<PAGE>

                          SECURITIES AND EXCHANGE COMMISSION
                                Washington, D.C. 20549

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

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
    ACT OF 1934.
                     FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

                                          OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
    EXCHANGE ACT OF 1934.
                  For the transition period from     -      to    -
                                                 ----------    ---------
                            Commission file number 1-10470

                          WAHLCO ENVIRONMENTAL SYSTEMS, INC.
    -----------------------------------------------------------------------
     Delaware                                         33-0391175 
--------------------                             -----------------------
(State or other jurisdiction of                  (I.R.S. Employer
incorporation or organization                    Identification No.)

3600 West Segerstrom Avenue
Santa Ana, California                                 92704
----------------------------------               ------------------------
(Address of principal executive offices)         (Zip Code)

Registrant's telephone number, including area code:   (714)  979-7300

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

      Title of Each Class             Name of Each Exchange on Which Registered
      -------------------             -----------------------------------------
      Common Stock
      par value $.01                       New York Stock Exchange

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

Indicate by check mark whether the registrant (1) has filed all reports 
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 
1934 during the preceding 12 months (or for such shorter period that the 
registrant was required to file such reports), and (2) has been subject to 
such filing requirements for the past 90 days. 
Yes    X      No         
    -------      -------

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment to this
Form 10-K [X]

At March 14, 1997, the aggregate market value of the voting stock held by 
non-affiliates of the registrant was  $2,673,750.

At March 14, 1997, there were 17,649,000 shares of the registrant's common 
stock outstanding.

Part III incorporates information by reference from a definitive Proxy Statement
to be filed with the Securities and Exchange Commission within 120 days after
the close of the registrant's fiscal year ended December 31, 1996.

                                                                Page 1 of 59
                                                      Exhibit Index at Page 53

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                                        PART I

ITEM 1.  BUSINESS.

         Wahlco Environmental Systems, Inc. ("WES") is a Delaware corporation 
with its principal executive offices located at 3600 West Segerstrom Avenue, 
Santa Ana, California  92704 (telephone number (714) 979-7300).  Unless 
otherwise indicated, the term "Company" or "WES" refers to WES and its 
consolidated subsidiaries.

         The Company designs, manufactures, and sells combined cycle gas 
turbine products, metallic bellows, air pollution control equipment, and 
related products and services to electric utilities, independent power 
producers, cogeneration plants, and industrial manufacturers worldwide.  The 
Company also provides mechanical plant installation services and rents 
associated equipment to users in the U.K.  The Company operates through 
several subsidiaries which focus on specific geographical regions or 
products.  These entities, located primarily in the United States and the 
U.K., are coordinated through common corporate management.

GENERAL DEVELOPMENT OF BUSINESS

         The Company was formed in 1990 by Pacific Diversified Capital 
Company ("PDC"), a wholly-owned subsidiary of San Diego Gas & Electric 
Company ("SDG&E"), for the purpose of acquiring and operating Wahlco, Inc. 
("Wahlco"), at that time a wholly-owned subsidiary of PDC.  In May 1990, the 
Company issued 3,389,000 shares of common stock in its initial public 
offering.  Upon the completion of the public offering, PDC's ownership 
interest in the Company was approximately 81%. 

         On June 6, 1995, PDC sold to WES Acquisition Corp., an affiliate of 
Wexford Capital Corporation ("WESAC"), its 81% stock interest in the Company. 

         On March 30, 1990, the Company acquired all of the capital stock of 
Bachmann Companies, Inc. ("Bachmann"), which designs, manufactures and sells 
gas flow diverters, dampers, and expansion joints used by electric utilities 
and other industrial companies. 

         On August 8, 1991, WES acquired all the outstanding shares of stock 
of Teddington Bellows Ltd. ("Teddington"), which manufactures specialized 
high performance metallic expansion joints.  Teddington's customers include 
power generation, petrochemical, automobile, construction, and steel 
companies.

         On August 17, 1991, the Company acquired substantially all of the 
Metro-Flex Group (now called Wahlco Engineered Products Ltd.), headquartered 
in Baar, Switzerland, and Pentney Engineering Ltd. ("Pentney"), and Treste 
Plant Hire Limited ("Treste") headquartered in Chesterfield, England.  Wahlco 
Engineered Products, Ltd. ("WEP Ltd."), now located at the Pentney facilities 
in Chesterfield, England, designs and markets gas flow diverters and dampers 

                                  2

<PAGE>

for electric utility and industrial power plant exhaust systems.  Pentney 
manufactures products for WEP Ltd. and also provides hydraulic equipment, 
pipework, and general metal fabrication.  

         In June 1995, the Company formed a division of Wahlco to identify 
and develop products designed for the destruction of volatile organic 
compounds ("VOCs").  In November 1995, the division signed a license 
agreement with LTG Lufttechnische GmbH ("LTG") to sell and  manufacture a 
line of products for the reduction and control of VOCs in the United States, 
Canada and Mexico.  LTG is located in Stuttgart, Germany and designs, 
manufactures and sells a broad line of catalytic and thermal VOC and odorant 
oxidizers.  

DESCRIPTION OF THE BUSINESS

         The Company's business is operated through its subsidiaries: 

         Wahlco Engineered Products, Inc. (U. S.) designs, manufactures and 
sells gas flow diverters, dampers and fabric and metallic expansion joints 
used by electric utilities and other industrial companies.

         Wahlco Engineered Products, Ltd. (U.K.) designs and sells gas flow 
diverters which control and direct the flow of gases from a gas turbine 
exhaust to a waste heat recovery boiler in a gas-turbine combined-cycle 
power-generation plant.

         Pentney Engineering Ltd. (U.K.) provides mechanical pipework and 
plant installation, hydraulic equipment manufacture, and general fabrication 
to WEP Ltd., utilities and industrial companies. 

         Teddington Bellows Ltd. (U.K.) designs, manufactures and sells 
specialized high performance metallic expansion joints for industrial and 
utility  applications.

         Wahlco (U.S.) designs, manufactures, sells, leases and services 
equipment used by electric utilities and others to reduce and control air 
pollution.  Wahlco's products and services include flue gas conditioning 
systems, Nitrogen Oxide ("NOx") reduction systems, and industrial electric 
heaters and thermocouples.  In addition, through its license agreement with 
LTG, Wahlco  manufactures and sells catalytic and thermal oxidizers to 
control and reduce VOCs.

         Treste Plant Hire, Ltd., rents mechanical equipment to the United 
Kingdom construction industry.

