<PAGE>
 
                                                                      EXHIBIT 13

       PORTIONS OF LUFKIN INDUSTRIES, INC. ANNUAL REPORT TO SHAREHOLDERS


                            LUFKIN INDUSTRIES, INC.
                            LETTER TO SHAREHOLDERS



LETTER TO THE SHAREHOLDERS

1996 was marked by the continued improvement of the Company's financial
performance. Sales were down almost 10% due to a major downturn in demand for
trailers, but profits were up in all other product lines. Our customer base was
expanded in all areas, and our international presence was increased. We were
successful in adapting to a different mix of products and were successful in
achieving our goals for the year. We believe that this improvement will continue
and that the outlook for 1997 is promising.
 
For the year ended December 31, 1996, net sales were $226.0 million compared
with $248.9 million reported for the year ended December 31, 1995.  Sales of
power transmission products increased 22% to $73.1 million compared with $60.1
million in 1995. Power transmission sales benefited from stronger foreign
markets. Oil field products sales rose 8% in 1996 to $50.0 million from $46.4
million in 1995 fueled in part by an improved price for oil around the world.
Foundry castings products sales were up 2% to $32.5 million from $31.8 million a
year ago. As anticipated, trailer products sales in 1996 were lower than in 1995
brought on by a decline in trailer orders and soft economic conditions affecting
the trucking industry. For 1996, sales were $70.4 million, a decrease of 36%
from $110.5 million in 1995. We are encouraged by the increase in order level
during the year from the low point which occurred in the first quarter.
 
Operating income in 1996 increased 36% to $14.3 million from $10.5 million in
1995. The increase reflects improvements in our operations to increase
productivity and lower costs and a favorable mix effect of increased shipments
of oil field and power transmission products. Cost of sales as a percentage of
total sales decreased to 83.6% from 87.1% a year ago. Net income rose 18% to
$10.5 million compared with $8.9 million, and earnings per share increased 19%
to $1.56 per share compared with $1.31 per share, a year ago.
 
Lufkin's total backlog as of December 31, 1996, was $99.7 million compared with
$76.6 million at the end of the third quarter in 1996 and $100.1 million at the
end of 1995. At year end, the backlog for oil field was $12.1 million compared
with $8.1 million. The backlog was at its highest level since 1991 having
increased sequentially in each of the last three quarters. The backlog at year
end for trailers was $40.1 million compared with $40.2 million a year ago. The
backlog showed significant improvement from the $24.9 million level of the first
quarter of 1996, and we have entered 1997 in a strong position. For foundry
products, the backlog at year end was $17.4 million compared with $15.8 million
and for power transmission products it was $30.1 million compared with $36.0
million a year ago.
 
The Company added to its sound financial position in 1996. Lufkin ended the year
with total assets of $185.9 million and working capital of $69.4 million.
Lufkin's shareholders' equity at year end was $144.6 million, and the book value
was $22.05 per share. Cash and temporary investments totaled $30.9 million, and
Lufkin had no outstanding debt at year end.
 
To increase the value of the Company's common stock, the Board of Directors
authorized the use of up to $4.0 million for the repurchase of shares of
Lufkin's common stock during 1996. As of December 31, 1996, a total of 238,000
shares have been repurchased under the Company's repurchase programs. The
current repurchase program is the Company's third such program. It is the
Board's belief that periodic repurchase of common stock of Lufkin


<PAGE>
 
represents a sound use of a portion of available cash.
 
Lufkin paid four quarterly cash dividends of $0.15 per share on the Company's
common stock for a total of $0.60 per share paid in 1996. Effective with the
first quarter of 1997, the quarterly dividend was increased 13% to $0.17 per
share. Lufkin has paid a quarterly cash dividend for 57 consecutive years.

During 1996 Lufkin was able to strengthen its market position within each of its
product lines. We accomplished this by:
 .   Introducing new trailer products
 .   Developing new gearing in direct support of the power generation market
 .   Extending our international sales presence
 .   Installing new iron melting capability for engineered castings
 .   Increasing our customer support of oil field markets
 .   Improving operational capability and
    performance
 .   Providing enhanced training for employees.

Our plan for the future is to continue to focus on investment opportunities
where we can capitalize on Lufkin's expertise within engineered industrial
products based in metalworking, strengthen our superior customer service and
improve the support facilities of all our product lines.
 
Lufkin's growth and financial performance is clearly supported by an excellent
organization structure. We are proud to employ some of the most experienced and
highly regarded people in our industry and to have the necessary financial
resources to achieve continued improvement. Our goal for 1997 is to see that all
Lufkin's stakeholders share in the increased performance it achieves.
 
Overall, we are very pleased with the results Lufkin achieved during the past
year. We are encouraged about the trends affecting our product lines,
particularly for oil field and trailer products and remain optimistic about
reporting 1997 results that compare favorably with 1996.

Sincerely,

/s/ Douglas V. Smith

Douglas V. Smith
President and Chief Executive Officer

2
<PAGE>
 
OIL FIELD

Overall demand for oil field pumping units in 1996 increased 8.0% over the 1995
level. This improvement was fueled by increased global investment in oil
production.  Shipments in the domestic market, increased 14% in 1996. Increased
domestic drilling and the tight availability of used pumping units accounted for
the improved demand. The 1997 domestic outlook is expected to continue to
expand.

Revenue in Canada, where the government continues to stress incentives to drill
for natural gas and oil , increased 35% in 1996.  The increase in Canada was
offset primarily by a slow down in Argentina.  For 1997, we are expecting  sales
in Canada to remain strong, a rebound in South America, and improved sales in
the Eastern Hemisphere.
 
The Company's presence in key South American, Far East, and Canadian markets
with local manufacturing capabilities provides the Company with the ability to
meet local demand with faster deliveries and prices competitive with local
economic conditions. This in-country presence also allows the Company to provide
technical support as well as field service which gives the Company an additional
competitive advantage.
 
With the completion of a factory consolidation project at the main manufacturing
facility during the third quarter of 1996, the division is positioned with
improved work flow, more efficient material handling, and new machine tool
technology which will further reduce costs and improve productivity.
 
The oil field division ended 1996 in a strong position. The backlog was $12.1
million, a 49% increase from $8.1 million at the end of 1995. The increase in
the average oil price (20% up over 1995) is generally expected to result in
higher investments by the oil industry in 1997. Prices for oil field equipment
are expected to outpace inflation. As a result, revenues are anticipated to show
continued improvement; and the combination of stronger prices, reduced cost, and
leverage on increased volume should yield improved financial performance in
1997.
 
Longer term, the future for the type of oil field equipment Lufkin manufactures
is positive. The oil industry is in better economic shape than it has been since
1981. Demand for oil continues to increase, and the ratio of supply to demand
for oil is supporting an oil price more stable than in the past 15 years. The
investments by the Company's customers in the business continues to grow. As the
major supplier worldwide, Lufkin is ready to meet the needs as the market
continues to expand.

