       1995       1994      1993      1992   
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                  <C>        <C>        <C>        <C>        <C>        <C>       <C>       
OPERATIONS
NET SALES                                            $265,219   $213,530   $175,440   $136,780   $119,703   $99,295   $81,899   
COST OF SALES                                         200,478    156,224    126,997     96,094     81,023    65,716    54,271   
RESEARCH AND DEVELOPMENT EXPENDITURES                   8,454      7,664      6,331      5,218      4,561     3,442     3,541   
                                                     ------------------------------------------------------------------------
GROSS PROFIT                                           56,287     49,642     42,112     35,468     34,119    30,137    24,087   
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES           33,415     30,298     25,990     23,200     21,176    18,558    15,646   
OTHER OPERATING EXPENSES (INCOME)                         664        964        544        481         44       114       137   
                                                     ------------------------------------------------------------------------
OPERATING INCOME                                       22,208     18,380     15,578     11,787     12,899    11,465     8,304   
OTHER EXPENSES                                          1,159        797        473        607        214       388     1,228   
                                                     ------------------------------------------------------------------------
PRE-TAX EARNINGS (CONTINUING OPERATIONS)               21,049     17,583     15,105     11,180     12,685    11,077     7,076   
INCOME TAXES                                            7,647      6,622      5,775      4,294      5,046     4,193     2,498   
                                                     ------------------------------------------------------------------------
EARNINGS FROM CONTINUING OPERATIONS                    13,402     10,961      9,330      6,886      7,639     6,884     4,578   
GAIN (LOSS) FROM DISCONTINUED OPERATIONS                   --         --         --         --         --        --       165   
USE OF NET OPERATING LOSS CARRYFORWARD                     --         --         --         --         --        --       273   
                                                     ------------------------------------------------------------------------
NET EARNINGS (LOSS)                                  $ 13,402   $ 10,961   $  9,330   $  6,886   $  7,639   $ 6,884   $ 5,016   
                                                     ------------------------------------------------------------------------
                                                     ------------------------------------------------------------------------

EFFECTIVE TAX RATE - CONTINUING OPERATIONS               36.3%      37.7%      38.2%      38.4%      39.8%     37.9%     35.3%  
RETURN ON SALES - CONTINUING OPERATIONS                   5.1%       5.1%       5.3%       5.0%       6.4%      6.9%      5.6%  
RETURN ON EQUITY - CONTINUING OPERATIONS                 15.8%      15.7%      16.1%      14.0%      17.7%     20.8%     30.1%  
RETURN ON EQUITY - TOTAL                                 15.8%      15.7%      16.1%      14.0%      17.7%     20.8%     33.0%  
WEIGHTED AVERAGE SHARES (000S) - BASIC*                10,541     10,313     10,217     10,187      9,649     8,948     7,672   

PER SHARE DATA*
EARNINGS FROM CONTINUING OPERATIONS - BASIC          $   1.27   $   1.06   $    .91   $    .68   $    .79   $   .77   $   .60   
NET EARNINGS (LOSS) - BASIC                              1.27       1.06        .91        .68        .79       .77       .65   
CASH DIVIDENDS                                            .11        .10        .10        .10        .10        --        --   
BOOK VALUE                                               7.97       6.68       5.66       4.82       4.27      3.49      1.88   
PRICE/EARNINGS RATIO RANGE - BASIC                  13.2-20.8  10.3-18.5   8.8-14.2  13.2-20.2  13.9-20.4 10.1-20.1  3.4-13.0  2

OTHER DATA AT YEAR-END
WORKING CAPITAL                                      $ 55,864   $ 50,323   $ 33,629   $ 35,014   $ 21,670   $20,790   $10,740   
TOTAL ASSETS                                          162,853    135,769    104,677     86,845     68,395    53,000    38,488   
LONG-TERM DEBT                                         19,540     15,456      3,412     12,090        733       439     4,898   
STOCKHOLDERS' EQUITY                                   84,958     69,762     57,939     49,232     43,063    33,086    15,197   
CURRENT RATIO                                          2.05:1     2.09:1     1.85:1     2.60:1     2.03:1    2.28:1    1.72:1   
QUICK ASSETS RATIO                                     1.01:1     1.12:1     1.01:1     1.16:1     1.03:1    1.32:1     .87:1   
LIABILITIES TO EQUITY RATIO                             .92:1      .95:1      .81:1      .76:1      .59:1     .60:1    1.53:1   
CAPITAL ADDITIONS (CONTINUING OPERATIONS)               8,271     10,475      6,371      5,532      3,242     3,189     2,154   
CAPITAL ADDITIONS (TOTAL)                               8,271     10,475      6,371      5,532      3,242     3,189     2,154   
DEPRECIATION & AMORTIZATION (CONTINUING OPERATIONS)     7,186      5,639      5,004      3,906      2,621     2,121     1,936   
DEPRECIATION & AMORTIZATION (TOTAL)                     7,186      5,639      5,004      3,906      2,621     2,121     1,936   
OUTSTANDING SHARES (000S)*                             10,662     10,437     10,244     10,208     10,092     9,493     8,075   

<CAPTION>
                                                                                                  FIVE-YEAR  TEN-YEAR  
                                                                                                   COMPOUND  COMPOUND  
YEARS ENDED DECEMBER 31                                  1991        1990        1989        1988   GROWTH    GROWTH   
--------------------------------------------------------------------------------------------------------------------   
<S>                                                  <C>         <C>         <C>         <C>         <C>        <C>    
OPERATIONS                                                                                                             
NET SALES                                            $ 70,934    $ 72,707    $ 70,154    $ 64,558    +22%       +15%   
COST OF SALES                                          45,536      47,478      46,377      42,044                      
RESEARCH AND DEVELOPMENT EXPENDITURES                   4,000       3,414       3,200       3,669                      
                                                     --------------------------------------------
GROSS PROFIT                                           21,398      21,815      20,577      18,845    +13%       +12%   
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES           13,550      14,427      13,186      11,965                      
OTHER OPERATING EXPENSES (INCOME)                       1,122         762        (263)        (27)                     
                                                     --------------------------------------------
OPERATING INCOME                                        6,726       6,626       7,654       6,907    +14%       +12%   
OTHER EXPENSES                                          2,118       1,504       1,244       1,301                      
                                                     --------------------------------------------
PRE-TAX EARNINGS (CONTINUING OPERATIONS)                4,608       5,122       6,410       5,606    +14%       +14%   
INCOME TAXES                                            1,688       2,022       2,506       2,100                      
                                                     --------------------------------------------
EARNINGS FROM CONTINUING OPERATIONS                     2,920       3,100       3,904       3,506    +14%       +14%   
GAIN (LOSS) FROM DISCONTINUED OPERATIONS               (2,492)    (12,306)     (2,744)     (1,020)                     
USE OF NET OPERATING LOSS CARRYFORWARD                    395          --          --          --                      
                                                     --------------------------------------------
NET EARNINGS (LOSS)                                  $    823    $ (9,206)   $  1,160    $  2,486    +14%       +18%   
                                                     --------------------------------------------
                                                     --------------------------------------------
                                                                                                                       
EFFECTIVE TAX RATE - CONTINUING OPERATIONS               36.6%       39.5%       39.1%       37.5%                     
RETURN ON SALES - CONTINUING OPERATIONS                   4.1%        4.3%        5.6%        5.4%                     
RETURN ON EQUITY - CONTINUING OPERATIONS                 39.6%       53.9%       26.5%       25.9%                     
RETURN ON EQUITY - TOTAL                                 11.2%     (160.2%)       7.9%       18.3%                     
WEIGHTED AVERAGE SHARES (000S) - BASIC*                 7,490       7,084       6,948       6,720                      
                                                                                                                       
PER SHARE DATA*                                                                                                        
EARNINGS FROM CONTINUING OPERATIONS - BASIC          $    .39    $    .44    $    .56    $    .52    +11%       + 9%   
NET EARNINGS (LOSS) - BASIC                               .11       (1.30)        .17         .37    +11%       +13%   
CASH DIVIDENDS                                             --        .042        .083        .083                      
BOOK VALUE                                                .98         .80        2.13        2.02    +18%       +15%   
PRICE/EARNINGS RATIO RANGE - BASIC                   1.2-44.0         N/A   23.0-34.9    9.5-14.6                      
                                                                                                                       
OTHER DATA AT YEAR-END                                                                                                 
WORKING CAPITAL                                      $  9,660    $  7,955    $ 14,444    $  7,037    +22%       +23%   
TOTAL ASSETS                                           36,575      41,408      48,082      42,948    +25%       +14%   
LONG-TERM DEBT                                         11,915      17,220      17,688      12,139                      
STOCKHOLDERS' EQUITY                                    7,377       5,747      14,756      13,557    +21%       +20%   
CURRENT RATIO                                          1.71:1      1.49:1      2.08:1      1.45:1                      
QUICK ASSETS RATIO                                      .76:1       .66:1       .84:1       .60:1                      
LIABILITIES TO EQUITY RATIO                            3.96:1      6.21:1      2.26:1      2.17:1                      
CAPITAL ADDITIONS (CONTINUING OPERATIONS)               1,098       2,187       2,236       1,830                      
CAPITAL ADDITIONS (TOTAL)                               1,098       4,521       4,589       9,886                      
DEPRECIATION & AMORTIZATION (CONTINUING OPERATIONS)     2,022       2,410       2,373       2,541                      
DEPRECIATION & AMORTIZATION (TOTAL)                     2,022       3,511       3,185       2,834                      
OUTSTANDING SHARES (000S)*                              7,497       7,185       6,942       6,717                      
</TABLE>