                                        3

<PAGE>

PRODUCTS AND SERVICES

         The Company's products are sold in the coal-fired utility 
after-boiler market, the gas-turbine power-generation  market, the market 
for elimination of volatile organic compounds and other industrial markets.

DAMPERS, DIVERTERS, EXPANSION JOINTS, PIPING SYSTEMS, HYDRAULIC EQUIPMENT AND 
OTHER SERVICES  (80% OF 1996 REVENUES AND 78% OF 1995 REVENUES)
 
         Gas flow diverters divert the flow of exhaust gases from gas 
turbines either to the atmosphere via stack or to a boiler for steam 
production.  The steam produced is principally used for power generation by 
steam turbines (combined cycle).  In some cases, the steam is used as process 
steam in district heating systems, water desalination, or operations such as 
liquefying oil to assist in its extraction from the ground (co-generation).  
Gas flow diverters are supplied to the power generation industry, industrial 
power plant systems, and similar process industries of gas type isolation 
equipment.  Diverters are sold to customers in Europe, Southeast Asia, the 
Far East and the United States.

         Dampers control the flow of air and gas by directing, throttling 
and/or channeling air and gas through a single path. They are used by power 
generating utilities, petrochemical plants, refineries, chemical plants, 
cement plants, paper and steel mills, and other industrial companies.

         Expansion joints are produced from various fabrics and metals, in a 
variety of configurations, and are used with diverters and other ducting 
systems.  These products are provided to a wide range of industries.

         Metallic expansion joints are installed in liquid and gas piping, 
pressure systems and exhaust systems in the chemical, petrochemical, utility 
power generation, aviation, nuclear, ship building, heating and other general 
industries.  Expansion joints are used primarily to counteract the negative 
effect of the expansion and contraction of pipes and ducts caused by extreme 
temperature changes from a production process such as electric power 
production and petroleum refining.

         In 1995 and 1996, only a small portion of these businesses was 
driven by environmental regulation. 

         WARRANTIES.  Warranties for the Company's products generally average 
from 12 to 24 months from the date of sale and provide for the repair or 
replacement, without charge, of any parts found to be defective in material 
or workmanship under normal and proper use (except wear and tear from 
abrasion or corrosion). The Company believes that the useful life for this 
group of products ranges from 3 to 20 years under normal and proper use.

                                  4

<PAGE>

FGC SYSTEMS, HEATERS AND THERMOCOUPLES, AND RELATED PRODUCTS AND SERVICES 
(20% OF 1996 REVENUES; 22% OF 1995 REVENUES)

         FLUE GAS CONDITIONING ("FGC") SYSTEMS.  The Company is the leading 
provider of FGC systems worldwide. The FGC business is principally driven by 
environmental regulations that require electric utilities to meet certain 
emissions standards for particulate matter and sulfur oxides.

         To comply with these regulations, many utilities previously burning 
high sulfur coal have switched to low sulfur coal.  While the conversion from 
high sulfur to low sulfur coal enables utilities to meet existing sulfur 
oxide emissions standards, the conversion generally results in an increase in 
particulate emissions.  FGC systems increase the collection efficiency of 
electrostatic precipitators ("ESPs"), which abate particulate (fly ash) 
emissions.  The Company's FGC technologies include sulfur trioxide, ammonia 
and dual conditioning (both sulfur trioxide and ammonia conditioning).  FGC 
systems may be installed on existing or new ESP's.

         The ability of Wahlco's customers to purchase low sulfur coal  
economically  is an important factor in the continuing demand for Wahlco's 
FGC business.  Experts in the field of coal resources expect this trend to 
continue.  Originally, low sulfur coal was thought to be more difficult to 
obtain and transport when planning for the Clean Air Act began in the early 
1990's. 

         RENTAL UNITS. The Company rents FGC test systems to its customers to 
demonstrate that the technology will reduce particulate emissions 
sufficiently to comply with regulations.  

         SERVICE AGREEMENTS. The Company has, from time to time, entered into 
maintenance agreements of varying terms and conditions under which it 
maintains systems purchased by its customers.

         NITROGEN OXIDE ("NOx") REDUCTION SYSTEMS. The Company's Staged NOx 
Reduction System ("SNRS") relies on two NOx reduction technologies: selective 
non-catalytic reduction ("SNCR") and selective catalytic reduction (SCR).  
The system uses the customer's existing air heater to further reduce NOx 
emissions.  The air heater SCR process is covered by U.S. and foreign patents 
owned by the Company.  In 1995, the Company received contracts for four SNCR 
systems in Russia. The contract is important because the global market for 
NOx reduction systems on both oil and coal-fired boilers is significant.

         HEATERS AND THERMOCOUPLES. Thermocouples are heat-sensing devices 
used in conjunction with a temperature controller or indicator to convert an 
electrical signal to a temperature readout.  The Company's electrical heaters 
include: (l) tubular heaters for plastic injection molding and extrusion, 
pipe heating and die heating; (2) immersion heaters for heating liquids in 
the chemical and process industries; (3) duct heaters for heating large 
quantities of air or gas passing through ducts; (4) tubular elements for 
specialty heating applications; and (5) silicone rubber heaters for drum and 
tank heating used for food processing, medical equipment 

                                     5

<PAGE>

and other applications.

         VOLATILE ORGANIC COMPOUND ("VOC") CONTROL SYSTEMS.  Under a license 
agreement with LTG Lufttechnische GmbH covering the U.S., Canada and Mexico, 
the Company manufactures a full line of thermal and catalytic oxidizers to 
control and destroy VOCs.  VOCs are an inherent by-product of many industrial 
processes, but the emission of these hazardous compounds to the atmosphere is 
limited under current state and federal regulations stemming from the 1990 
Clean Air Act Amendments Titles I, III and V. 

         WARRANTIES.  Warranties for FGC and VOC systems generally provide 
for the repair or replacement, without charge, of any parts found to be 
defective in material or workmanship under normal and proper use (excepting 
wear and tear from abrasion or corrosion) within 18 months from the date of 
shipment or 12 months from the date of initial operation, whichever occurs 
first. In addition, under certain circumstances, the Company guarantees that 
proper operation of its FGC and VOC systems will not exceed certain effluent 
opacity or emission levels over an initial acceptance period.