POWER TRANSMISSION

Power transmission enjoyed one of its best years in 1996 with revenues rising
22% over 1995. This marked the fifth consecutive year of revenue growth for the
division. Earnings were also up significantly, due to both added volume and
improvements in productivity.
 
While demand was strong in virtually all segments of power transmission's
business, there was some softening mid-year in bookings in both the power
generation and petrochemical segments. These were offset by growth in demand for
gears used in the steel and marine industries. In addition, orders received from
new international accounts provided new opportunities and countered the effect
of the temporary drop in demand in the power generation and petrochemical
sectors. Demand strengthened in these two markets during the fourth quarter, and
the outlook for 1997 is strong.
 
The demand for gears in the power generation sector will grow from the need for
electrical power generation in developing countries and the continuing move to
combined cycle operations in industrialized countries. The petrochemical sector
will respond to continued investment in new plants in developing countries, as
well as the drive to update existing refineries and petrochemical plants to
improve efficiency and address the ongoing safety and environmental
requirements.

Lufkin's products and services are ideally positioned to compete successfully as
its major markets continue their

                                                                               3
<PAGE>
 
trend of steady growth. Product development efforts have yielded significant
improvements in product performance, while investments in both capital equipment
and training have improved operational efficiency.
 
Lufkin's sales and services coverage are recognized as among the best in the
industry. Efforts in 1997 will be directed at strong customer support as the
primary strategy for growth in those sectors that offer attractive returns,
coupled with a strong focus on operational and quality improvement in our design
and manufacturing activities.


FOUNDRY CASTINGS

Lufkin's foundry division experienced continued strong demand from commercial
castings during 1996. The division again achieved a new cupola tonnage record of
charging over 67,000 tons of ductile and gray iron. This was approximately 200
tons above the record set during 1995. While continuing to operate at near
capacity levels, revenues also increased modestly due to some product mix shift
to higher value-added engineered castings.
 
Lufkin's casting capabilities include low-to medium-volume ductile and gray iron
castings which are used as components for numerous original equipment
manufacturers (OEMs). Over 300 tons of iron are poured each production day for
castings ranging in size from 100 pounds to over 30,000 pounds. This capacity
ranks Lufkin as one of the largest suppliers in the United States.
 
The foundry's customer base expanded during the past several years to include
such industrial sectors as building construction equipment, material handling
equipment, machine tools, valves and water works, pump and compressor, as well
as heavy truck suspension manufacturers. Lufkin's casting products can be found
in such diverse applications as strainer bodies for fire protection systems,
bridge support bearings, horizontal and vertical CNC machining centers, or
front-end loaders working in quarries.

In 1997, Lufkin's efforts will remain focused on expanding the more technically
demanding, higher value-added engineered castings. The strategy will allow for
the continued development of profitable, long-term relationships with strategic
customers while remaining focused on unsurpassed customer service. These efforts
will be maintained while continuing to support Lufkin's power transmission and
oil field divisions where it is economically advantageous.

TRAILERS

While overall economic conditions in 1996 were generally favorable in most of
Lufkin's markets, the factors directly affecting the transportation industry
were negative. The trailer industry saw consolidation among its participants and
some of the weaker companies falling by the wayside. The decline experienced in
1996 was moderated as a result of the strategy Lufkin implemented in 1995 to
position itself for an anticipated downturn in the trailer market by bringing
its production capability and workforce in line with expected demand. Although
financial performance in the trailer division was depressed from record levels
of the past two years, 1996 was a good, steady business year in which Lufkin had
several noteworthy achievements.
 
During the past year, Lufkin was able to expand its customer base by making a
concerted effort to reach a greater number of users and dealers. This action
lessened the dependency on its largest customers and showed positive results.
Lufkin's reputation for quality construction, reliability, innovation of design,
and competitive prices has helped it expand the customer base. Also, Lufkin's
solid financial base made it a more reliable supplier in the financially
distressed trailer industry.
 
During the past year the trailer division added to its diverse product offering
by introducing a new open-top chip trailer. In addition, the new plate trailer
introduced in 1995 went into full production and has been well received by
customers. The many different sizes and styles of vans, platforms, and high
capacity and light-weight dump trailers have tended to minimize the risk
associated with dependency on one type of trailer.
 
With the economy holding steady, the trailer division is expected to benefit
from growth in the demand for trailers.

4
<PAGE>
 
The division is focused on continuing to improve productivity and is well
positioned to capitalize on opportunities to increase market share. Lufkin's
established manufacturing facilities provide ample capability to meet short-term
supply. On a long-term basis, several favorable trends are expected to increase
the demand for trailers. One, the average age of trailer fleets is increasing.
Secondly, more companies are outsourcing their transportation needs. And, third,
more trailers are being used as warehouses for short-term storage. These
industry trends should favorably impact the trailer division.

                                                                               5
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                                FINANCIAL REVIEW
                    Lufkin Industries, Inc. and Subsidiaries

COMMON STOCK INFORMATION

<TABLE>
<CAPTION>
                      1996                     1995
            ------------------------  ------------------------
               Stock Price              Stock Price
            --------------            --------------
Quarter       High     Low  Dividend    High     Low  Dividend
--------------------------------------------------------------
<S>         <C>     <C>     <C>       <C>     <C>     <C>
First       $22.50  $17.00      $.15  $18.50  $16.63      $.15
Second       21.75   18.00       .15   20.00   18.00       .15
Third        21.25   18.00       .15   23.50   18.50       .15
Fourth       25.25   20.75       .15   23.50   18.50       .15
</TABLE>

  The Company's common stock is traded on The Nasdaq Stock Market (National
Market) under the symbol LUFK and as of February 28, 1997, there were
approximately 800 record holders of its common stock.

  The Company has paid cash dividends for 57 consecutive years.  Total dividend
payments were $3,993,000 and $4,071,000 in 1996 and 1995, respectively.

QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE>
<CAPTION>
 
  In millions, except   First   Second    Third   Fourth
       per share data  Quarter  Quarter  Quarter  Quarter
<S>                    <C>      <C>      <C>      <C>
---------------------------------------------------------
 
1996
Net sales                $55.9    $55.6    $55.1    $59.4
Gross margin               8.8      9.9      8.9      9.5
Net earnings               2.4      2.9      2.5      2.6
Earnings per share         .36      .43      .38      .39
 
1995
Net sales                $59.0    $58.6    $62.9    $68.4
Gross margin               6.7      8.4      8.3      8.8
Net earnings               1.6      2.4      2.1      2.8
Earnings per share         .24      .36      .31      .40
</TABLE>
_________________________________________________________

ADDITIONAL FINANCIAL INFORMATION

  Shareholders may obtain additional information for the year ended December 31,
1996, from the Company's Form 10-K Report filed with the Securities and Exchange
Commission. A copy of such report may be obtained without charge by written
request to the Secretary, Lufkin Industries, Inc., P.O. Box 849, Lufkin, Texas
75902-0849.