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

<PAGE>

20

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

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

During the past five years, Harmon's sales have increased at an average 
compound rate of 22% per year. The North American freight railroads are its 
largest market, accounting for 84% of Harmon's sales in 1998. Business with 
North American freight railroads has been excellent in recent years. This is 
due principally to their increased demand for advanced signal and control 
systems that maximize the capacity and efficiency of their rail systems, a 
major consideration due to various rail mergers and railroad privatizations 
in recent years. In addition, demand for Harmon's purchasing, materials 
management, and project management services continues to grow rapidly. These 
services fill an increasing need in the railroad industry as it continues to 
outsource functions it previously performed internally. International 
business (chiefly, Britain, the European continent, South America, Asia and 
Australia) has grown materially in recent years. Finally, the new 
construction portion of the North American rail transit market, which Harmon 
entered in 1991, is entering a major growth cycle. Contract awards for Harmon 
and its subsidiaries amounted to $43 million in 1998 compared to $5 million 
in 1991.

     Growth has been aided also by acquisitions of businesses and/or product 
lines that fit Harmon's core business. In 1998, Harmon acquired the following 
companies: CSS, Inc. of Delphi, IN, and SES CO, Inc. and its sister company, 
Seaboard Systems, Inc., of Hingham, MA. CSS installs and maintains products 
and equipment used by railroads, primarily at grade crossings. This 
acquisition adds equipment maintenance as well as additional installation 
capabilities to Harmon's railroad service operation. SES CO is a world-wide 
leader in railroad communications, particularly in rail transit applications. 
It integrates communication, detection and monitoring equipment of many 
manufacturers into functional systems. At year-end 1998, SES CO had a $43.5 
million backlog. Also in 1998, Harmon acquired the assets of its long-time 
Australian affiliate, turning it into a wholly-owned subsidiary in that 
country. Harmon also created a new subsidiary operation in Mexico to capture 
expanding business opportunities in that country. In 1997, Harmon acquired 
Devtronics, Inc., which makes recorders and remote maintenance monitoring 
equipment that offer substantial savings to railroads. In 1996 Harmon 
acquired United Kingdom-based Vaughan Systems Ltd. (since renamed Vaughan 
Harmon Enterprises Ltd.). It was a strategic acquisition to increase Harmon's 
sales in Europe. It 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. In 1997, 
Harmon acquired a remaining majority interest in Vale Harmon Enterprises, 
Ltd. In 1996, Harmon acquired two railroad contract-engineering firms, which 
provided a significant gain in engineering resources.

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

The Company's sales are summarized by product category in the table on page 
21. The table 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 Products and 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 Products and 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. A system to remotely monitor rail/highway 
crossing systems is under development.

     Asset Management Services is a single-source, rapid delivery/and or
installation of railroad components. 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.

<PAGE>
                                                                           21

     Train Inspection Products and 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.

     Communications Products and Systems include products and systems used to 
provide voice and data communications for rail systems. These include 
conventional and fiber optic networks, tunnel and above ground radio systems, 
passenger emergency telephone systems, audio/visual passenger information 
systems, fire alarm systems, closed circuit tv, local area networks and 
Supervisory Control and Data Acquisition (SCADA) systems.

     Printed Wiring Boards include production of customer-designed printed 
wiring boards for shipment to other electronics manufacturers.      Other 
sales include products that do not fit readily into the other six categories.

SALES BY PRODUCT OR SERVICE FUNCTION*

<TABLE>
<CAPTION>
                                                                  YEARS ENDED DECEMBER 31,
                                                        1998                1997                1996
                                                 ---------------------------------------------------------
         (DOLLARS IN THOUSANDS)                    AMOUNT      %       AMOUNT      %        AMOUNT      %
         -------------------------------------------------------------------------------------------------
         <S>                                     <C>        <C>       <C>       <C>      <C>         <C>
         TRAIN CONTROL PRODUCTS & SYSTEMS        $ 132,348  50.5%     $101,624  47.4%     $  87,080  47.4%
         CROSSING PRODUCTS & SYSTEMS                53,035  20.2%       55,598  25.9%        48,927  26.6%
         ASSET MANAGEMENT SERVICES                  34,928  13.3%       29,913  14.0%        22,217  12.1%
         TRAIN INSPECTION PRODUCTS & SYSTEMS        16,312   6.2%       13,407   6.3%        12,906   7.0%
         COMMUNICATIONS PRODUCTS & SYSTEMS           6,606   2.5%          655   0.3%         1,891   1.0%
         PRINTED WIRING BOARDS                       5,220   2.0%        5,772   2.7%         5,249   2.9%
         OTHER                                      13,547   5.2%        7,458   3.5%         5,598   3.0%
         -------------------------------------------------------------------------------------------------
            TOTAL                                $ 261,996 100.0%     $214,427 100.0%     $ 183,868 100.0%
         -------------------------------------------------------------------------------------------------
         -------------------------------------------------------------------------------------------------
</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 figures 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, 1998, 1997 AND 1996.

Harmon achieved record sales and earnings in 1998. Net sales increased 24% to 
$265.2 million compared with $213.5 million in 1997 and $175.4 million for 
1996. Net earnings for 1998 set records for the third consecutive year, 
increasing 22.3% to $13.4 million ($1.25 per share-diluted) compared with 
$11.0 million ($1.06 per share-diluted) for 1997, and $9.3 million for 1996 
($0.91 per share-diluted). The increase in earnings from 1996 to 1998 was due 
chiefly to substantially higher sales levels each year. Return on equity was 
15.8% for 1998 compared with 15.7% for 1997 and 16.1% for 1996. Return on 
capital employed was 23.2% in 1998 compared with 23.8% in 1997 and 25.9% in 
1996.

SALES ANALYSIS. Harmon's continuing strengths in signal and train control
products and systems, train inspection products and systems, asset management
services and new acquisitions offering communication products and systems were
the principal reasons its 1998 sales reached a record $265.2 million. Thus, 1998
sales were $51.7 million above those of 1997 and $89.8 million higher those of
1996. 

      Throughout 1998, 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 larger suppliers that 
have broad-based product lines, meaningful research and engineering support, 
and strong service capabilities. In addition, in 1998, several railroads 
began to enter into long-term supplier contracts to obtain price concessions 
for their larger and longer-term orders. These trends benefited Harmon in 
1998.


<PAGE>

22


     Sales of train control systems and products increased $30.7 million to 
$132.3 million; sales of asset management services were up $5.0 million to 
$34.9 million; sales of train inspection systems and products rose $2.9 
million, communication products and system sales gained $6 million, and sales 
of other miscellaneous products rose $6.1 million to $13.5 million. Lower 
sales were posted by crossing products and systems, which were off 4.6% at 
$53 million, and printed wiring boards, which slipped 9.6% to $5.2 million.

     The increase in train control systems and products sales is chiefly the 
result of increased orders from recently-merged railroads and continued 
strong sales of Harmon's Ultra Cab units. The sales gain in asset management 
services reflects an increased continuation toward outsourcing among domestic 
freight railroads and an expansion in Harmon's material management contracts. 
The gain in communication products and system sales is due primarily to the 
1998 acquisition of SES CO. The increase in train inspection sales is due 
chiefly to the 1997 Devtronics acquisition and increased business in Mexico. 
The decrease in crossing system sales primarily reflects timing differences 
in shipments between 1998 and 1997, and the decrease in printed wiring board 
sales reflects reduced demand industry-wide.

     Orders booked in 1998 were a record $289.2 million, a 26.5% gain over 
the $228.6 million booked 1997 and 54.2% better than the $187.5 million 
booked in 1996. Freight orders were $219 million; rail transit, $43 million; 
and international, $27 million. At 1998 year-end, Harmon's backlog was a 
record $132 million, of which approximately $95 million is expected to ship 
in 1999. Approximately 30% ($39 million) of the backlog was North American 
freight related; 16% ($22 million) related to international business (chiefly 
Great Britain and Brazil), and 54% ($71 million) related to North American 
rail transit. The backlog soared late in the year as Harmon added $30.5 
million in rail transit orders and $20.1 million in international business 
during the fourth quarter of 1998.

     The table below 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.