         Warranties for heaters and thermocouples generally provide that the 
Company will repair or replace, without charge, any parts found to be 
defective in material or workmanship under normal and proper use (excepting 
wear and tear from abrasion or corrosion) within 12 months from the date of 
sale.  The Company believes the useful life of each of these products exceeds 
five years under normal and proper use.

PATENTS AND TRADEMARKS
    
         The Company holds twenty-four U.S. patents and corresponding foreign 
patents and/or applications.  Existing patents expire between 1999 and 2015.  
Although initially enhanced by its patent rights, the Company believes its 
ability to compete effectively in the FGC market depends primarily upon its 
engineering, scientific and technological expertise and its reputation for 
successful installations.  This includes a database of information relating 
to coal and ash analysis and precipitator size and operating conditions.  In 
addition, the Company has competed successfully in the sale of its sulfur 
dioxide-based and ammonia conditioning systems, which are not protected by 
patents, and in the sale of its sulfur-burning FGC systems in foreign 
countries in which it does not have significant patent protection.  

         During 1996, the Company was awarded four new U.S. patents covering 
different approaches to environmentally beneficial "In-duct gas conditioning" 
which the Company believes could become an important FGC technology.  Foreign 
patent applications for this technology are in progress.

         In May 1992, the Company acquired from L&C Steinmuller GmbH three 
U.S. and a number of corresponding foreign patents which broadly cover the 
core component of Wahlco's  entry into the market for the control of NOx 
emissions.

                                   6

<PAGE>

         The Company holds several U.S. and foreign patents, relating to 
dampers, diverters and expansion joints, which expire between 1998 and 2015.  
In addition, a number of applications are pending, for some of which patent 
grants are imminent.  As these patents and applications relate to a diverse 
range of products, and because the Company's business is more dependent upon 
the engineering quality of the Company's products, the Company does not view 
its success as dependent upon any single patent.

         Dampers, diverters, expansion joints and related services are 
marketed under the trademarks or tradenames "WAHLCO," "METRO-FLEX," and 
"TEDDINGTON."

RESEARCH AND PRODUCT DEVELOPMENT

         Expenditures for research and product development were approximately 
$277 thousand in 1996 and $460 thousand in 1995. The Company's research and 
development activities are substantially augmented by the knowledge gained 
through custom engineering provided for individual customers.

         The Company has an ongoing program to improve its products.  As 
examples, its research efforts have resulted in the development of FGC 
process improvements, development of high efficiency catalysts, improvements 
to heat exchange surfaces, NOx reduction systems, a heat transfer testing 
facility, and a sophisticated database containing information relating to 
coal and ash analysis for sizing and improving the performance of 
electrostatic precipitators, and precipitator size and operating conditions. 

MARKETING

         The Company markets its products, technologies and services to 
electric utilities and industrial customers worldwide. The principal export 
markets for the Company's products are Asia, Europe and Canada.  (See Note 13 
to Consolidated Financial Statements.)

         The Company has a dedicated sales force for each subsidiary, managed 
under common corporate control.  Coordination among these groups has aided 
the development of relationships and future business prospects for all 
products.

         Since January 1997, Wahlco's sales organization has been 
headquartered in Santa Ana, California.  A sales manager oversees 
approximately 40 independent sales representative organizations in North 
America that sell to utility customers and industrial customers, primarily in 
the steel, cement, pulp and paper and related process industries.  The 
international sales function operates through a network of 42 representatives 
in 57 countries in Africa, Asia, the Pacific Rim, the Caribbean, Europe, the 
Middle East, and Central and South America.  In addition to this sales 
organization, Wahlco markets its products through sales and/or service 
offices located in California, and Illinois.

                                     7

<PAGE>

         Wahlco's FGC marketing efforts are targeted primarily at coal-fired 
power plants operated by electric utilities.  Repeat business for FGC systems 
is limited because individual customers typically have a small number of 
electrostatic precipitators and because FGC systems operate for many years 
without the need for replacement.

         In recent years, Wahlco has increased its international marketing 
efforts for FGC systems.  While U.S. environmental regulations, mandating 
lower emissions levels for power generating plants, have been in place for 
several years, many other countries have not yet adopted or enforced strict 
regulations aimed at reducing emissions from coal fired power plants. Wahlco 
believes that Asia, Europe, and Africa, may enact stricter regulations to 
control power plant emissions.  It is impossible to predict with certainty, 
however, whether such regulations will be enacted or, if enacted, enforced, 
or the effect of such regulations upon the Company's business.

         Wahlco has developed a proprietary staged NOx reduction system 
("SNRS") that provides gas and coal-fired utilities with a modular, economic 
solution to NOX removal.  To increase market penetration, the Company is 
working with Nalco Fueltech, a significant participant in NOx reduction, to 
jointly market the staged reduction technique using the Company's patented 
heater basket technology.

         Wahlco's marketing activities for the VOC control product line are 
similar to those for the FGC product line.  A sales manager oversees a 
network of independent sales representative organizations in the United 
States, Mexico and Canada.  VOC and FGC sales representatives do not 
generally overlap because the VOC market addresses a different industrial 
base.  During 1996, the primary VOC control markets in the U.S. were wood 
products, semiconductor manufacturing, printing/coating, surface finishing, 
metal decorating and chemical processing.

         Marketing and sales for Wahlco Engineered Products, Inc. ("WEP, 
Inc.") is based in Lewiston, Maine and focuses on customers in the power, 
pulp & paper, cement, metals, and petro-chemical industries in North, Central 
and South America through a network of approximately 28 independent sales 
representative organizations.

         WEP, Inc. also markets dampers and expansion joints to customers in 
Europe and Asia through a network of 18 independent sales representative 
organizations in Europe and Asia.  In addition, WEP, Inc. sell diverters to 
U.S. based customers for projects in Europe and Asia.

         WEP Ltd.'s products are marketed internationally  by 28 direct and 
independent sales representatives in 34 countries.  Sales, engineering and 
technical support are performed from the Chesterfield, U.K. facility.

         Teddington uses 10 of its own and several of the Company's 
international sales and marketing representatives.


                                       8

<PAGE>

CUSTOMERS

         No customer accounted for more than 10% of the Company's revenues in 
1996.  (See Note 13 to Consolidated Financial Statements).

RAW MATERIALS

         The materials used in the production of the Company's product lines 
are generally available through a number of sources, and the Company does not 
anticipate difficulty in obtaining the materials and components used in its 
operations.  Most of the materials used by the Company are ordered to a 
number of standards, including ASME, ASTM and DIN.