6
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                     MANAGEMENT'S DISCUSSION AND ANALYSIS
                   Lufkin Industries, Inc. and Subsidiaries

RESULTS OF OPERATIONS

          Net sales for 1996 were $226.0 million compared to $248.9 million for
1995 and $217.3 million for 1994. The Company reported net operating income of
$14.3 million and $10.5 million for 1996 and 1995, respectively. In 1994, the
Company had an operating loss of $3.1 million.  For 1996, the Company reported
net income of $10.5 million, compared to a net income of $8.9 million for 1995
and a net loss of $1.2 million for 1994.  The 1994 results included an $11.2
million pre-tax charge for special inventory write-downs.

          During 1996, the Company experienced a decline in trailer revenues
while revenues for all other product groups increased.  The annual percentage
increases (decreases) in revenues for the Company's product groups for the three
years ended December 31, 1996 were as follows:
<TABLE>
<CAPTION>
                               Annual increases (decreases) in revenues
--------------------------------------------------------------------------------------
                                                                    1996  1995   1994
--------------------------------------------------------------------------------------
<S>                                                                 <C>   <C>    <C>
Oil field pumping units                                               8     13%  (30)%
Power transmission products                                          22      9    16
Foundry castings                                                      2      5    25
Trailers                                                            (36)    26    37
--------------------------------------------------------------------------------------
   Total company                                                     (9)%   15%    7 %
--------------------------------------------------------------------------------------
</TABLE>


  The sales mix of the Company's products for the three years ended December 31,
1996 was as follows:
<TABLE>
<CAPTION>
 
                               Percent of total sales
--------------------------------------------------------------------
                                                  1996  1995   1994
<S>                                               <C>   <C>    <C>
--------------------------------------------------------------------
Oil field pumping units                            22%    19%    19%
Power transmission products                        32     24     25
Foundry castings                                   15     13     14
Trailers                                           31     44     41
Other                                               -      -      1
--------------------------------------------------------------------
   Total company                                  100%   100%   100%
--------------------------------------------------------------------
</TABLE>

          Oil field revenues increased 8% to $50.0 million in 1996 over 1995
revenues of $46.4 million.  Oil field revenues were $40.9 million in 1994.
During 1996, the Company booked new orders of $54.0 million compared to $47.3
million in 1995 and $42.9 million in 1994.  Demand for oil field products
increased at the end of 1996 resulting in a backlog for oil field products at
December 31, 1996 of $12.1 million, its highest level since 1991.  At December
31, 1995 and December 31, 1994, the backlog for oil field products was $8.1
million and $8.5 million, respectively.

          Sales of power transmission products increased 22% to $73.1 million
from sales of $60.1 million in 1995.  Power transmission sales for 1994 were
$55.3 million.  New order bookings totaled $67.2 million for 1996 compared to
$75.5 million and $54.0 million for 1995 and 1994, respectively.  At December
31, 1996, the power transmission backlog was $30.1 million compared to $36.0
million at the end of 1995 and $21.1 million at year end 1994.

          Foundry castings revenues increased to $32.5 million for 1996, up 2%
from 1995. Sales of foundry castings were $31.8 million in 1995 and $30.2
million in 1994. New order bookings totaled $34.0 million in 1996 and 1995. The
backlog for foundry castings at December 31, 1996 was $17.4 million compared to
$15.8 million and $4.2 million at the end of 1995 and 1994, respectively.

          The Company's trailer product sales decreased by 36% to $70.4 million
from $110.5 million in 1995 due to decreased sales volumes as a result of lower
trailer market demand levels.  Trailer product sales in 1994 were $87.8 million.
New trailer orders booked during 1996 totaled $70.3 million compared to $79.0
million in 1995 and $112.4 million in 1994.  At the end of 1996, the trailer
backlog was $40.1 million compared to $40.2 million at December 31, 1995 and
$75.6 million at December 31, 1994.

          Gross profit margins before special inventory write-downs increased to
16% for 1996 from 13% for 1995 and 1994.  The 1996 sales mix reflected increased
sales in the higher margin oil field and power transmission product lines while
lower margin trailer sales decreased.  In addition, the Company continued to
emphasize cost awareness and cost reduction programs.

          Selling, General and Administrative (S. G. & A.) expenses were $23.2
million in 1996 compared to $22.2 million and $20.7 million in 1995 and 1994,
respectively.  The increase in SG & A expenses was due primarily to increased
power transmission selling expenses associated with expansion of the Company's
selling efforts and market presence in western Europe and other areas.

                                                                               7
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                      MANAGEMENT'S DISCUSSION AND ANALYSIS
                    Lufkin Industries, Inc. and Subsidiaries


RESULTS OF OPERATIONS (CONTINUED)

  Net operating income for 1996 was $14.3 million.  The Company realized net
operating income of $10.5 million in 1995 and a net operating loss of $3.1
million in 1994.  The Machinery Division's net operating income as a percentage
of sales before special inventory writedowns was 6% for 1996 compared to 2% for
1995 and 1% in 1994.  The increase reflects improved product mix and increased
sales volumes in Machinery Division products.  The Trailer Division's net
operating income as a percentage of sales was 6% for 1996, down from 7% for 1995
and 1994.  The decrease in net operating income for the Trailer Division was due
to decreased sales volumes partially offset by cost reductions in the area of
fixed costs.

  Other income was $.3 million in 1996 compared to $.5 million in 1995.
Investment income decreased in 1996 to $1.9 million from $3.1 million in 1995.
The decrease in investment income was due to lower investment balances resulting
in decreased interest income.  In addition, capital gains on investments were
lower in 1996 than 1995.

  Net income was increased by approximately $.4 million ($.06 per share) for
1996 and was reduced by approximately $1.0 million ($.15 per share), for 1995,
as a result of using the LIFO method as compared to the FIFO method of
accounting for certain inventories.  During 1996 and 1994, LIFO inventories were
reduced and these reductions resulted in a liquidation of LIFO inventory
quantities carried at lower costs prevailing in prior years.  The impact of
these LIFO inventory liquidations increased net income in 1996 and reduced the
net loss in 1994 by approximately $.1 million ($.02 per share) and $3.6 million
($.53 per share), respectively.