<TABLE>
<CAPTION>
         OPERATING SUMMARY                       PERCENTAGE OF NET SALES            PERCENTAGE OF CHANGE
                                              -----------------------------------------------------------
                                                YEARS ENDED DECEMBER 31,           1998     1997     1996
                                                                                   OVER     OVER     OVER
                                               1998       1997      1996           1997     1996     1995
         ------------------------------------------------------------------------------------------------
         <S>                                  <C>        <C>        <C>           <C>       <C>    <C>
         NET SALES                            100.0%     100.0%     100.0%         24.2%    21.7%   28.3%
         COST OF SALES                         75.6%      73.2%      72.4%         28.3%    23.0%   32.2%
         RESEARCH AND DEVELOPMENT               3.2%       3.6%       3.6%         10.3%    21.1%   21.3%
         GROSS PROFIT                          21.2%      23.2%      24.0%         13.4%    17.9%   18.7%
         SELLING, GENERAL AND
         ADMINISTRATIVE EXPENSES               12.6%      14.2%      14.8%         10.3%    16.6%   12.0%
         OTHER, NET                             0.3%       0.4%       0.3%        (31.1)%   77.2%   13.1%
         OPERATING INCOME                       8.3%       8.6%       8.9%         20.8%    18.0%   32.2%
         OTHER EXPENSES                         0.4%       0.4%       0.3%         45.4%    68.5%  (22.1)%
         EARNINGS BEFORE INCOME TAXES           7.9%       8.2%       8.6%         19.7%    16.4%   35.1%
         INCOME TAXES                           2.9%       3.1%       3.3%         15.5%    14.7%   34.5%
         NET EARNINGS                           5.0%       5.1%       5.3%         22.3%    17.5%   35.5%
</TABLE>

     The market for the majority of the Company's products is largely 
dependent on the financial condition of the railroad industry, the trend of 
the general economy, individual railroads' budgets for capital expenditures 
and repairs and maintenance, and the Company's reputation for reliable and 
cost-effective products. At year-end 1998, the freight railroad industry was 
enjoying good market conditions. It is estimated that 1999 capital 
expenditure budgets will be at or above 1998 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 also remained merger 
minded, which historically has reduced capital spending while mergers were 
pending and increased spending after they were completed. 


<PAGE>

                                                                            23


      The market for the Company's signal and control systems is influenced 
by all of the factors listed above plus one other element-the level of 
activity by the railroads in authorizing grade crossing warning system 
improvements. These latter improvements receive up to 80% federal support. 
The Transportation Equity Act for the 21st Century (tea-21) was passed in 
1998. It increased funding to $217 billion over the next six years, which 
resulted in a 55% increase for rail/highway grade crossing installations and 
at least a 50% increase for transit projects. These increases are an 
extremely positive development for the sale of our products and systems.

GROSS PROFIT. Gross profit as a percent of sales declined to 21.2% for 1998 
as compared with 23.2% for 1997 and 24.0% for 1996 . The declines in 1998 and 
1997 reflect a continuing 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 
$58 million upgrade project for a Class I railroad, which commenced in 1997 
and was completed in 1998, added substantially to the sale of Harmon products 
and systems in 1997 and 1998, but the upgrade project also contained sizable 
amounts of "pass-through" business that provide only modest profit margins. 
In addition, profit margins were under additional pressure during the past 
two years because of Harmon capacity expansions in 1997.

     Traditionally, declining profit margins have negative con-notations. 
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 philosophy. Standing 
alone, it is a low margin, narrowly 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 out-source their asset management, maintenance and line 
upgrade projects.

RESEARCH AND DEVELOPMENT. Research and development expenditures increased 
$790,000 in 1998 and $1.3 million in 1997, which illustrates Harmon's ongoing 
commitment to incorporating new technology into its products. The increase in 
1998 relates to product development on Harmon's Electro Code 5, advanced 
train control systems, new technology for communication systems, and carborne 
products. During the 1998 fourth quarter, R&D expenses decreased as some 
engineering costs were charged directly to customer orders. In 1997, the 
increase was related 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 
to several prospective buyers. Although R&D expenditures were up in absolute 
dollar terms in 1998 and 1997, as a percent of sales they declined because of 
the sales increase in 1998.

SELLING, GENERAL & ADMINISTRATIVE EXPENSES. Selling, general and 
administrative expenses (SG&A) for 1998 were $33.4 million as compared with 
$30.3 million in 1997, an increase of 10.3% on a sales gain of 24% from 1997 
to 1998, 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 fifth consecutive year-to 12.6% of sales from 14.2% in 1997 and 14.8% 
in 1996. This down-ward 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 is the result of inflation, higher 
overall personnel-related expenses, commissions on higher sales volume, 
converting and upgrading Harmon's operating systems, and added SG&A expenses 
for acquisitions made in the past several years. In 1997, the company also 
incurred an additional $1.5 million in certain other SG&A expenses, chiefly, 
costs related to employee recruiting as well as legal and outside computer 
consulting services.

AMORTIZATION EXPENSES. Amortization expenses increased 48.1 % from 1997 to 
1998 and 18.7% from 1996 to 1997. The increases are the result of 
acquisitions made during 1998 and 1997.

MISCELLANEOUS INCOME - Net. Miscellaneous income advanced $303,000 over that 
of 1997. The difference resulted from increases in purchase discounts, gains 
on disposal of certain assets, and a variety of other transactions, which 
collectively accounted for the positive gains in 1998 compared with 1997. 
Changes between 1997 and 1996 were insignificant.


<PAGE>

24


INTEREST INCOME AND EXPENSE. Interest expense was $1,555,000 in 1998, 
$1,219,000 in 1997 and $724,000 in 1996. The increase in 1998 over 1997 
reflected higher average borrowings to finance increased working capital and 
acquisitions and a full year of interest on senior notes in 1998 versus a 
partial year in 1997. The increase in 1997 over 1996 was the result of 
interest on a January, 1997 private placement of $15 million in senior 
unsecured notes. Investment income was greater in 1997 than in 1998 or 1996 
because the proceeds from the $15 million private placement were invested 
during the first half of 1997. Subsequently, 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 36.3% in 1998 
compared with 37.7% in 1997 and 38.2% in 1996. The tax rate in 1998 was lower 
than in 1997 because of increased benefit for our Foreign Sales Corporation 
and a reduced effective tax rate in the Company's state of incorporation from 
tax refunds arising under recent legislation. The tax rate in 1997 was lower 
than in 1996 because of United Kingdom net operating loss usage applied in 
1997.

-------------------------------------------------------------------------------
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 1996, and negligible in 1997 and 1998. 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 avail-able products through internal development and 
acquire products or companies in the railroad supply industry that will 
expand Harmon's product or service offerings.

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

The Company concluded 1998 with a very strong balance sheet. Total assets 
were $162.9 million, up $27.1 million. Stock-holders' equity rose to $85.0 
million ($7.97 per share) from $69.8 million ($6.68 per share). Working 
capital was $55.9 million, which produced a current ratio of 2.05:1 compared 
to 2.09:1 a year earlier. Interest-bearing long-term debt was up $4.1 million 
at $19.5 million as a result of making acquisitions in 1998. Accounts 
receivable were up $7.2 million principally because of added sales volume 
derived from our acquired companies.      The Company completed a new, $75 
million line of credit in September, 1998. The new line, which carries lower 
interest rates than our previous line, provides $40 million for working 
capital and $35 million for acquisitions. The expanded line gives Harmon 
added financial strength to meet its strategic objectives over the next 
several years. At December 31, 1998, availability under the Company's new 
credit line was $68.5 million, with borrowings of $4.2 million against it. 
Capital expenditures for 1999 are budgeted at $17.5 million, roughly $3.0 
million higher than the capital expenditure budget for 1998. Traditionally, 
the Company spends less on capital expenditures than it actually budgets.     
 The Company believes cash flow from operations and borrowings under the new 
line of credit will provide sufficient funds for both its capital expenditure 
and acquisition programs.

-------------------------------------------------------------------------------
1999 OUTLOOK

On balance, the outlook for 1999 is excellent. Positive aspects are: 
increased bookings in January, 1999, which added to our record 1998 year-end 
backlog of $13i.8 million, up $57.3 million from the year earlier backlog of 
$74.5 million; recent and upcoming railroad mergers, which typically result 
in railroad purchases of efficiency-enhancing systems and products of a type 
that Harmon makes; a trend toward sole-source, multi-year supplier 
arrangements under which Harmon secured several major contracts in 1998; and 
substantially increased funding for rail transit projects and rail/highway 
crossing protection installations under the 1998-enacted tea 21 legislation. 
Other positives include the possibility of substantial 

<PAGE>

                                                                            25


additional rail transit business as Harmon was the low bidder on several 
contracts; the possibility of obtaining even more rail transit contracts in 
1999 as signal and control portions with communications-based train control 
technology are expected to be put up for bid in 1999. Finally, upgrading and 
privatization of railroads in Mexico is continuing; more railroads are 
becoming interested in outsourcing; international sales opportunities are 
increasing, particularly because of the expanding business relationship 
between Harmon's British-based subsidiary (Vaughan Harmon Systems Ltd.) and 
British Railtrack; and an opportunity to gain a greater portion of future 
rail transit contracts, owing to SES CO's added technical capabilities and 
its excellent reputation within the rail transit industry.