         Certain materials and components must withstand extreme operating 
conditions and because only relatively few component suppliers consistently 
meet necessary specifications, the Company purchases from a limited number of 
suppliers.  Generally, the Company has not experienced difficulty in 
obtaining the necessary materials and components and has several alternative 
sources of supply.

         Pentney and Teddington have achieved ISO 9000 standards.  The 
remaining subsidiaries continue to work toward achieving ISO 9000 
accreditation or equivalent standards.

COMPETITION

         Wahlco, Inc. competes primarily on its engineering, scientific and 
technological expertise.  Wahlco believes that its past performance record of 
approximately 400 installed systems is a benefit in dealing with its 
customers.  Wahlco bases its belief with respect to the performance record of 
its FGC systems on its ongoing communications with customers for which it has 
installed such systems.

         Since 1990, Wahlco's domestic FGC business has experienced increased 
price competition as domestic utilities attempted to reduce the overall costs 
of compliance with state and federal regulations.  Several smaller domestic 
manufacturers including Chemithon, Inc. and Wilhelm Environmental 
Technologies, Inc., have been successful in securing some FGC contracts.

         As a result of price competition, Wahlco has experienced a decline 
in market share and  in overall FGC margins.  During the period 1993-1996, 
Wahlco confronted competitive pricing pressures by reducing certain 
engineering and manufacturing costs and by reconfiguring various products to 
better meet customer demand.  Based upon internal market information, the 
Company believes that Wahlco still continues to be the leading provider for 
FGC systems in the United States and maintains a strong market position 
internationally.


                                       9

<PAGE>

         Since there are several alternatives to FGC systems, Wahlco faces 
substantial competition from companies providing devices which reduce 
particulate emissions generally without the need for FGC systems.  Examples 
of such devices are scrubbers, certain ESPs, and baghouses.  Numerous factors 
may be considered by an electric utility in determining whether to install 
FGC systems or an alternative technology to achieve compliance. These include 
the amount of initial capital expenditures, issues and policies related to 
fuel sources, related on-going operating and maintenance costs, availability 
and associated costs of low and/or high sulfur coal, the particular emission 
standards applicable to the public utility, and the value of any credits or 
allowances which may be available.

         One of the largest factors affecting the market and its competitive 
nature has been the utilities' strategy to postpone adding FGC and other 
compliance equipment by blending coals.  Utilities have mixed high and low 
sulfur coal or burned low sulfur coal containing enough sulfur content to 
reduce sulfur emissions without impairing the effectiveness of the 
particulate control devices.

         Wahlco faces substantial competition with respect to its 
thermocouple and electrical heater products and serves a relatively small 
portion of the total market.  In addition to a few large companies which 
market such products nationally, there are also several regional suppliers 
which compete with Wahlco.  In establishing a market niche, Wahlco targets 
customers requiring specially engineered and customized products.

         The Company's line of products to control VOC's compete with 
products from numerous competitors.  Products are customized for particular 
applications, and companies compete based on design and engineering 
capabilities as well as installation and on-site reliability.

         WEP, Inc. faces significant competition in the sale of its dampers, 
diverters, and expansion joints.  Although these products are differentiated 
by design, sophistication, reliability, and customer service, many purchasing 
decisions are made on the basis of price and delivery.

         WEP Ltd. continues to win a significant share of the international 
market for gas flow diverters.  Pentney, Treste and Teddington complete in 
the U.K. construction market which has been somewhat depressed during the 
last two years.  Recent strength of the U.K. pound has adversely affected the 
U.K. market.

         WEP, Inc. and WEP, Ltd. believe that, as a group, they command a 
significant share of the global market for gas flow diverters and dampers.  
Significant competitors in this market include Rappold, Braden, Effox, and 
Stober & Morlock.  Domestically, WEP, Inc. faces competition in the damper 
market from Effox, American Warming & Ventilating, ACDC, DDI, and others.  In 
the expansion joint market, WEP, Inc. competes with Pathways, EJS, Senior 
Flexonics, Badger, and others.


                                      10

<PAGE>

GOVERNMENTAL REGULATION

         Although the Company's manufacturing operations are subject to 
environmental regulations governing the discharge of pollutants, compliance 
by the Company with these environmental regulations has not had, and is not 
anticipated to have, a material effect on the capital expenditures, earnings 
or competitive position of the Company.

         Certain of the Company's business is dependent upon government 
regulation of air pollution at the federal, state, local and foreign levels.  
In the United States, the Federal Clean Air Act ("CAA") (which was amended in 
1990 to impose stricter requirements for emissions), and the associated 
federal and state regulations largely determine the size and timing of the 
investments the Company's customers make in pollution control equipment.  
Clean air legislation in the United States requires compliance with ambient 
air quality standards and empowers the Environmental Protection Agency 
("EPA") to establish and enforce limits on the emission of various 
pollutants. The states have primary responsibility for implementing these 
standards and, in some cases, have adopted more stringent standards than 
those adopted by the EPA.

         Several factors have negatively impacted the air pollution control 
equipment marketplace since the passage of the CAA Amendments in 1990. There 
was a general increase in competition and an associated decrease in unit 
prices.  These factors combined to erode gross margins. Weakness in general 
business conditions and changes specific to utility industry customers, such 
as the availability of emission credit trading, caused many air pollution 
control equipment customers to reevaluate or postpone capital equipment 
decisions. As an example, the market for FGC equipment plunged almost 70% in 
1992. Many of the Company's customers were able to meet January 1, 1995 
(Phase I) compliance requirements by blending coal, using environmental 
credits, derating plants, and other methods rather than by purchasing FGC 
equipment.

EMPLOYEES

         At December 31, 1996, the Company employed 354 persons, of whom 250 
were engaged in production and operations, 35 were engaged in engineering and 
scientific research, 36 were engaged in accounting and administration, 26 
were engaged in sales, and 7 were in general management.

FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS; EXPORT SALES

         Information about revenues, results of operations and identifiable 
assets by geographic areas and the amount of export sales for the periods 
indicated is set forth in Note 13 to Consolidated Financial Statements.  The 
Company's operations outside the United States are subject to the usual risks 
and limitations attendant upon investments in foreign countries, such as 
fluctuations in currency values, exchange control regulations, wage and price 
controls, employment regulations, effects of foreign investment laws, 
governmental instability (including 


                                       11

<PAGE>

expropriation or confiscation of assets) and other potentially detrimental 
domestic and foreign governmental policies affecting U.S. companies doing 
business abroad.