LIQUIDITY AND CAPITAL RESOURCES

  At December 31, 1996, the Company had working capital of $69.4 million
compared to $74.9 million in 1995 and $70.8 million in 1994.  The Company
generated $19.1 million net cash from operating activities in 1996.  Net cash
provided from operating activities in 1995 and 1994 was $7.4 million and $20.7
million, respectively. Accounts receivable decreased by 7.5% to $33.5 million
from $36.2 million at the end of 1995 primarily as a result of decreased sales
volumes. At December 31, 1996 inventories were $3.2 million lower and accounts
payable were $4.4 million lower than the December 31, 1995 balances. These
decreases were primarily due to the lower sales volumes of trailer products in
1996. Dividends of $.60 per share totaling $4.0 million were paid in 1996.
During 1995 and 1994, dividends totaled $4.1 million ($.60 per share) each year.
During 1996, the Company's expenditures for property, plant and equipment (PP &
E) totaled $12.4 million related to capacity expansions in the foundry and power
transmission repair businesses, equipment replacement and business
consolidation. PP&E expenditures for 1995 and 1994 totaled $7.6 million and $5.2
million, respectively. Treasury stock purchases increased to $4.4 million in
1996 over $.4 million in 1995. Under the Company's current stock repurchase
program, authorizations of approximately $1.3 million remained at December 31,
1996 for future treasury stock purchases. The Company believes that existing
working capital will be sufficient to satisfy its 1997 requirements. In recent
years, capital expenditures have been financed with internally generated funds,
and the Company plans to finance future improvements of its facilities in this
manner. No significant commitments were outstanding at December 31, 1996.

  The Internal Revenue Service (IRS) has examined the Company's federal income
tax returns for calendar years 1991 through 1993.  The IRS has recommended an
assessment of additional taxes for 1991 and 1993.  The Company disagrees with
the IRS' position and is currently pursuing its rights of administrative review
and appeal and intends to vigorously contest this matter.  Although the
resolution of these remaining issues could affect the timing of the payment of
previously accrued tax liabilities and require the use of a portion of its
available capital, the Company does not believe that the results of the audit or
the ultimate resolution of the IRS' proposed adjustments will have a material
impact on its consolidated results of operations or financial position.

FORWARD-LOOKING STATEMENTS AND ASSUMPTIONS

  This Annual Report may contain or incorporate by reference certain forward-
looking statements, including by way of illustration and not of limitation,
statements relating to liquidity, revenues, expenses, margins and contract rates
and terms.  The Company strongly encourages readers to note that some or all of
the assumptions, upon which such forward-looking statements are based, are
beyond the Company's ability to control or estimate precisely, and may in some
cases be subject to rapid and material changes.

8
<PAGE>
 
                           CONSOLIDATED BALANCE SHEET
                    Lufkin Industries, Inc. and Subsidiaries


December 31, 1996 and 1995
(Thousands of dollars except share data)
<TABLE>
<CAPTION>
 
ASSETS                                                         1996       1995
<S>                                                          <C>        <C>
--------------------------------------------------------------------------------
Current assets:
Cash                                                         $    655   $    277
Temporary investments                                          30,211     33,040
Receivables, net                                               33,472     36,204
Inventories                                                    21,563     24,737
Deferred income taxes                                           2,132      3,853
--------------------------------------------------------------------------------
   Total current assets                                        88,033     98,111
 
Property, plant and equipment, net                             65,993     60,823
Prepaid pension costs                                          24,469     20,936
Other assets                                                    7,430      6,426
--------------------------------------------------------------------------------
     Total assets                                            $185,925   $186,296
--------------------------------------------------------------------------------
 
LIABILITIES AND SHAREHOLDERS' EQUITY
-------------------------------------------------------------------------------
Current liabilities:                                      
Accounts payable                                            $  7,035   $ 11,430
Accrued liabilities:                                      
   Payroll and benefits                                        5,050      5,084
   Accrued warranty expenses                                   1,329      2,032
   Taxes payable                                               3,072      2,849
   Commissions and other                                       2,162      1,774
-------------------------------------------------------------------------------
   Total current liabilities                                  18,648     23,169
                                                          
Deferred income taxes                                         10,478      8,500
Post retirement benefits                                      12,192     12,035
                                                          
Shareholders' equity:                                     
Common stock, par $1 per share; 20,000,000 shares         
   authorized; 6,792,381 shares issued                         6,792      6,792
Capital in excess of par                                      15,367     15,367
Retained earnings                                            128,150    121,692
Treasury stock, 233,998 shares and 16,108 shares, at cost     (4,754)      (311)
Cumulative translation adjustment                               (948)      (948)
-------------------------------------------------------------------------------
   Total shareholders' equity                                144,607    142,592
-------------------------------------------------------------------------------
      Total liabilities and shareholders' equity            $185,925   $186,296
-------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.

                                                                               9
<PAGE>
 
                       CONSOLIDATED STATEMENT OF EARNINGS
                    Lufkin Industries, Inc. and Subsidiaries
 
Years ended December 31, 1996, 1995 and 1994
(Thousands of dollars, except per share data)

<TABLE>
<CAPTION>
 
                                                     1996       1995       1994
--------------------------------------------------------------------------------
<S>                                              <C>        <C>        <C>
Sales                                            $225,974   $248,909   $217,273
--------------------------------------------------------------------------------
Costs and expenses:
   Cost of sales                                  188,877    216,733    189,999
   Selling, general and
      administrative expenses                      23,163     22,171     20,725
   Special inventory provisions                         -          -     11,224
   Other income, net                                 (345)      (481)    (1,610)
--------------------------------------------------------------------------------
      Total costs and expenses                    211,695    238,423    220,338
--------------------------------------------------------------------------------
Operating income (loss)                            14,279     10,486     (3,065)
Investment income                                   1,928      3,118      1,266
--------------------------------------------------------------------------------
Earnings (loss) before income taxes                16,207     13,604     (1,799)
Income taxes (benefits)                             5,756      4,686       (592)
--------------------------------------------------------------------------------
Net earnings (loss)                              $ 10,451   $  8,918   $ (1,207)
--------------------------------------------------------------------------------
Net earnings (loss) per share                       $1.56      $1.31      $(.18)
--------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.