     Despite the many positives for Harmon, there are several potential 
negatives as well. First, we are getting increased price pressure from major 
customers, particularly from those granting long-term supplier contracts. 
Second, we are seeing heightened price competition in the markets of our 
higher margin products. Third, competition is increasing in two areas: on the 
domestic front as well as from huge European conglomerates. Fourth, potential 
problems may be encountered with y2k compliance issues, which are outlined 
below. Finally, although we expect a record year for sales in 1999, our first 
quarter sales and earnings will be weak-not because of a lack of business but 
rather because we obtained several contracts in the fourth quarter of 1998 
that are not expected to reach the applicable milestones before any 
proportionate profit can be booked. Thus, we expect our greater gains will 
occur as the year unfolds.

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

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

-------------------------------------------------------------------------------
THE EURO

There was no impact on Harmon as a result of the January 1999 implementation 
of the new common European currency, the euro. Our current European presence 
is largely confined to the United Kingdom, which is not a participant in the 
first implementation of the euro. Virtually all sales by our UK subsidiary 
are to UK customers and are denominated in pounds sterling. Sales by our U.S. 
operations to European customers to date have typically been denominated in 
U.S. dollars.

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

"Year 2000 Issue" or "y2k" refers to the practice in many existing computer 
programs that uses only the last two digits when designating a year. 
Therefore, these programs cannot distinguish a year that begins with 19 from 
a year that begins with 20. If not corrected, many computer applications 
could fail or create erroneous results beginning January 1, 2000.

BACKGROUND--

In 1997, the Company's Management Information Systems Steering Team developed 
a long-range plan to consolidate substantially all of its domestic operations 
onto a single computer operating system. The software vendor chosen was the 
one that currently supplies the largest of the Company's three primary 
operating systems. The benefits of this consolidation are increased 
efficiency and uniformity throughout the Company, particularly in the areas 
of manufacturing, inventory management and engineering, as well as achieving 
y2k compliance.

READINESS--

      PROJECT MANAGEMENT. To properly manage and coordinate the Company's y2k
      efforts, the Management Information Systems Steering Team, using a formal
      team structure, appointed a project leader who supervises various
      sub-teams responsible for y2k compliance in the following areas:

      OPERATING SYSTEMS. To complete the consolidation discussed above, the
      Company completed one systems upgrade and will perform two systems
      conversions. The upgrade, which affected the largest portion of the
      Company's business, was successfully completed at the end of the third
      quarter 1998. The conversions of the 


<PAGE>

26


      remaining two systems are scheduled for 1999. An inventory of 
      workstation hardware identified over 300 personal computers that 
      require installation of y2k compliant systems boards. These boards are 
      being installed in 1999.

      CUSTOMERS. A review by the Company of the products it sells has thus far
      identified a minimal number of areas of y2k non-compliance. One area
      involves a vendor-supplied operating system. The Company is currently
      awaiting a proposed solution from the manufacturer. An installed base of
      fewer than ten is affected by this issue. All customers have been informed
      of this problem and are being kept up-to-date with the progress. Another
      potential issue involves a clock chip that the Company has been informed
      is not y2k compliant. The Company is conducting a review to determine if
      and when this component may have been used in any of its products. The
      Company believes that none of the y2k issues described above, if not
      corrected, would jeopardize the systems of any of its customers or the
      safety of the public at large. While final action plans are not yet
      complete, the Company does not believe the costs necessary to achieve y2k
      compliance for its products will be material to the Company's financial
      statements on a consolidated basis.

      VENDORS. The Company is nearing completion of a survey of all significant
      vendors to determine if the Company's operations could be materially
      impacted by the failure of key vendors to achieve y2k compliance. The next
      step is to determine which vendor responses require follow-up or audit.

      MISCELLANEOUS. The Company is presently testing manufacturing and
      production equipment, telephone systems, security systems, and other
      peripheral devices associated with the Company's facilities for y2k
      compliance.

COSTS-

As discussed above, y2k compliance is one of two benefits achieved by the 
Company's upgrade and conversion efforts. While the Company is monitoring the 
costs of these projects against established budgets, it is not possible to 
allocate these costs between the two objectives; the benefits of a common 
operating system and the requirement for y2k compliance. The Company incurred 
operating expenses of approximately $1.1 million in 1998 and has budgeted 
operating expenses of $1.1 million in 1999. These costs will be funded by 
cash flow from operations.

RISKS-

The Company's primary y2k risks are in the timing of the conversions planned 
for 1999 and the potential for failure of key vendors to achieve y2k 
compliance. Operations of the Company's Lee's Summit, MO and Riverside, CA 
locations could be impacted if those conversions are not completed by the 
time it is necessary to enter dates beyond December 31, 1999. The Company 
believes the impact of y2k non-compliance at these locations would be limited 
to decreased productivity and the substitution of manual processes for 
certain automated ordering and planning processes. The evaluation of the 
Company's exposure resulting from non-compliance by key vendors is in process 
and the impact, if any, is therefore not yet known.

CONTINGENCY PLANS-

The Company is upgrading the operating system at its Riverside, CA location 
to be y2k compliant to minimize the chance of any disruptions in production 
if the conversion of that location to the chosen common operating system is 
delayed. The Company is also identifying alternative suppliers for certain 
critical components.

<PAGE>

                                                                            27


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

Sales for Harmon's 1998 fourth quarter were $73.2 million compared with $73.8 
million for fourth quarter sales of 1997. Cost of sales as a percentage of 
sales was 75.7% compared with 74.4% in 1997. The difference between the two 
years reflects greater shipments of lower margin products in 1998. In 1997, a 
sizable portion of Harmon's fourth quarter revenues were comprised of 
Harmon-manufactured goods, which traditionally carry higher margins. Although 
shipments were fractionally lower in the 1998 fourth quarter, overall 
business was extremely strong. New orders written during the fourth quarter 
of 1998 were $105 million, a record level for any quarter.

     Net earnings for the 1998 fourth quarter were $3.5 million, or $0.33 per 
share - diluted,  compared with $3.9 million, or $0.37 per share, for the 
1997 fourth quarter.

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

<TABLE>
<CAPTION>
                                               1998                                      1997
      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                $ 60,558  $73,705  $ 57,754  $73,202      $35,988  $ 47,621  $56,125   $73,796
      COST OF SALES              46,014   55,324    43,749   55,392       26,196    33,607   41,512    54,909
      R&D EXPENDITURES            2,107    2,376     2,103    1,867        1,602     1,809    1,758     2,496
                               ------------------------------------------------------------------------------
      GROSS PROFIT               12,437   16,005    11,902   15,943        8,190    12,205   12,855     16,391
      SELLING, GENERAL AND
      ADMINISTRATIVE EXPENSES     7,540    8,426     7,783    9,665        5,847     6,687    8,228     9,534
      AMORTIZATION                  217      217       234      365          160       166      178       192
      MISCELLANEOUS (INCOME)
      EXPENSE-NET                    10      (27)     (188)    (163)         (23)      281       (4)       13
                               ------------------------------------------------------------------------------
      OPERATING INCOME            4,670    7,389     4,073    6,076        2,206     5,071    4,453     6,652
      INVESTMENT INCOME              36       75        98      187          138       176       67        41
      INTEREST EXPENSE              304      352       304      594          124       428      333       334
                               ------------------------------------------------------------------------------
      EARNINGS BEFORE
      INCOME TAXES                4,402    7,112     3,867    5,669        2,220     4,819    4,187     6,359
      INCOME TAXES                1,590    2,510     1,399    2,149          772     1,832    1,548     2,470
                               ------------------------------------------------------------------------------
      NET EARNINGS             $  2,812  $ 4,602  $  2,468  $ 3,520      $ 1,448  $  2,987  $ 2,639   $ 3,889
                               ------------------------------------------------------------------------------
                               ------------------------------------------------------------------------------
      EARNINGS PER COMMON
      SHARE - DILUTED          $   0.27  $  0.43  $   0.23  $  0.33      $  0.14  $   0.29  $  0.25   $  0.37
      WEIGHTED AVERAGE
      SHARES - DILUTED           10,608   10,685    10,666   10,774       10,304    10,335   10,392    10,467
</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.