                                       12

<PAGE>

ITEM 2.  PROPERTIES.

         The building which houses the Company's and Wahlco's headquarters 
located in Santa Ana, California, is occupied under a lease expiring July 31, 
2001 at a rental of $42,000 per month. The building consists of approximately 
28,000 square feet of office space and approximately 22,000 square feet of 
production space.  Wahlco also owns a 5,000 square foot service/installation 
office located in Thornton, Illinois.

         Wahlco Engineered Products, Inc. is headquartered in Lewiston, 
Maine, in a 49,300 square foot facility owned by the Company, consisting of 
12,000 square feet of office space, and 37,300 square feet of manufacturing 
area.

         Wahlco Engineered Products Ltd. operates from leased facilities in 
Chesterfield, England aggregating to approximately 115,000 square feet.  The 
facilities consist of 95,000 square feet of manufacturing space and 20,000 
square feet of office space.  Approximately 24,000 square feet of 
manufacturing space are subleased, which generates approximately $85 thousand 
per year.  Lease payments required on these facilities total $277 thousand 
per year. These lease payments, which are part of the purchase agreement when 
the Company purchased Pentney Engineering Ltd., are made to a company which 
is 50% owned by an officer of the Company and a previous  co-owner of Pentney 
Engineering Ltd. Teddington owns and operates a 75,000 square foot facility 
in Swansea, Wales.  In March 1993, the Company purchased the facility for 
approximately $227 thousand.

         The Company believes that its facilities are adequate for its 
current operations.


                                       13

<PAGE>

ITEM 3.  LEGAL PROCEEDINGS.

         None.


                                      14

<PAGE>

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         None.

                              EXECUTIVE OFFICERS

         The names and ages of the executive officers of the Company and the 
positions held by each during the last five years were as follows:

         C. Stephen Beal, 49, is the President and Chief Executive Officer of 
 Wahlco Environmental Systems, Inc. Prior to joining Wahlco, as a result of 
the acquisition by the Company of Pentney Engineering, Ltd. in 1991, Mr. Beal 
served as Managing Director and joint owner of the Pentney Group since 1974.  
From 1991 to 1996, Mr. Beal served as President and CEO of the Company's 
Engineered Products Group.

         A. Noel DeWinter, 58, has been Vice President and Chief Financial 
Officer since October 1996 after serving as Vice President, Controller since 
March 1995.  Mr. DeWinter  served as Vice President, Finance from October 
1991 to January 1992, and Chief Financial Officer from January 1990 to 
October 1991. From January 1992 to January 1994, he served at the Company's 
Lewiston, Maine subsidiary as Vice President, Finance.

         James J. Ferrigan, 43, has been Senior Vice President, NOx Reduction 
Technologies, Wahlco, Inc., since March 1997.  Prior thereto, he was Senior 
Vice President of North American Marketing for Wahlco, Inc. for more than 
five years.

         Barry J. Southam, 60,  has served as Senior Vice President, FGC 
Technologies, Wahlco, Inc., since March 1997.  He served as Senior Vice 
President, International Sales and Marketing for the Company since September 
1991. Prior thereto, he was Vice President of International Operations for 
Wahlco, Inc. for more than five years.

         The officers are elected annually by the Board of Directors at the 
first meeting following the Annual Meeting of Stockholders. There is no 
family relationship between any of the officers, directors or persons 
nominated to become a director.  There were no arrangements or understandings 
between any officer and any other person pursuant to which he was elected as 
an officer.


                                       15

<PAGE>


                                     PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

COMMON STOCK PRICE FROM JANUARY 1, 1996 TO DECEMBER 31, 1996

<TABLE>
<CAPTION>

                   1st Quarter    2nd Quarter    3rd Quarter    4th Quarter
---------------------------------------------------------------------------
<S>                <C>            <C>            <C>            <C>
High Price            1 7/8         1 3/8           5/8            1/2  
Low Price             1 1/4          5/8            3/8            9/32

</TABLE>




COMMON STOCK PRICE FROM JANUARY 1, 1995 TO DECEMBER 31, 1995
<TABLE>
<CAPTION>

                   1st Quarter    2nd Quarter    3rd Quarter    4th Quarter
---------------------------------------------------------------------------
<S>                <C>            <C>            <C>            <C>
High Price           2 3/8          2 1/4          3 1/4          2 7/8
Low Price            1 1/8          1              1 1/2          1 3/8

</TABLE>

         The Company's Common Stock is list ed on the New York Stock Exchange 
and trades underthe symbol WAL. At March 14, 1997, there were approximately 
279 stockholders of record of the Company's Common Stock.  This number does 
not include shareholders whose shares are held in the name of a nominee. 


                                      16
<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA

(Dollar and share amounts in thousands, except per share data)

<TABLE>
<CAPTION>

SUMMARY OF OPERATIONS                   1996(1)     1995(1)     1994(1)     1993(1)     1992(1)
------------------------------------------------------------------------------------------------
<S>                                    <C>         <C>         <C>         <C>         <C>
Revenues                               $ 43,051    $ 60,100    $ 69,897      82,121      81,877
Operating income (loss)                 (12,945)    (12,536)    (73,523)    (16,353)    (16,608)
Net income (loss)                       (10,809)    (11,352)    (66,149)    (10,896)    (12,788)
Net income (loss) per common share        (0.61)   $  (0.64)   $  (3.75)   $  (0.62)   $  (0.72)
Average shares outstanding               17,649      17,649      17,649      17,649      17,649

Backlog at year end                    $ 23,899    $ 20,613    $ 32,250    $ 33,500    $ 39,208
Number of employees at year end             354         423    $    508    $    814         788

FINANCIAL POSITION AT YEAR END
------------------------------------------------------------------------------------------------
Working capital (deficit)              $  5,163    $ 12,713    $ (6,860)   $  5,695    $  3,215
Property, plant and equipment, net        5,190       5,921      10,232      15,468      24,242
Goodwill, net                                 -           -       2,606      53,491      55,685
Total assets                             29,820      46,519      58,930     129,780     136,378
Long-term debt                           12,145       7,948       1,037       1,265       4,593
Other liabilities                         2,435       3,689       4,128       3,300       3,847
Stockholders' equity (deficit)           (2,820)      7,367       6,678      72,653      83,932

FINANCIAL PERFORMANCE
------------------------------------------------------------------------------------------------
Current ratio                               1.3         1.5         0.9         1.1         1.1
Long-term debt as a %
  of total capitalization                 130.2%       51.9%       13.4%        1.7%        5.2%
</TABLE>

(1)  During the years 1990 - 1992, the Company made several business 
     acquisitions, and from 1993 to 1995 disposed of various businesses, which 
     may affect the comparability of the information.  (See Note 3 to 
     Consolidated Financial Statements.)