10
<PAGE>
 
                 CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
                    Lufkin Industries, Inc. and Subsidiaries


Years ended December 31, 1996, 1995, and 1994
(Thousands of dollars, except share and per share data)

<TABLE>
<CAPTION>
 
 
                                                                                                          
                                        Common Stock         Capital                          Cumulative  
                                   ----------------------   In Excess    Retained   Treasury  Translation 
                                      Shares       Amount     Of Par     Earnings     Stock    Adjustment
----------------------------------------------------------------------------------------------------------
<S>                                <C>           <C>         <C>        <C>          <C>       <C>
Balance December 31, 1993             6,792,381    $ 6,792    $15,372     $122,127               $  (800)
   Net loss                                                                 (1,207)
   Cash dividends,
     $.60 per share                                                         (4,075)
   Foreign currency translation
     adjustment                                                                                     (245)
----------------------------------------------------------------------------------------------------------
Balance December 31, 1994             6,792,381      6,792     15,372      116,845                (1,045)
   Net earnings                                                              8,918
   Cash dividends,
     $.60 per share                                                         (4,071)
   Foreign currency translation
     adjustment                                                                                       97
   Purchases of Treasury Stock
     (20,108 shares)                                                                    (384)
   Exercise of Stock Options
     (4,000 shares)                                                (5)                    73
----------------------------------------------------------------------------------------------------------
Balance December 31, 1995             6,792,381      6,792     15,367      121,692      (311)        (948)
   Net earnings                                                             10,451
   Cash dividends,
    $.60 per share                                                          (3,993)
   Purchases of Treasury Stock
    (218,015 shares)                                                                  (4,445)
   Exercise of Stock Options
    (125 shares)                                                                           2
----------------------------------------------------------------------------------------------------------
Balance December 31, 1996             6,792,381    $ 6,792    $15,367     $128,150   $(4,754)     $  (948)
----------------------------------------------------------------------------------------------------------
</TABLE>



See notes to consolidated financial statements.


                                                                              11
<PAGE>
 
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                    Lufkin Industries, Inc. and Subsidiaries
<TABLE>
<CAPTION>
 
 
Years ended December 31, 1996, 1995 and 1994
(Thousands of dollars)
                                                             1996      1995       1994
-----------------------------------------------------------------------------------------
<S>                                                     <C>           <C>       <C> 
Cash flow from operating activities:
 Net earnings (loss)                                       $ 10,451   $ 8,918    $(1,207)
 Adjustments to reconcile net earnings (loss) to net
     cash provided by operating activities:
  Depreciation                                                6,950     7,050      7,895
  Deferred income tax provision                               3,699     2,997         28
  Pension income                                             (3,533)   (3,151)    (3,628)
  Post retirement benefits                                      157       192        216
  Gain on sales of property,    
  plant and equipment                                           (45)     (247)    (1,299)
  Changes in:           
   Receivables                                                2,732    (7,942)     9,341
   Inventories                                                3,174    (2,818)    11,239
   Accounts payable                                          (4,395)      769        796
   Accrued liabilities                                         (126)    1,605     (2,677)
-----------------------------------------------------------------------------------------
Net cash provided by operating activities                    19,064     7,373     20,704
 
Cash flows from investing activities:
 Additions to property, plant and equipment                 (12,357)   (7,646)    (5,238)
 Proceeds from disposition of property,
   plant and equipment                                          282       725      5,356
 (Increase) decrease in other assets                         (1,004)      232         66
-----------------------------------------------------------------------------------------
Net cash provided (used) by investing activities            (13,079)   (6,689)       184
 
Cash flows from financing activities:
 Dividends paid                                              (3,993)   (4,071)    (4,075)
 Proceeds from exercise of stock options                          2        68          -
 Purchase of treasury stock                                  (4,445)     (384)         -
-----------------------------------------------------------------------------------------
Net cash used by financing activities                        (8,436)   (4,387)    (4,075)
 
 
Effect of translation on cash and
  temporary investments                                           -        97       (245)
-----------------------------------------------------------------------------------------
 
Net increase (decrease) in cash and
  temporary investments                                      (2,451)   (3,606)    16,568
Cash and temporary investments,
  at beginning of year                                       33,317    36,923     20,355
-----------------------------------------------------------------------------------------
Cash and temporary investments,
  at end of year                                           $ 30,866   $33,317    $36,923
-----------------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.

12
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries


(1) SUMMARY OF MAJOR ACCOUNTING POLICIES

  PRINCIPLES OF CONSOLIDATION:  The consolidated financial statements include
the accounts of Lufkin Industries, Inc. and Subsidiaries (the Company) after
elimination of all significant intercompany accounts and transactions.

  USE OF ESTIMATES: The preparation of the financial statements in conformity
with generally accepted accounting principles requires the use of certain
estimates by management in determining the Company's assets, liabilities,
revenue and expenses.

  TRANSLATION OF FOREIGN CURRENCIES.  Assets and liabilities of foreign
operations are translated into U. S. dollars at the exchange rate in effect at
the end of each accounting period and income statement accounts are translated
at the average exchange rates prevailing during the period.

  TEMPORARY INVESTMENTS:  The Company's temporary investments consisting of
highly liquid government and corporate debt securities have been classified as
trading securities which are carried at market value.  All realized and
unrealized gains and losses are recognized currently in investment income.

  RECEIVABLES:  The following is a summary of the Company's receivable balances:

<TABLE>
<CAPTION>
 
(Thousands of dollars)                  1996      1995
--------------------------------------------------------
<S>                                   <C>       <C>
   Accounts receivable                $31,586   $34,645
   Notes receivable                     2,486     2,159
--------------------------------------------------------
                                       34,072    36,804
 
   Allowance for doubtful accounts       (600)     (600)
--------------------------------------------------------
   Net receivables                    $33,472   $36,204
--------------------------------------------------------
</TABLE>

  INVENTORIES:  The Company reports its inventories by using the last-in, first-
out (LIFO) and the first-in, first-out (FIFO) methods less reserves necessary to
report inventories at the lower of cost or estimated market.  Inventory costs
include material, labor and factory overhead.

  PROPERTY, PLANT AND EQUIPMENT:  The Company records investments in these
assets at cost.  Improvements are capitalized, while repair and maintenance
costs are charged to operations as incurred.  Gains or losses realized on the
sale or retirement of these assets are reflected in income.  Depreciation for
financial reporting purposes is provided on a straight-line method based upon
the estimated useful lives of the assets.  Accelerated depreciation methods are
used for tax purposes.  The following is a summary of the Company's property,
plant and equipment balances and useful lives.

<TABLE>
<CAPTION>
                                                 Useful
                                                  Life
(Thousands of dollars)                          in Years     1996        1995
----------------------------------------------  --------  ----------  ----------
<S>                                             <C>       <C>         <C>
  Land                                                 -  $   2,800   $   2,819
  Land improvements                                10-25      6,015       5,965
  Buildings                                      12.5-40     54,339      52,555
  Machinery and equipment                         3-12.5    162,542     155,702
  Furniture and fixtures                          5-12.5     17,318      16,735
--------------------------------------------------------------------------------
    Total property, plant and equipment                     243,014     233,776
  Less accumulated depreciation                            (177,021)   (172,953)
--------------------------------------------------------------------------------
    Total property, plant and equipment, net              $  65,993   $  60,823
--------------------------------------------------------------------------------
</TABLE>

  The Company applies Statement of Financial Accounting Standards (SFAS) No. 121
for recognition of a loss if impairment occurs in its fixed assets. The adoption
of this policy in 1996 had no impact on the Company's results of operations or
financial condition.