<PAGE>

28


CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>

At December 31,                                                                           1998              1997
-------------------------------------------------------------------------------------------------------------------
<S>                                                                                    <C>               <C>
Assets
Current assets:
   Cash and cash equivalents                                                           $   1,669         $    6,748
   Trade receivables, less allowance for doubtful accounts
     of $351 in 1998 and $318 in 1997                                                     52,229             45,001
   Costs and estimated earnings in excess of billings on
     uncompleted contracts (note 2)                                                        9,649              2,850
   Inventories:
        Work in process                                                                    6,372              6,171
        Raw materials and supplies                                                        36,640             32,894
                                                                                        ---------------------------
                                                                                          43,012             39,065
   Income tax receivable                                                                     597                 -
   Deferred tax asset (note 4)                                                               587              2,215
   Prepaid expenses and other current assets                                               1,301                473
                                                                                        ---------------------------
            Total current assets                                                         109,044             96,352
                                                                                        ---------------------------
Property, plant and equipment, at cost (note 3):
   Land                                                                                      465                465
   Buildings                                                                              11,671             11,363
   Machinery and equipment                                                                18,830             16,319
   Office furniture and equipment                                                         25,246             20,671
   Transportation equipment                                                                1,709              1,393
   Leasehold improvements                                                                  3,938              3,120
                                                                                        ---------------------------
                                                                                          61,859             53,331
   Less accumulated depreciation and amortization                                         35,284             29,302
                                                                                        ---------------------------
            Net property, plant and equipment                                             26,575             24,029

Deferred tax asset (note 4)                                                                  654                414
Cost in excess of fair value of net assets acquired, net of accumulated
  amortization of $4,212 in 1998 and $3,180 in 1997 (note 11)                             17,327              8,766
Deferred compensation asset (note 6)                                                       6,839              5,807
Other assets                                                                               2,414                401
                                                                                       ----------------------------
                                                                                       $ 162,853         $  135,769
                                                                                       ----------------------------
                                                                                       ----------------------------
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

                                                                             29

<TABLE>
<CAPTION>

At December 31,                                                                           1998              1997
--------------------------------------------------------------------------------------------------------------------  29
<S>                                                                                    <C>               <C>
Liabilities and Stockholders' Equity
Current liabilities:
   Current debt installments (note 3)                                                  $     280         $    1,162
   Accounts payable                                                                       16,415             21,554
   Accrued payroll, bonus and employee
     benefit plan contributions (note 6)                                                  13,342             11,893
   Billings in excess of costs and estimated earnings on
     uncompleted contracts (note 2)                                                       17,493              5,677
   Other accrued liabilities                                                               5,650              5,177
   Current tax liability                                                                      -                 566
                                                                                       ----------------------------
            Total current liabilities                                                     53,180             46,029
                                                                                       ----------------------------
Deferred compensation liability (note 6)                                                   5,175              4,522
Long-term debt (note 3)                                                                   19,540             15,456
                                                                                       ----------------------------
            Total liabilities                                                             77,895             66,007

Stockholders' equity (notes 3, 6, 7 and 11):
   Common stock of $.25 par value; authorized 50,000,000 shares,
     issued 10,662,400 shares in 1998 and 10,437,369 shares in 1997                        2,666              2,609
   Additional paid-in capital                                                             27,457             24,514
   Foreign currency translation                                                              127                104
   Unearned compensation                                                                    (287)              (224)
   Retained earnings                                                                      54,995             42,759
                                                                                       ----------------------------
            Total stockholders' equity                                                    84,958             69,762

Commitments and contingencies (notes 6 and 10)

                                                                                       ----------------------------
                                                                                       $ 162,853         $  135,769
                                                                                       ----------------------------
                                                                                       ----------------------------
</TABLE>

<PAGE>

30


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

<TABLE>
<CAPTION>
Years ended December 31,                                               1998               1997              1996
-------------------------------------------------------------------------------------------------------------------
<S>                                                                  <C>               <C>               <C>
Net sales                                                            $ 265,219         $ 213,530         $  175,440
Cost of sales                                                          200,478           156,224            126,997
Research and development expenditures                                    8,454             7,664              6,331
                                                                     ----------------------------------------------
            Gross profit                                                56,287            49,642             42,112
                                                                     ----------------------------------------------

Selling, general and administrative expenses                            33,415            30,298             25,990
Amortization of cost in excess of fair value
  of net assets acquired (note 11)                                       1,032               697                587
Equity in net loss of affiliate (note 8)                                    -                330                 -
Miscellaneous income - net                                                 368                63                 43
                                                                     ----------------------------------------------
            Operating income                                            22,208            18,380             15,578

Interest expense                                                         1,555             1,219                724
Investment income                                                          396               422                251
                                                                     ----------------------------------------------
            Earnings before income taxes                                21,049            17,583             15,105

Income tax expense (benefit) (note 4):
   Current                                                               6,259             6,876              6,945
   Deferred                                                              1,388              (254)            (1,170)
                                                                     ----------------------------------------------
                                                                         7,647             6,622              5,775
                                                                     ----------------------------------------------
            Net earnings                                             $  13,402         $  10,961         $    9,330
                                                                     ----------------------------------------------
                                                                     ----------------------------------------------
Basic earnings per common share                                      $    1.27         $    1.06         $     0.91
Diluted earnings per common share                                    $    1.25         $    1.06         $     0.91
                                                                     ----------------------------------------------
                                                                     ----------------------------------------------
Weighted average shares used in computation (000s)
   Basic earnings per common share                                      10,541            10,313             10,217
   Diluted earnings per common share                                    10,684            10,374             10,268
                                                                     ----------------------------------------------
                                                                     ----------------------------------------------
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

                                                                              31

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>

                                                    ADDITIONAL    FOREIGN                             TOTAL      COMPRE-
                                           COMMON     PAID-IN    CURRENCY    UNEARNED    RETAINED  STOCKHOLDERS' HENSIVE
                                            STOCK     CAPITAL   TRANSLATION COMPENSATION EARNINGS     EQUITY     INCOME
------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>      <C>         <C>         <C>          <C>       <C>           <C>    
Balance at December 31, 1995               $2,553    $ 22,152    $     -    $      -     $ 24,527    $ 49,232
Net earnings                                   -           -           -           -        9,330       9,330    $ 9,330
Foreign currency translation                   -           -          203          -           -          203        203
                                                                                                                 -------
Comprehensive income                           -           -           -           -           -           -       9,533
                                                                                                                 -------
                                                                                                                 -------
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
                                          -------------------------------------------------------------------
Balance at December 31, 1996                2,561      22,340         203          -       32,835      57,939
                                          -------------------------------------------------------------------
                                          -------------------------------------------------------------------
Net earnings                                   -           -           -           -       10,961      10,961     10,961
Foreign currency translation                   -           -          (99)         -           -          (99)       (99)
                                                                                                                 -------
Comprehensive income                           -           -           -           -           -           -      10,862
                                                                                                                 -------
                                                                                                                 -------
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
                                          -------------------------------------------------------------------
Balance at December 31, 1997                2,609      24,514         104        (224)     42,759      69,762
                                          -------------------------------------------------------------------
                                          -------------------------------------------------------------------
Net earnings                                   -           -           -           -       13,402      13,402     13,402
Foreign currency translation                   -           -           23          -           -           23         23
                                                                                                                 -------
Comprehensive income                           -           -           -           -           -           -     $13,425
                                                                                                                 -------
                                                                                                                 -------
Cash dividends paid ($0.11 per share)          -           -           -           -       (1,166)     (1,166)
Common stock issued (notes 6, 7 and 11):                                           
   Acquisitions of businesses                  44       2,114          -           -           -        2,158
   Deferred compensation                        2         184          -          (63)         -          123
   Stock options and other                     11         645          -           -           -          656
                                          -------------------------------------------------------------------
Balance at December 31, 1998               $2,666    $ 27,457    $    127   $    (287)   $ 54,995    $ 84,958
                                          -------------------------------------------------------------------
                                          -------------------------------------------------------------------
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

32


CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>

YEARS ENDED DECEMBER 31,                                                      1998           1997           1996
-------------------------------------------------------------------------------------------------------------------
<S>                                                                          <C>            <C>             <C>
Cash Flows From Operating Activities:
Net earnings                                                                 $13,402        $10,961         $ 9,330
Adjustments to reconcile net earnings to net cash provided by (used in)
operating activities:
   Depreciation and amortization                                               7,186          5,639           5,004
   Loss (gain) on sale of property, plant and equipment                           20             45              (5)
   Deferred tax expense (benefit)                                                 -            (254)         (1,170)
   Earned stock compensation                                                     122            137              -
   Equity in net loss of affiliate                                                -             330              -
Changes in assets and liabilities, net of acquisitions of businesses:
   Trade receivables                                                           4,666         (3,900)        (13,740)
   Inventories                                                                (3,414)       (11,677)         (1,060)
   Estimated costs, earnings and billings on contracts                        (3,387)        (1,371)          7,381
   Prepaid expenses and other current assets                                    (319)         2,454            (360)
   Current income taxes receivable                                               340             -               -
   Accounts payable                                                           (6,745)         5,209           3,345
   Accrued payroll and benefits                                                 (130)           911           4,000
   Other liabilities                                                             473           (995)          5,007
   Other deferred liabilities                                                    653            597             371
                                                                             --------------------------------------
        Total adjustments                                                       (535)        (2,875)          8,773
                                                                             --------------------------------------
            Net cash provided by operating activities                         12,867          8,086          18,103
                                                                             --------------------------------------