                                       17
<PAGE>

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
RESULTS OF OPERATIONS.

YEAR ENDED DECEMBER 31, 1996 COMPARED TO THE YEAR ENDED DECEMBER 31, 1995.

         Revenues in 1996 decreased $17.0 million, or 28%, to $43.1 million 
from $60.1 million in 1995.  Revenues from businesses discontinued in late 
1995, primarily the operations in Australia, represented $2.9 million of the 
revenue decrease.  The decrease was primarily associated with reduced 
revenues for gas flow diverters ($7.2 million), pipe work systems and 
hydraulics equipment ($5.6 million), and flue gas conditioning (FGC) systems 
($5.6 million). These lower revenues were partially offset by an increase in 
shipments of damper products from the Company's facility in Maine. ($3.2 
million).  International revenues accounted for 67% of total revenues in 1996 
compared to 78% of total revenues in 1995.

         FGC revenues have decreased in each of the last three years due to 
the absence of large contracts from domestic utilities.  Commencing in 1994, 
the U.S. Electric Utility Industry has undergone major restructuring, as a 
result of ongoing federal and state deregulation. Orders for all significant 
capital expenditures, including air pollution control equipment, have been 
minimal during this period.

         The Company's 1996 cost of revenues totaled $39.1 million and 
represented 91% of revenues.  In 1995, the Company's cost of revenues totaled 
$51.5 million and represented 86% of revenues.  The increase in cost of 
revenues as a percent of revenues in 1996, as compared to 1995, was due to 
contract provisions of approximately $2.9 million taken in the second, third 
and fourth quarters of 1996, primarily related to jobs subcontracted from 
Italy and the U. K. in foreign locations.  Cost of revenues for FGC systems 
increased to 91% of revenues in 1996 from 74% of revenues in 1995, due to a 
large significant profitable FGC contract in 1995 which did not recur in 
1996.  In addition, fixed manufacturing and engineering cost became more 
significant against the lower 1996 revenues.

         Selling, general and administrative (SG&A) expense, before 
restructuring charges and intangible write-downs, totaled $16.8 million in 
1996, down from $19.1 million in 1995 and $21.4 million in 1994.  SG&A 
expense, as a percent of revenues, before restructuring charges and 
intangible write-downs, was 39% in 1996, and 32% in 1995 and 31% in 1994.  
SG&A expense in 1996 included one-time charges of approximately $2.8
million, including $2.4 million of reserves for bad debts and $0.7 million 
for executive severance and option costs, partially offset by the reversal of 
$0.3 million in reserves deemed unnecessary.  Approximately $0.8 million of 
the bad debt reserve related to reserves required in the Company's Italian 
operation.  SG&A expense in 1995 contained one-time charges totaling $2.3 
million for legal and closing costs related to the purchase by WESAC of an 
81% interest in the Company and a decision to close the Puerto Rico 
production facility.  In 1996, SG&A expense included approximately $0.9 
million of expenses related to the marketing and sale of VOC products and the 
Company's license agreement with Viking Water Systems, Inc.  SG&A expense 
related to these businesses was $0.3 million in 1995. The number of employees 
in the Company

                                   18

<PAGE>

totaled 354 at December 31, 1996, down from 423 and 508 at the end of 1995 
and 1994, respectively.

         Prior to the acquisition by WESAC of 81% of the Company's common 
stock,  the Company's U.S. operations were consolidated into the tax return 
of San Diego Gas & Electric Company, its former 81% parent, through a tax 
sharing agreement dated April 1990.  This agreement terminated on the closing 
of the equity sale to WESAC.

         With respect to WESAC's acquisition of PDC's shares on June 6, 1995, 
the buyer and seller agreed to jointly elect tax treatment for the 
transaction as similar to an asset acquisition under section 338(h)(10) of 
the Internal Revenue Code.  Under this election, the allocation of the 
purchase price to the assets deemed purchased resulted in the recording of 
deferred tax liabilities totaling $5.0 million, of which approximately $700 
thousand was recorded in current liabilities.


         Subsequent to the closing of the WESAC transaction on June 6, 1995, 
and after the deferred tax liabilities were recorded, the Company provided 
tax benefits of $3.0 million in 1995 and $2.0 million in 1996 against losses 
from domestic operations.  The tax benefit in 1996 also included $0.9 million 
from the release of tax reserves deemed unnecessary.

YEAR ENDED DECEMBER 31, 1995 COMPARED TO THE YEAR ENDED DECEMBER 31, 1994.

         Revenues of $60.1 million in 1995 were $9.8 million, or 14%, below 
1994 revenues of $69.9 million.  Revenues from businesses discontinued in 
1995 and 1994 decreased to $3.5 million in 1995 from $10.3 million in 1994,  
accounting for $6.8 million of the total revenue decrease. Revenues from 
continuing operations decreased $3.0 million, to $56.6 million in 1995 from 
$59.6 million in 1994, primarily due to a $3.1 million decrease in FGC and 
De-NOx system revenues. International revenues accounted for 78% of total 
revenues in 1995 compared to 60% of revenues in 1994.

         The decrease in FGC and De-NOx systems revenues in 1995 resulted 
from the absence of large contracts from domestic utilities. Confronted by 
increased competition developing from continuous Federal and state 
deregulation, the U.S. electric utility industry is in the midst of major 
restructuring with the result that order activity for domestic FGC systems 
has been declining in this marketplace.

         In addition, the air pollution control industry is in a period of 
relatively low activity between two compliance deadlines.  Demand for 
domestic clean air products, including FGC and De-NOx systems, is principally 
driven by compliance with emission limits established by the Federal Clean 
Air Act Amendments in 1990.  The Phase I Compliance deadline was January 1, 
1995, and the Phase II Compliance deadline is January 1, 2000.  Having met 
the Phase I requirements, many  North American utilities will likely delay 
Phase II compliance actions until later in the decade.