  EARNINGS PER SHARE:  Earnings per share amounts are based on the weighted
average number of shares of common stock and common stock equivalents
outstanding during the period.  The weighted average number of shares used to
compute earnings per share was 6,714,812 shares, 6,823,776 shares, and 6,792,381
shares for 1996, 1995, and 1994, respectively.

  OTHER:  Certain prior year amounts have been reclassified to conform with the
current year presentation.

  INCOME TAXES: The Company follows Statement of Financial Accounting Standards
(SFAS) No. 109 "Accounting for Income Taxes". Under SFAS No. 109, deferred tax
assets or liabilities are recorded based on the difference between the financial
statement and income tax bases of assets and liabilities using enacted tax
rates.

                                                                              13
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries


(2) INCOME TAXES
  The net deferred income tax liabilities are comprised of the following:

<TABLE>
<CAPTION>
(Thousands of dollars)                          1996       1995
------------------------------------------------------------------
<S>                                           <C>        <C> 
Current deferred income tax assets
   Gross assets                               $  3,404   $  5,300
   Gross liabilities                            (1,272)    (1,447)
------------------------------------------------------------------
Total, net                                       2,132      3,853
------------------------------------------------------------------
 
Noncurrent deferred income tax liabilities
   Gross assets                                  8,245      6,715
   Gross liabilities                           (18,723)   (15,215)
------------------------------------------------------------------
Total, net                                     (10,478)    (8,500)
------------------------------------------------------------------
Net deferred income tax liabilities           $ (8,346)  $ (4,647)
------------------------------------------------------------------
</TABLE>


The tax effects of significant temporary differences representing deferred tax
assets and liabilities are as follows:
<TABLE>
<CAPTION>
 
(Thousands of dollars)                         1996       1995
----------------------------------------------------------------
<S>                                          <C>        <C>
Inventories                                   $   156   $ 1,732
Prepaid pension costs                          (8,564)   (7,336)
Payroll and benefits                            1,073     1,174
Accrued warranty expenses                         465       711
Post retirement benefits                        4,267     4,212
Capital loss and tax credit carryforwards       1,598     2,509
Depreciation                                   (7,387)   (7,053)
Other, net                                         46      (596)
----------------------------------------------------------------
Net deferred income tax liabilities           $(8,346)  $(4,647)
----------------------------------------------------------------
</TABLE>


The income tax provision (benefit) for 1996, 1995, and 1994 consisted of the
following:
<TABLE>
<CAPTION>
 
  (Thousands of dollars)   1996    1995    1994
------------------------------------------------
<S>                       <C>     <C>     <C>
Current                   $2,057  $1,689  $(620)
Deferred                   3,699   2,997     28
------------------------------------------------
Total                     $5,756  $4,686  $(592)
------------------------------------------------
</TABLE>

A reconciliation of the income tax provision (benefit) as computed at the
statutory U. S. income tax rate and the income tax provision (benefit) presented
in the consolidated financial statements is as follows:
<TABLE>
<CAPTION>
 
(Thousands of dollars)                                  1996     1995     1994
------------------------------------------------------------------------------
<S>                                                   <C>      <C>      <C>
Tax provision (benefit) computed at statutory rate    $5,672   $4,693   $(612)
Tax effect of:
   Expenses for which no benefit was realized            362      271       -
   Tax-exempt interest and dividend
      income exclusion                                  (158)    (170)    (72)
   Other, net                                           (120)    (108)     92
------------------------------------------------------------------------------
Actual provision (benefit)                            $5,756   $4,686   $(592)
------------------------------------------------------------------------------
</TABLE>

14
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries


  Cash payments for income taxes totaled $2,178,000, $2,292,000 and  $235,000
for 1996, 1995 and 1994, respectively.

  For income tax reporting purposes at December 31, 1996, the Company has
alternative minimum tax carryforwards of $785,000 and foreign tax credit
carryforwards of $796,000.

  The Internal Revenue Service (IRS) has examined the Company's federal income
tax returns for calendar years 1991 through 1993. The IRS has recommended an
assessment of additional taxes for 1991 and 1993. The Company disagrees with the
IRS' position and is currently pursuing its rights of administrative review and
appeal and intends to vigorously contest this matter. Although the resolution of
these remaining issues could affect the timing of the payment of previously
accrued tax liabilities and require the use of a portion of its available
capital, the Company does not believe that the results of the audit or the
ultimate resolution of the IRS' proposed adjustments will have a material impact
on its consolidated results of operations or financial position .

(3) INVENTORIES

  Inventories used in determining cost of sales were as follows:
<TABLE>
<CAPTION>
  (Thousands of dollars)   1996     1995
------------------------------------------
<S>                       <C>      <C>
Finished goods            $ 5,898  $ 6,845
Work in process             4,566    6,050
Raw materials              11,099   11,842
------------------------------------------
Total                     $21,563  $24,737
------------------------------------------
</TABLE>

  Inventories accounted for on a LIFO basis were $16,655,000 and $19,258,000 and
on a FIFO basis were $4,908,000 and $5,479,000 at December 31, 1996 and 1995,
respectively.  Had the FIFO method been used in determining all inventory
values, inventories would have been $17,624,000 and $18,194,000  higher at
December 31, 1996 and 1995, respectively.

  Net income was increased by approximately $.4 million ($.06 per share) for
1996 and was reduced by approximately $1.0 million (15 per share), for 1995, as
a result of using the LIFO method as compared to the FIFO method of accounting
for certain inventories. During 1996 and 1994, LIFO inventories were reduced and
these reductions resulted in a liquidation of LIFO inventory quantities carried
at lower costs prevailing in prior years. The impact of these LIFO inventory
liquidations increased net income in 1996 and reduced the net loss in 1994 by
approximately $.1 million ($.02 per share) and $3.6 million ($.53 per share),
respectively.

(4) EMPLOYEE STOCK OPTION PLAN

  The Company's 1990 Stock Option Plan provides for the granting of options to
key employees to purchase an aggregate of not more than 900,000 shares of the
Company's stock at fair market value on the date of grant.  One fourth of
granted options generally become exercisable after one year and each year
thereafter.   The options may not be exercised after ten years from the date of
grant.  Outstanding options may be canceled and reissued under terms specified
in the plan.