Cash Flows From Investing Activities:
Capital expenditures                                                          (8,271)       (10,475)         (6,371)
Acquisitions of businesses                                                    (8,487)          (196)         (2,146)
Proceeds from sale of property, plant and equipment                               49             29              46
Deferred compensation, net                                                    (1,032)          (809)         (1,339)
Other investing activities                                                    (2,013)          (358)          1,584
                                                                             --------------------------------------
            Net cash used in investing activities                            (19,754)       (11,809)         (8,226)
                                                                             --------------------------------------
Cash Flows From Financing Activities:
Proceeds from issuance of common stock                                           542            501              46
Cash dividends                                                                (1,166)        (1,037)         (1,022)
Proceeds from issuance of long-term debt                                          -          15,000              -
Borrowings under line of credit agreements                                    60,126         52,370          46,530
Repayments under line of credit agreements                                   (56,514)       (55,293)        (55,165)
Principal payments of long-term debt                                          (1,203)          (971)           (469)
                                                                             --------------------------------------
            Net cash provided by (used in) financing activities                1,785         10,570         (10,080)
                                                                             --------------------------------------
Foreign currency translation                                                      23            (99)            203
                                                                             --------------------------------------
Net increase (decrease) in cash and cash equivalents                          (5,079)         6,748              -
Cash and cash equivalents at beginning of year                                 6,748             -               -
                                                                             --------------------------------------
Cash and cash equivalents at end of year                                     $ 1,669       $  6,748         $    -
                                                                             --------------------------------------
                                                                             --------------------------------------
Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for:
   Interest                                                                  $ 1,442        $   884         $   690
   Income taxes                                                              $ 8,570        $ 6,635         $ 6,019
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

                                                                          33

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),  CSS Inc.  (CSS),  Harmon  
Industries  Australia PTY LTD (Harmon Australia),  Seaboard Systems Co., Inc. 
(Seaboard),  SES CO., Inc. (SESCO),  Industrias  Harmon De Mexico,  S.A. De 
C.V. (Harmon de Mexico) 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 communications 
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 twenty 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.


<PAGE>

34


COMPREHENSIVE  INCOME. In June 1997, the Financial  Accounting  Standards 
Board issued Statement No. 130,  "Reporting  Comprehensive Income" which 
establishes rules for the reporting of comprehensive  income and its 
components.  Comprehensive income consists of net income and foreign  
currency  translation  adjustments and is presented in the Statement of  
Stockholders'  Equity.  The adoption of Statement No. 130 had no impact on 
total stockholders' equity.

FOREIGN CURRENCY TRANSLATION. Assets and liabilities in foreign currencies are
translated into dollars at the rates prevailing at the balance sheet date.
Revenues and expenses are translated at average rates for the year. The net
exchange differences resulting from these translations are reported in
stockholders' equity, net of tax effects.

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.

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. Basic earnings per common share 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 
earnings per common share 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, 1998, 1997 and 1996 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, 1998, 1997 and 1996 the denominator used in 
computing basic earnings per share represents the weighted average number of 
common shares outstanding (10,553,000 shares-1998, 10,319,000 shares-1997, 
10,217,000 shares-1996), reduced by the weighted average number of shares of 
nonvested stock (12,000 shares - 1998, 6,000 shares - 1997) 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 (10,541,000 
shares-1998, 10,313,000 shares-1997, 10,217,000 shares-1996) 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 (143,000 shares-1998, 61,000 
shares-1997, 51,000 shares-1996).

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.

<PAGE>

                                                                            35


ENVIRONMENTAL REMEDIATION LIABILITIES. 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.

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, 1998:
         Costs and estimated earnings                          $ 30,374         $ 121,701        $ 152,075
         Billings                                                20,725           139,194          159,919
                                                               -------------------------------------------
                                                               $  9,649         $ (17,493)       $  (7,844)
                                                               -------------------------------------------
                                                               -------------------------------------------
         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)
                                                               -------------------------------------------
                                                               -------------------------------------------
</TABLE>

     Balances billed, but not paid by customers under retainage provisions in 
contracts amounted to $2,643,000 and $798,000 at December 31, 1998 and 1997, 
respectively. Receivables on contracts in progress are considered to be 
collectible within twelve months.

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

<TABLE>
<CAPTION>

         (DOLLARS IN THOUSANDS)                                                   1998             1997
         -------------------------------------------------------------------------------------------------
         <S>                                                                    <C>              <C>     
         Revolving credit agreements                                            $   4,200        $      -
         Senior unsecured notes payable                                            15,000           15,000
         Lines of credit                                                               39              583
         Bank loans       387                                                                          336
         Capitalized lease obligations                                                194              699
                                                                                --------------------------
                 Total indebtedness                                                19,820           16,618
             Less current installments                                                280            1,162
                                                                                --------------------------
                 Long-term debt                                                 $  19,540        $  15,456
                                                                                --------------------------
                                                                                --------------------------
</TABLE>

REVOLVING CREDIT AGREEMENTS. On September 29, 1998 the Company entered into a 
new credit agreement with a major commercial bank. The new credit agreement 
provides for a five (5) year unsecured Revolving Line of Credit (RC) of 
$40,000,000 to be used to provide working capital and refinance existing 
indebtedness, replacing the old revolving credit agreement of $20,000,000. At 
December 31, 1998, there are no outstanding borrowings. Outstanding 
borrowings bear interest at the base rate less one half percent (1/2%) or 
LIBOR plus a variable component depending on the Company's funded debt/EBITDA 
ratio.

<PAGE>

36


     Also, included in this new agreement is an unsecured reducing revolving 
credit agreement with original total credit availability of $35,000,000 
reducing $1,750,000 as of the last day of each quarter beginning December 31, 
2000. The Company has remaining total credit availability of $35,000,000 at 
December 31, 1998 against which there are outstanding borrowings of 
$4,200,000 at December 31, 1998. Outstanding borrowings are due on September 
28, 2003 and bear interest at the base rate less one half percent (1/2%) or 
LIBOR plus a variable component depending on the Company's funded debt/EBITDA 
ratio.

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.

LINES OF CREDIT. A subsidiary company has a line of credit with total 
availability of $423,000 against which there are outstanding borrowings of 
$39,000 at December 31, 1998. 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 1/2% (7.25% at December 31, 1998), 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 
$2,000,000 against which there are no outstanding borrowings at December 31, 
1998. The line of credit does not have a stated expiration date as all 
amounts are payable upon demand of the lender. The line of credit bears 
interest at the lender's prime lending rate plus 1% (8.75% at December 31, 
1998), payable monthly. The line of credit is collateralized by liens against 
certain real and personal property.

BANK LOANS. A subsidiary company has a $166,000 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% 
(8.1% at December 31, 1998). The note is collateralized by liens against 
certain real and personal property.

     A subsidiary company has a $68,000 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% 
(11.75% at December 31, 1998). The note is collateralized by liens against 
certain real and personal property.

     A subsidiary company has, in aggregate, a $102,000 bank loan which 
represents term notes payable in monthly installments including interest 
through July 2002. These notes bear interest at fixed rates ranging from 4.9% 
to 9.75%. The notes are collateralized by motor vehicles.

     A subsidiary company has, in aggregate, a $51,000 bank loan which 
represents term notes payable in monthly installments including interest 
through November 2002. These notes bear interest at fixed rates ranging from 
5.9% to 12%. The notes are collateralized by motor vehicles.

CAPITALIZED LEASE OBLIGATIONS. The Company entered into various computer 
hardware and software capital lease agreements totaling $312,000 in 1997. 
Monthly installments are due through November 2000. The implied interest 
rates in the lease agreements range from 7.0% to 9.0%. The Company did not 
enter into any new capital lease agreements during 1998.

COVENANTS. The various indebtedness agreements contain, among other things, 
covenants relating to: maintenance of certain levels of consolidated net 
worth, limitations of maximum capital expenditures and maintenance of minimum 
EBITDA; maintenance of certain ratios of debt to EBITDA, debt service 
coverage ratio and funded debt to total capitalization ratio. At December 31, 
1998, the Company is in compliance with all covenants under its indebtedness 
agreements.