                                  19

<PAGE>

         The Company's cost of revenues in 1995 totaled $51.5 million and 
represented 86% of revenues, compared to cost of revenues of $64.7 million at 
93% of revenues in 1994. Approximately $11.3 million of 1994 cost of revenues 
relates to operations which were closed or cut back over the last two years, 
including Wahlco Power Products, Inc. ("WPPI"), Field Service Associates, 
Inc. ("FSA"), Exergetic Systems, Inc. ("ESI") and Wahlco Engineered Products, 
Pty. Ltd. (Australia).  When these operations are excluded, the percentage of 
cost of revenues to total revenues is 86% and 89% in 1995 and 1994, 
respectively.

         In 1995, cost of revenues as a percent of revenues decreased 
primarily due to lower costs on De-NOx contracts and the absence of high 
costs on a large domestic 1994 FGC contract. In addition, closing the Puerto 
Rican manufacturing facility and transferring FGC production systems to 
California reduced duplicate factory overhead costs and lowered unit 
production costs.

         During 1995, the Company continued its cost reduction program which 
commenced in 1992.  As a result, selling, general and administrative ("SG&A") 
expense, before restructuring charges and intangible write-downs, declined 
from $21.4 million in 1994 to $19.1 million in 1995.  SG&A expense, as a 
percent of revenues, before restructuring charges and intangible write-downs 
was 32%, in 1995, 31% in 1994 and 30% in 1993.  As a result of the cost 
reduction program, the number of employees declined to 423 at December 31, 
1995, down from 508 and 814 at the end of 1994 and 1993, respectively.

         During the third quarter of 1995, the Company released restructuring 
accruals totaling approximately $590 thousand, primarily related to strategic 
actions no longer under consideration by  management.  The reserves had been 
provided for 1993 and 1994 for the closing of facilities used in 
international operations and associated severance.  After review, management 
deemed these reserves unnecessary.

         During the fourth quarter of 1995, management evaluated the value of 
goodwill remaining on the Company's books at Wahlco, Inc. and Pentney in the 
U.K.  As a result of this analysis, which involved a forecast for each 
business and the discounting of future cash flows, the goodwill at Wahlco, 
Inc. and Pentney, which totaled $1.8 million and $634 thousand, respectively 
was written off. 

         Subsequent to the write-off of goodwill, the Company adopted the 
provisions of FAS 121, effective December 31, 1995.  No additional 
write-downs of assets was required under FAS 121 in 1995.  (See Note 1 to 
Consolidated Financial Statements)

         The Company was unable to book a tax benefit against 1995 losses 
prior to June 6, 1995, the date WESAC purchased SDG&E's 81 percent stock 
interest in the Company, since the tax sharing agreement with SDG&E limited 
the Company's reimbursements for tax credits and losses which the Company 
would be entitled had it filed separate income tax returns. 

                                    20

<PAGE>

         Subsequent to the closing of the WESAC transaction on June 6, 1995, 
and after the deferred tax liabilities were recorded, the Company provided 
tax benefits of $3.0 million against losses from domestic operations.

LIQUIDITY AND CAPITAL RESOURCES

         The Company had a negative cash flow from operating activities in 
1996 of $4.1 million compared to a negative cash flow of $10.3 million in 
1995.  The negative cash flow in 1996 resulted from the net loss of $10.8 
million, partially offset by reductions in working capital, principally 
accounts receivable and inventories.  The negative cash flow in 1995 resulted 
primarily from the net loss of $11.4 million reported in that year.  In 1996 
and 1995, the Company funded its operating cash flow deficit through 
borrowings from its 81% stockholder, WESAC, and its primary bank, as 
described below. 

         The Company had a working capital position of $5.2 million at 
December 31, 1996 compared to working capital of $12.7 million at December 
31, 1995.  The decrease in working capital reflects a $5.0 million reduction 
in accounts receivable and a $4.6 million decline in inventories, due to the 
lower level of production and revenues in 1996 compared to 1995, and contract 
adjustments and operating losses in 1996.  Working capital improved in 1995 
principally due to the contribution to capital of approximately $20 million 
of short-term debt owed by the Company to PDC as part of the WESAC 
transaction.  (See Note 1 to the Consolidated Financial Statements). 

         As a security for performance and advances on long-term contracts, 
the Company is contingently liable in the amount of $1.3 million at December 
31, 1996 under standby letters of credit of which $1.1 million are fully 
secured by restricted cash and marketable securities. 

         Capital expenditures in 1996 totaled $402 thousand compared to $648 
thousand in 1995.  Approximately $155 thousand was spent on additions to the 
rental equipment inventory at Treste Plant Hire Ltd.  Another $48 thousand 
was spent to expand the Treste facility.  The balance of the capital 
expenditures were for a variety of production equipment and certain building 
improvements.

         On October 25, 1996, the Company's loan and security agreement with 
Silicon Valley Bank was modified, so that (i) the maturity date was extended 
to May 1998, and (ii) the interest rate on funds borrowed by the Company was 
reduced from about 11% to about 5.5%, since WESAC deposited cash collateral 
equivalent to the funds borrowed with Silicon Valley Bank.  As part of the 
loan and security agreement in October 1995 and the renegotiation in October 
1996, the Company issued warrants to SVB to purchase 175,000 shares of the 
Company's Common Stock at $2.29 per share, which warrants expire on October 
26, 2000.

         On August 28, 1996,  the Company reached an agreement with WESAC, 
pursuant to which WESAC agreed to lend the Company up to $1.6 million.  The 
loan bears

                                    21

<PAGE>

interest at an annual rate of 13%, and is secured by all of the 
assets of the Company.  Interest and a commitment fee of $32,000 have been 
paid in kind and added to principal.  In further consideration for making the 
loan, the Company agreed to issue to WESAC or its designee five year warrants 
to purchase the Company's common stock as the funds are drawn down.  Each 
warrant covers the number of shares of common stock equal to the quotient of 
(i) the dollar amount of the draw down divided by (ii) $0.47, the approximate 
closing price of the common stock on August 16, 1996. The warrants become 
exercisable on issuance at $0.47 per share.  The Company had drawn $1.5 
million against this loan as of December 31, 1996, and issued warrants 
covering 3,404,255 shares of common stock to four WESAC partnerships which 
provided the funding.  The loan matured on January 1, 1997 but was extended 
as described below.

         On October 18, 1996, the Company announced a capital restructuring 
plan that will reduce the Company's debt and provide additional working 
capital.  The capital restructure plan, subject to final documentation and 
stockholder approval, involves converting $5 million of WESAC debt into 12% 
preferred stock.  The preferred stock will be convertible into 10,958,904 
common shares, representing a per share conversion price of $0.45625, the 
average closing price of the common stock for the thirty trading days prior 
to October 18, 1996.  Quarterly dividends on the preferred stock can be paid 
in additional preferred stock in lieu of cash, at the option of the Company.