  The following table summarizes activity under the Company's stock option plan:

<TABLE>
<CAPTION>
                                                    1996               1995     1994
<S>                                       <C>                        <C>       <C>
--------------------------------------------------------------------------------------
Options outstanding, beginning of year                     447,965   355,465   260,715
  Granted (per share)
     1994 ($15.875 to $18.625)                                                  94,750
     1995 ($19.00 to $20.00)                                          97,500
     1996 ($18.125 to $21.75)                              106,150
  Exercised (per share)
     1995 ($15.31 to $17.50)                                          (4,000)
     1996 ($15.875)                                           (125)
  Forfeited (per share)
     1995 ($30.00)                                                    (1,000)
     1996 ($15.875 to $20.00)                               (3,000)
--------------------------------------------------------------------------------------
Options outstanding, end of year                           550,990   447,965   355,465
--------------------------------------------------------------------------------------
</TABLE>

                                                                              15
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries


4) EMPLOYEE STOCK OPTION PLAN (CONTINUED)

  The Company accounts for its stock option plan under APB opinion No. 25 under
which no compensation cost has been recognized. Had compensation cost for these
plans been determined consistent with SFAS Statement No. 123, "Accounting for
Stock-Based Compensation", the Company's net income and earnings per share would
have been reduced to the following pro forma amounts, (in thousands except per
share data):

<TABLE>
<CAPTION>
                                     1996    1995
                                   -------  ------
<S>                   <C>          <C>      <C>
Net Earnings          As reported  $10,451  $8,918
                      Pro forma    $10,316  $8,897
Earnings Per Share    As reported  $  1.56  $ 1.31
                      Pro forma    $  1.54  $ 1.30
--------------------------------------------------
</TABLE>

  The effects of applying SFAS No. 123 in the pro forma disclosure may not be
indicative of future amounts. SFAS No. 123 does not apply to options awarded
prior to 1995, and additional awards in future years are anticipated. The fair
value of each option grant is estimated on the date of grant using the Black-
Scholes option-pricing model with the following assumptions:

             Expected dividend yield            2.8% - 3.3%
             Expected stock price volatility  25.69%-27.25%
             Risk free interest rate          6.03% - 6.71%
             Expected life of options              10 years

  During 1996, 106,150 options were granted.  These options had a weighted
average fair value of $7.11 per option and a weighted average exercise price of
$21.13 per option.

  The following table summarizes information about stock options outstanding at
December 31, 1996.

<TABLE>
<CAPTION>
                          Options Outstanding                       Options Exercisable
                          -------------------                       -------------------
                                 Wgtd. Avg.
Range of            Number      Remaining    Wgtd. Avg.     Number     Wgtd. Avg.
Exercise          Outstanding  Contractual   Exercise    Exercisable    Exercise
Prices            at 12/31/96     Life         Price     at 12/31/96     Price
----------------  -----------  -----------  -----------  -----------  -----------
<S>               <C>          <C>          <C>          <C>          <C>
$15.31-$18.625        230,625  6.9 years         $16.98      167,250       $17.11
$19.00-$21.75         255,650  8.6 years         $20.90       75,875       $20.89
$28.50-$30.00          64,715  3.8 years         $29.89       64,715       $29.89
----------------      -------  -----------       ------      -------       ------ 
$15.31-$30.00         550,990  7.3 years         $20.32      307,840       $20.73
----------------      -------  -----------       ------      -------       ------ 
</TABLE> 

(5) STOCK REPURCHASE PLAN

  In March, 1995, the Company began a stock repurchase plan under which the
Company was authorized to spend up to $2.1 million for purchases of its common
stock. During 1996, an additional $4.0 million was authorized for the purchase
of common stock. The Company repurchased 218,015 shares at an aggregate cost of
approximately $4.4 million in 1996 and 20,108 shares at an aggregate cost of $.4
million in 1995. Repurchased shares are added to treasury stock and are
available for general corporate purposes including the funding of the Company's
employee stock option plan.

(6) CAPITAL STOCK

  In May 1987, the Board of Directors adopted a "Shareholder Rights Plan"
designed to protect against unsolicited attempts to acquire control of the
Company that the Board believes are not in the best interest of the
shareholders. The Plan, which was renewed on May 31, 1996,  provides for the
possible issuance of a dividend of one common stock purchase right for each
outstanding share of common stock.  Under certain conditions, each right may be
exercised to purchase one share of common stock at an exercise price of $75,
subject to adjustment.  Under certain circumstances, the rights entitle holders
to purchase the common stock of the Company or an acquiring company having a
value of twice the exercise price of the rights.  The rights would become
exercisable, or transferable apart from the common stock, ten days after a
person or group acquired 20% or more, or announced or made a tender offer

16
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries



(6) CAPITAL STOCK (CONTINUED)

for 30% or more, of the outstanding common stock.  Under certain circumstances,
all rights owned by an acquiring person would be null and void.  The rights
expire on May 31, 2006, and may be redeemed by the Company at any time prior to
the occurrence of certain events at $.05 per right.

  The Company is authorized to issue 2.0 million shares of preferred stock, the
terms and conditions to be determined by the Board of Directors in creating any
particular series.

(7) RETIREMENT BENEFITS

  The Company has noncontributory pension plans covering substantially all
employees.  The benefits provided by these plans are measured by length of
service, compensation and other factors, and are currently funded by trusts
established under the plans.  Funding of retirement costs for these plans
complies with the minimum funding requirements specified by the Employee
Retirement Income Security Act.  Plan investment assets are invested primarily
in equity securities, United States government securities and cash equivalents.

  The following tables provide the detail of the components of pension income
and expense, the funded status of the plans and amounts of prepaid pension cost
recognized as an asset in the Company's consolidated balance sheet, and major
assumptions used to determine these amounts.

<TABLE>
<CAPTION>
(Thousands of dollars)                                   1996       1995       1994
--------------------------------------------------------------------------------------
<S>                                                    <C>        <C>        <C>
Components of pension income:
  Service cost                                         $  2,304   $  1,780   $  2,092
  Interest cost                                           6,539      5,698      5,334
  Actual return on plan assets                          (13,660)   (27,424)        97
  Net (amortization) and deferral                         1,284     16,795    (11,151)
--------------------------------------------------------------------------------------
Net pension income                                     $ (3,533)  $ (3,151)  $ (3,628)
--------------------------------------------------------------------------------------
 
Plan assets at fair value                              $137,039   $128,361   $105,902
Actuarial present value of projected
  benefit obligations:
  Accumulated benefit obligations
    Vested                                              (76,447)   (72,644)   (56,406)
    Nonvested                                            (9,496)    (9,164)    (5,358)
Provision for future salary increases                    (7,802)    (7,703)    (8,259)
--------------------------------------------------------------------------------------
Plan assets over projected benefit obligations           43,294     38,850     35,879
Unrecognized transition gain                            (10,830)   (11,756)   (12,683)
Other unrecognized gain                                  (6,369)    (4,393)    (3,161)
Unrecognized prior service credits                       (1,626)    (1,765)    (2,251)
--------------------------------------------------------------------------------------
Net prepaid pension costs                              $ 24,469   $ 20,936   $ 17,784
--------------------------------------------------------------------------------------
Major assumptions at year end:
   Discount rate                                           7.50%      7.50%      8.25%
   Rate of assumed increase in compensation levels            5%         5%         5%
   Expected long-term rate of return on plan assets           9%         9%         9%
--------------------------------------------------------------------------------------
</TABLE>

  The Company also has defined contribution retirement plans covering
substantially all of its employees.  During the year, the Company makes
contributions of 75% of employee contributions up to a maximum of 6% of employee
earnings.  All obligations of the Company are funded through December 31, 1996.
The Company's expense for these plans totaled $1,610,000, $1,560,000 and
$1,444,000 in 1996, 1995 and 1994, respectively.