<PAGE>
                                                                             37


MATURITIES. At December 31, 1998, long-term debt maturities for 1999 and 
thereafter are: 

<TABLE>
<CAPTION>

         YEARS ENDED DECEMBER 31                         (DOLLARS IN THOUSANDS)
         ---------------------------------------------------------------------
         <S>                                             <C>
         1999                                                          $   280
         2000                                                              244
         2001                                                            2,205
         2002                                                            2,177
         2003 and thereafter                                            14,914
                                                                      --------
                                                                       $19,820
                                                                      --------
                                                                      --------
</TABLE>

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

Income tax expense consisted of the following:

<TABLE>
<CAPTION>

        (DOLLARS IN THOUSANDS)                       1998            1997            1996
         ----------------------------------------------------------------------------------
         <S>                                       <C>             <C>              <C>    
         Current:
            Federal                                $  4,857        $  4,992         $ 5,741
            Foreign                                     600           1,002              -
            State                                       802             882           1,204
                                                   ----------------------------------------
               Total current                          6,259           6,876           6,945

         Deferred:
            Federal                                   1,251            (223)           (976)
            State                                       137             (31)           (194)
                                                   ----------------------------------------
               Total deferred                         1,388            (254)         (1,170)
                                                   ----------------------------------------
               Total income tax expense            $  7,647        $  6,622         $ 5,775
                                                   ----------------------------------------
                                                   ----------------------------------------
</TABLE>

     Income tax expense for the years ended December 31, 1998, 1997, and 
1996, 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)                                     1998            1997            1996
         -------------------------------------------------------------------------------------------------
         <S>                                                      <C>             <C>              <C>    
         Computed "expected" tax expense                          $  7,367        $  6,154         $ 5,287
         Increase (reduction) in income taxes resulting from:
            State and local income taxes, net of
             federal income tax benefit                                610             553             657
             Other, net                                               (330)            (85)           (169)
                                                                  ----------------------------------------
                                                                  $ 7,647   $       6,622   $        5,775
                                                                  ----------------------------------------
                                                                  ----------------------------------------
</TABLE>

<PAGE>

38


     The tax effects of temporary differences that give rise to significant 
portions of the deferred tax assets and deferred tax liabilities at December 
31, 1998 and 1997 are presented below:

<TABLE>
<CAPTION>
         (DOLLARS IN THOUSANDS)                                                       1998            1997
         -------------------------------------------------------------------------------------------------
         <S>                                                                       <C>             <C>    
         Deferred tax assets:
            Deferred compensation                                                  $ 2,080         $ 1,805
            Compensated absences                                                       495             425
            Inventories                                                                516             481
            Allowance for doubtful accounts                                            124             117
            Various other reserves                                                     999           1,561
                                                                                   -----------------------
               Total gross deferred tax assets                                       4,214           4,389
               Less valuation allowance                                                369             369
                                                                                   -----------------------
                                                                                     3,845           4,020
         Deferred tax liabilities:
            Depreciation and Amortization                                           (1,426)         (1,391)
            Long-term contract deferred costs                                       (1,178)             -
                                                                                   -----------------------
               Total deferred tax liabilities                                       (2,604)         (1,391)
                                                                                   -----------------------
               Net deferred tax assets                                             $ 1,241         $ 2,629
                                                                                   -----------------------
                                                                                   -----------------------
</TABLE>

     There were no net changes in the total valuation allowance for the years 
ended December 31, 1998 and 1997. 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.

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

Harmon Industries manages its operations through two business segments: 
domestic and international. Each unit sells train control and train signal 
products as well as services to railroads and transit authorities. The 
international business segment sells the Company's products and services 
outside the U.S.

     The Company is reporting business segment information in accordance with 
the provisions of Financial Accounting Standards No. 131, "Disclosures about 
segments of an Enterprise and Related Information" which was issued in June 
1997. Prior to a series of acquisitions and establishment of new foreign 
subsidiaries, which occurred between 1995 and 1998, the Company had only one 
business segment. Because of the desire to market its products and services 
on a global scale, the Company began to manage its operations using the 
domestic and international approach in fiscal year 1997.

     Harmon Industries evaluates performance based upon net operating profit. 
Administrative functions such as finance, treasury and information systems 
are centralized. However, where applicable portions of the administrative 
function expenses are allocated between the operating segments. The operating 
segments do not share manufacturing or distribution facilities. In the event 
any materials and/or services are provided to one operating segment by the 
other, the transaction is valued according to the company's transfer policy, 
which approximates market price. The costs of operating the manufacturing 
plants are captured discretely within each segment. The Company's property, 
plant and equipment, inventory and accounts receivable are captured and 
reported discretely within each operating segment.

<PAGE>
                                                                             39


     Summary financial information for the two reportable segments is as 
follows (dollars in thousands):                                             

<TABLE>
<CAPTION>
                                                                              1998                  1997
         -------------------------------------------------------------------------------------------------
         <S>                                                                 <C>                   <C>
         USA Operations
         Net Sales                                                           251,537               200,181
         Operating Income/(Loss)                                              21,516                15,273
         Assets                                                              156,245               129,352
         Accounts Receivable                                                  50,513                42,396
         Inventory                                                            42,448                38,645

         International Operations
         Net Sales                                                            13,682                13,349
         Operating Income/(Loss)                                                 692                 3,107
         Assets                                                                6,608                 6,417
         Accounts Receivable                                                   1,716                 2,605
         Inventory                                                               564                   420

         Consolidated
         Net Sales                                                           265,219               213,530
         Operating Income/(Loss)                                              22,208                18,380
         Assets                                                              162,853               135,769
         Accounts Receivable                                                  52,229                45,001
         Inventory                                                            43,012                39,065
</TABLE>


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 $2,667,000, 
$2,122,000 and $1,661,000 for the years ended December 31, 1998, 1997 and 
1996, 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>
         1999                                          $   322               $ 2,093               $ 2,415
         2000                                              193                 1,800                 1,993
         2001                                               91                 1,431                 1,522
         2002 and Thereafter                                 1                 9,630                 9,631
</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 1999.


<PAGE>

40


EMPLOYEE BENEFITS. In 1985, the Company formed an Employee Stock Ownership 
Plan and Trust (ESOP), which includes all employees. The ESOP held 743,437 
shares and 746,358 shares of Company common stock which had been allocated to 
plan participants at December 31, 1998 and 1997, 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 $4,809,000,  
$3,874,000 and $3,815,000 for the years ended December 31, 1998, 1997 and 
1996, respectively.

     The Company and its subsidiaries have various bonus plans based 
primarily on Company performance. Accrued and unpaid bonuses at December 31, 
1998 and 1997 were $3,133,000 and $2,776,000, 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 $286,000, $573,000 and $(365,000) for 
the years ended December 31, 1998, 1997 and 1996, 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 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 $15,000 in 1998.

     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 50% 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 $120,000 in 1998 and $27,000 in 1997.

     The Company also has employment agreements with certain key executives. 
Under the terms of these agreements the Company contributed 9,268 shares and 
24,150 shares of common stock of the Company to a grantor trust in 1998 and 
1997 respectively. The stock price as of the date of grant was $19.25 in 1998 
and ranged from $13.92 to $16.50 in 1997. 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.


<PAGE>

                                                                             41

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>               <C>          
         Balance at January 1, 1996                      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

         Granted                                         168,000             20.375-23.875
         Exercised                                       (39,600)            11.00-20.875
         Expired                                          (3,900)            11.00-20.875
         Balance at December 31, 1998                    435,600           $ 14.93           Average Price
</TABLE>

     The Company has outstanding stock options for 435,600 shares of common 
stock at prices ranging from $9.33 to $23.88 with a weighted-average 
remaining contractual life of 4.85 years of which 230,175 shares (average 
price $12.86) are exercisable as of December 31, 1998. In May 1998 the 
Company granted stock options for up to 1,500 common shares to each of the 
Company's eight non-employee directors which expire on May 31, 2005. In May 
1997 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, 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.

     The Company issued 43,962,  92,307 and 26,471 shares of  unregistered  
common stock in connection  with the 1998, 1997 and 1996 acquisitions of 
businesses respectively (See Note 11).

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

As of December 31, 1997 the Company had an investment of 20% in Henkes & 
Harmon Industries PTY LTD, an unconsolidated affiliate which was accounted 
for under the equity method. During 1998 the Company sold its 20% interest in 
the affiliate and acquired the Assets of Henkes & Harmon through an asset 
purchase (See note 11). Equity in earnings from this affiliate was not 
significant prior to the asset purchase or for the years ended December 31, 
1997 and 1996. Prior to the acquisition, the Company had sales to this 
related entity totaling $373,000, $253,000 and $559,000 for 1998, 1997 and 
1996, respectively. The Company had receivables due from this entity of 
$69,000 at December 31, 1997.

     As of December 31, 1996 the Company also had an investment of 38% in a 
formerly unconsolidated affiliate, Vale Harmon Enterprises, Ltd., 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 year ended 
December 31, 1996. 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 $90,000, $150,000 and $283,000 for the years ended December 31, 
1998, 1997 and 1996, respectively.


<PAGE>

42


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 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.

     On August 25, 1998 the United States District court for the Western 
District of Missouri granted the Company's motion of summary judgment, 
overturning the EAB's ruling. The Missouri Department of Natural Resources 
(MDNR) agreed to forego monetary damages and a subsequent circuit court 
decree released Harmon from further claims in exchange for performing further 
monitoring and cleanup. The decision dismisses the EPA's complaint and 
releases Harmon from the EPA penalty action. A federal judge ruled the 
complaint is barred by the RCRA which requires the EPA to delegate 
enforcement to authorized states. Under the statute, the actions of states 
"have the same force and effect" as those taken by the EPA directly. Missouri 
has been an authorized state since 1985. On December 28, 1998 the EPA filed 
an appeal with the United States Court of Appeals contesting the United 
States District courts decision. Harmon is expected to file its opening brief 
in the first quarter of 1999, with oral arguments expected 3 to 6 months 
thereafter.