  The Company sponsors two defined benefit post retirement plans that cover both
salaried and hourly employees. One plan provides medical benefits, and the other
plan provides life insurance benefits.  Both plans are contributory, with
retiree contributions adjusted periodically.  Under SFAS No. 106 "Employers'
Accounting for Post-retirement Benefits Other than Pensions", the Company
accrues the estimated costs of the plans over the employee's service periods.


                                                                              17
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries


(7) RETIREMENT BENEFITS (CONTINUED)
  The following table sets forth the plans' combined funded status December 31,
1996, 1995 and 1994:
<TABLE>
<CAPTION>
(Thousands of dollars)                                    1996     1995      1994
----------------------------------------------------------------------------------
<S>                                                     <C>      <C>      <C>
Accumulated post retirement benefit obligation:
   Retirees                                             $ 7,213  $ 7,701  $ 9,208
   Fully eligible active plan participants                1,357      951      883
   Other active plan participants not yet eligible        2,554    2,133    1,932
----------------------------------------------------------------------------------
Total accumulated post retirement benefit obligation     11,124   10,785   12,023
Unrecognized net actuarial gain (loss)                    1,068    1,250     (180)
----------------------------------------------------------------------------------
Accrued post retirement benefit cost                    $12,192  $12,035  $11,843
----------------------------------------------------------------------------------
Net periodic cost of post retirement benefit:
   Service cost                                         $   156  $   135  $   168
   Interest cost                                            801      923      882
----------------------------------------------------------------------------------
Net periodic post retirement benefit cost               $   957  $ 1,058  $ 1,050
----------------------------------------------------------------------------------
</TABLE>

  The Company's post retirement health care plan is unfunded.  For measurement
purposes, the submitted claims medical trend was assumed to be 10% in 1996, and
9.25% in 1997.  Thereafter, the Company's obligation is fixed at the amount of
the Company's contribution for 1997.  A one percentage point increase in each
year's healthcare costs trend rate would increase the accumulated post
retirement benefit obligations as of December 31, 1996 by approximately $125,000
and the aggregate of the service and interest costs components of net periodic
post retirement cost for the year ended December 31, 1996 by $11,000.  In
determining the accumulated post retirement obligation, a weighted-average
discount rate of 7.50% in 1996 was used.

(8) BUSINESS SEGMENT INFORMATION

  The Company manufactures, sells and services various types of oil field
pumping units, power transmission products, foundry castings and trailers.
Corporate expenses are allocated to industry segments primarily based upon
outside revenues.  The following is a summary of key business segment and
product group information:
<TABLE>
<CAPTION>
 
(Thousands of dollars)                1996      1995      1994
<S>                                 <C>       <C>       <C>
----------------------------------------------------------------
SALES:
   Machinery Division
     Oil field pumping units        $ 49,952  $ 46,449  $ 40,938
     Power transmission products      73,127    60,131    55,334
     Foundry castings                 32,487    31,792    30,165
     Other                                 -         -     3,051
   Trailer Division                   70,408   110,537    87,785
----------------------------------------------------------------
Total sales                         $225,974  $248,909  $217,273
----------------------------------------------------------------
 
SALES BY GEOGRAPHIC REGION:
   United States                    $182,724  $208,989  $183,147
   Europe                              2,980     3,362     2,916
   Canada                             12,470    10,870     8,273
   Latin America                      16,326    16,411    14,765
   Other                              11,474     9,277     8,172
----------------------------------------------------------------
Total sales                         $225,974  $248,909  $217,273
----------------------------------------------------------------
</TABLE>

18
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                  NOTES TO CONSOLIDATED FINANCCIAL STATEMENTS
                   Lufkin Industries, Inc. and Subsidiaries

 
(8) BUSINESS SEGMENT INFORMATION (CONTINUED)

<TABLE>
<CAPTION>
 
                                                  1996      1995      1994
<S>                                             <C>       <C>       <C>
-----------------------------------------------------------------------------
OPERATING INCOME (LOSS):
   Machinery Division                           $  9,993  $  2,257  $ (9,382)
   Trailer Division                                4,286     8,229     6,317
-----------------------------------------------------------------------------
Total operating income (loss)                   $ 14,279  $ 10,486  $ (3,065)
-----------------------------------------------------------------------------
 
ASSETS:
   Machinery Division                           $ 96,574  $ 90,866  $ 83,155
   Trailer Division                               16,125    23,058    19,046
   General Corporate                              73,226    72,372    74,573
-----------------------------------------------------------------------------
Total assets                                    $185,925  $186,296  $176,774
-----------------------------------------------------------------------------
 
CAPITAL EXPENDITURES:
   Machinery Division                           $ 11,295  $  6,600  $  4,016
   Trailer Division                                  634       835       356
   General Corporate                                 428       211       866
-----------------------------------------------------------------------------
Total capital expenditures                      $ 12,357  $  7,646  $  5,238
-----------------------------------------------------------------------------
 
DEPRECIATION:
   Machinery Division                           $  5,622  $  5,621  $  6,345
   Trailer Division                                  848       878       930
   General Corporate                                 480       551       620
-----------------------------------------------------------------------------
Total depreciation                              $  6,950  $  7,050  $  7,895
-----------------------------------------------------------------------------
</TABLE>

                                                                              19
<PAGE>
 
                            LUFKIN INDUSTRIES, INC.
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
                   Lufkin Industries, Inc. and Subsidiaries



To the Shareholders of Lufkin Industries, Inc.:

  We have audited the accompanying consolidated balance sheet of Lufkin
Industries, Inc. (a Texas corporation) and subsidiaries as of December 31, 1996
and 1995, and the related consolidated statements of earnings, shareholders'
equity and cash flows for each of the three years in the period ended December
31, 1996.  These financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these financial
statements based on our audits.

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

  In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Lufkin Industries, Inc., and
subsidiaries as of December 31, 1996 and 1995, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1996, in conformity with generally accepted accounting principles.


ARTHUR ANDERSEN LLP


/s/ ARTHUR ANDERSEN LLP

Houston, Texas
February 18, 1997


20