     Based on the Company's cooperation with the 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 EPA 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.

     The Company has recorded a total of $2,472,000 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 any 
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 January 29, 1998 the Company acquired the stock of CSS Inc. This 
acquisition was made with the issuance of 80,820 shares of unregistered 
common stock valued at $17.92 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 $1,158,348.

     On April 20, 1998 the Company established a new wholly owned subsidiary, 
Industrias Harmon de Mexico, S.A. de C.V. (Harmon de Mexico). The operating 
results have been included in the Company's consolidated results of 
operations from the date of incorporation.

     On October 1, 1998 the Company established a new wholly owned 
subsidiary, Harmon Industries Australia PTY LTD (Harmon Australia), which was 
capitalized through a cash investment. On that same date, Harmon Australia 
(the newly formed subsidiary) acquired substantially all of the assets of 
Henkes & Harmon Industries PTY LTD (Henkes Harmon) which consisted primarily 
of inventory and accounts receivable. Harmon Australia also assumed certain 
liabilities related to the purchased assets on the acquisition date. 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 $373,000.

<PAGE>

                                                                           43


     On October 1, 1998 the Company acquired the stock of Seaboard Systems 
CO., Inc. for an initial purchase price of $1,800,000 in cash. In addition to 
the initial purchase price, the purchase agreement provides for contingent 
payments. These payments are based on the average earnings before taxes for 
the calendar years 1998 through 2000. 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 $277,166.

     On October 1, 1998 the Company acquired the stock of SES CO, Inc. This 
acquisition was made with the issuance of 95,026 shares of unregistered 
common stock valued at $21.05 per share and $10,200,000 in cash. In addition 
to the initial purchase price, the purchase agreement provides for contingent 
payments. These payments are based on the average earnings before taxes for 
the calendar years 1998 through 2000. 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 $7,601,076.

     The following unaudited pro forma consolidated results of operations are 
presented as if the acquisition of SES CO, Inc. had been made at the 
beginning of the periods presented. The effects of the other 1998 
acquisitions on the consolidated financial statements are not significant and 
have been excluded from the pro forma presentation.

<TABLE>
<CAPTION>
                                                                          (IN THOUSANDS OF DOLLARS)
               YEARS ENDED DECEMBER 31,                                    1998               1997
               -------------------------------------------------------------------------------------
               <S>                                                      <C>                <C>      
               Net sales                                                $ 276,812          $ 227,653
               Net earnings                                                13,440             12,020
               Basic earnings per common share                               1.28               1.17
               Diluted earnings per common share                             1.26               1.16
</TABLE>

     The pro forma consolidated results of operations include adjustments to
give effect to amortization of goodwill, interest expense on acquisition debt
and certain other adjustments, together with related income tax effects. The
unaudited pro forma information is not necessarily indicative of the results of
operations that would have occurred had the purchase been made at the beginning
of the periods presented or the future results of the combined operations.

     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 shares of unregistered common stock valued at $14.73 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 shares of 
unregistered common stock valued at $5.67 per share, a $198,000 note payable 
and $145,000 in

<PAGE>

44


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.

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 
1998, 1997 and 1996 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 $637,000 in 1998, $280,000 in 
1997 and $325,000 in 1996, or $.06 per share in 1998, $.03 per share in 1997 
and $.03 per share in 1996. The fair value of the options granted is 
estimated at values ranging from $7.56 to $11.86 in 1998, $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 .11 per share in 1998 and .10 per share in 1997 and 1996, volatility 
of 49% in 1998 and ranging between 46% and 48% in 1997 and between 41% and 
70% in 1996, risk-free interest rate ranging between 5.57% and 5.65% in 1998, 
5.90% and 6.40% in 1997 and 5.25% and 7.01% in 1996, assumed forfeiture rate 
of 0% in 1998, 1997 and 1996, and an expected life of 2.85 years in 1998 and 
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.

NOTE 13. SUBSEQUENT EVENT
-------------------------------------------------------------------------------

On March 2, 1999, the Company  signed a letter of intent to acquire the 
majority  control of Angiolo  Siliani S.p.A.  and of Siliani Elettronica ed 
Impianti S.p.A. of Florence,  Italy (Siliani).  The acquisitions  will 
involve a combination of cash and the issuance of common stock.  The 
companies will operate under the name Siliani Harmon.  Closing is expected on 
April 30, 1999.

     Angiolo  Siliani  S.p.A.  is a market leader in switch point  machines 
for both standard and  high-speed  lines,  equipment and devices for 
interlockings, as well as electromechanical devices for locomotives.

     Siliani Elettronica ed Impianti S.p.A. operates in the field of 
electronic equipment and systems for signaling and train control, including 
axle-counter equipment, hot wheel and hot box detectors, Automatic Train 
Control (ATC), speed control and diagnostics. It also has a division in 
Genoa, Italy that designs and installs railway interlockings.

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>

                                                                            39

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 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. Foudrec

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

February 10, 1999


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, 1998 and 1997, 
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, 1998. 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, 1998 and 1997, and the 
results of their operations and their cash flows for each of the years in the 
three year period ended December 31, 1998, in conformity with generally 
accepted accounting principles.

KPMG LLP

Kansas City, Missouri
February 10, 1999

<PAGE>

46


INVESTOR INFORMATION

FORM 10-K
-------------------------------------------------------------------------------
Shareholders  may receive a copy of the  Corporation's  1998 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 11, 1999, 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 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
-------------------------------------------------------------------------------
1600 NE Coronado Drive
Blue Springs, Missouri 64014-6236
816/229-3345
Telefax: 816/229-0556

COMMON STOCK PRICE -RANGE AND
DIVIDEND INFORMATION
-------------------------------------------------------------------------------
At December 31, 1998, there were 10,662,400 shares  outstanding and 
approximately 613 shareholders of record.  Cash dividends are 11 cents per 
share per year, paid semi-annually at 51_2 cents per share.

     The range of high and low prices for the past eight -quarters ended 
December 31, 1998 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             1998                  1997
------------------------------------------------------------
<S>                <C>                    <C>
March 31           $ 22     -  $16 5/6    $12 2/3 - $ 11
June 30              26     -   19 3/4     16     -   11 1/6
September 30         24     -   17 3/8     18 1/3 -   12 5/6
December 31          26 1/2 -   18 5/8     19 2/3 -   15 1/3
</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 4, 1999, 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
Knight Securities L.P.
Mayer & Schweitzer, Inc.
Sherwood Securities Corp.


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>

                                                                             47


MANAGEMENT, DIRECTORS AND CORPORATE DATA

BOARD OF DIRECTORS                     
--------------------------------------------------
Robert E. Harmon (59)                  
Chairman of the Board                  

Bruce M. Flohr (60)                    
Founder & Chairman Emeritus            
RailTex, Inc.                          
San Antonio, Texas

Charles M. Foudree (54)                
Executive Vice President-              
Finance, Treasurer and Secretary       

Rodney L. Gray (46)                    
Vice Chairman                          
Azurix                                 
Houston, Texas                         

Herbert M. Kohn (60)                   
Attorney-at-Law                        
Bryan Cave LLP                         
Kansas City, Missouri                  

Douglass Wm. List (43)                 
Management Consultant                  
Baltimore, Maryland                    

Gerald E. Myers (57)                   
Management Consultant                  
Tempe, Arizona                         

Bjorn E. Olsson (53)                   
President & CEO                        

John A. Sprague (45)                   
Managing General Partner               
Jupiter Partners, LP                   
New York, New York                     

Judith C. Whittaker (60)               
Vice President, General                
Counsel/Secretary                      
Hallmark Cards, Inc.                   
Kansas City, Missouri                  

( ) Indicates Age of Director


MANAGEMENT
--------------------------------------------------
Bjorn E. Olsson
President & CEO

Charles M. Foudree
Executive Vice President-
Finance and Secretary

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

William P. Marberg
Executive Vice President-
System Sales & Support

Raymond A. Rosewall
Executive Vice President-
Manufacturing

Ronald G. Breshears
Vice President-Human Resources

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

William J. Scheerer
Vice President--
Applications Engineering

Stephen L. Schmitz
Vice President-Controller

Jeffery J. Utterback
Vice President and
General Manager-
Riverside Operations


DOMESTIC LOCATIONS
--------------------------------------------------
Riverside, California
Torrance, California
Jacksonville, Florida
Atlanta, Georgia
Delphi, Indiana
Louisville, Kentucky
Hingham, Massachusetts
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 Australia, Pty. Ltd.
Bayswater, Victoria, Australia

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

Vaughan Harmon Systems Ltd.
Ware, England

Industrias Harmon de Mexico, SA de CV
Monterrey, Mexico

<PAGE>


                           HARMON INDUSTRIES, INC.

                           1600 NE Coronado Drive

                        Blue Springs, Missouri 64014

                           Telephone 816-229-3345

                          Facsimile: 816-229-0556

                              www.hamonind.com

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