         The impact on the Company's capital structure of  the conversion of 
WESAC debt into preferred stock, as described above, is as follows:

          Proforma Impact of Converting Debt into Preferred Stock 
             Consolidated Balance Sheet at December 31, 1996
<TABLE>
<CAPTION>

                                                  PRIOR TO             AFTER
                                                 CONVERSION          CONVERSION
                                                 ----------          ---------
<S>                                               <C>                  <C>
Long-term debt                                    $12,145              $7,145
Stockholders' equity                              $(2,820)             $2,180
</TABLE>

         As part of the restructuring plan, WESAC extended the maturity of 
the August 1996 $1.6 million facility and the existing Silicon Valley Bank 
loan.  Both facilities mature in May 1998.  WESAC also agreed to provide the 
Company with a new $2.4 million standby line of credit.

         As of March 31, 1997, the Company had not drawn the remaining $100 
thousand available under the August 1996 term loan or any funds on the $2.4 
million line.

         The Company believes that the extension of the existing facilities 
with WESAC and Silicon Valley Bank, along with the new line of credit, will 
be adequate to fund the Company's operations during 1997;  however, there can 
be no assurances that this will be the

                                22

<PAGE>

case. Significant changes in the Company's anticipated level of business and 
other events could substantially increase the Company's cash requirements 
above those now anticipated, and thereby materially and adversely affect the 
Company's results of operations and financial condition.

BACKLOG AND BOOKINGS


         Backlog at December 31, 1996 was $23.9 million compared to $20.6 
million at December 31, 1995.  FGC system backlog increased to $5.2 million 
at December 31, 1996 from $3.1 million at the end of 1995.  Backlog is 
unaudited and is defined as work for which the Company has entered into a 
signed agreement or has received a requisition or purchase order.  
Approximately $3.9 million of the December 31, 1996 backlog is scheduled for 
delivery after December 31, 1997. Historically, substantially all of the 
Company's backlog has resulted in completed contracts. 

EFFECTS OF INFLATION; OTHER COST INCREASES

         Management does not believe that inflation has had a material effect 
on operations during the past several years.  However, the Company 
experienced significant stainless steel price increases on one large contract 
in Southeast Asia in 1995 and 1996.  Increases in labor, materials and other 
operating costs could adversely affect the Company's operations, if the 
Company is unable to raise its prices to cover the increases.

FOREIGN CURRENCY TRANSLATION

         A substantial portion of the Company's assets are outside of the 
United States and are subject to fluctuation in exchange rates. The foreign 
currency translation adjustment to the Balance Sheet at December 31, 1996  
was $2.0 million (net of tax) compared to $2.5 million as of December 31, 
1995. 

CAUTIONARY STATEMENT 

         The foregoing discussion under the heading "Business" and 
"Management's Discussion and Analysis of Financial Condition and Results of 
Operations" contains various "forward looking statements" within the meaning 
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of 
the Securities Exchange Act of 1934, as amended, and represent the Company's 
expectations or beliefs concerning future events, including the following: 
Statements regarding increasing competition from other manufacturers of FGC 
equipment; statements regarding compliance methods other than FGC systems 
such as coal blending, environmental credits, etc.; statements regarding the 
timing of demand for clean air products under CAA Phase II deadlines; 
statements regarding the adequacy of the Company's cash provided by 
internally generated funds and outside borrowings.  The Company cautions that 
these statements are further qualified by important factors that could cause 
actual results to differ

                                     23

<PAGE>

materially from those projected by the Company, including, but not limited 
to, the following: change in emphasis regarding compliance of existing clean 
air legislation under a new administration; changing governmental regulations 
or legislation; development of alternative compliance technologies; and 
emergence of new competitors as Phase II of the CAA deadlines draw closer.  
Future results actually achieved thus may differ materially from historical 
results and/or from Company forecasts.

                                      24

<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Public Accountants

TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF WAHLCO ENVIRONMENTAL SYSTEMS, 
INC.:

         We have audited the accompanying consolidated balance sheets of 
Wahlco Environmental Systems, Inc. as of December 31, 1996 and 1995, and the 
related consolidated statements of operations, stockholders' equity 
(deficit), and cash flows for the years then ended. These consolidated 
financial statements and the schedule referred to below 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 Wahlco 
Environmental Systems, Inc. as of  December 31, 1996, and the results of 
their operations and their cash flows for the years then ended in conformity 
with generally accepted accounting principles.

         The accompanying consolidated financial statements have been 
prepared assuming that Wahlco Environmental Systems, Inc. will continue as a 
going concern. As more fully described in Note 1, the Company has incurred 
recurring operating losses, and has been dependent on advances from its 
parent as well as proceeds from the sale of fixed assets to fund its cash 
flow requirements. These conditions raise substantial doubt about the 
Company's ability to continue as a going concern. Management's plans in 
regard to these matters are also described in Note 1. The consolidated 
financial statements do not include any adjustments to reflect the possible 
future effects on the recoverability and classification of assets, or the 
amount and classification of liabilities that may result from the possible 
inability of Wahlco Environmental Systems, Inc. to continue as a going 
concern.

         Our audit was made for the purpose of forming an opinion on the 
basic consolidated financial statements taken as a whole.  The schedule 
listed in the index of the consolidated financial statements is presented for 
purposes of complying with the Securities and Exchange Commission's rules and 
is not part of the basic financial statements.  This schedule has been 
subjected to the auditing procedures applied in the audit of the basic 
consolidated financial statements and, in our opinion, fairly states in 
all material respects the financial data required to be set forth therein 
in relation to the basic consolidated financial statements taken as a 
whole.

Orange County, California
April 7, 1997
                                 Arthur Andersen LLP


                                      25

<PAGE>

Report of Independent Public Accountants

THE BOARD OF DIRECTORS AND STOCKHOLDERS OF WAHLCO ENVIRONMENTAL SYSTEMS, INC.

         We have audited the accompanying consolidated statements of 
operations, stockholders' equity, and cash flows of Wahlco Environmental 
Systems, Inc. for the year ended December 31, 1994.  Our audit also included 
the financial statement schedule listed in the Index at Item 14(a) for the 
year ended December 31, 1994.  These financial statements and schedule are 
the responsibility of the Company's management. Our responsibility is to 
express an opinion on these financial statements based on our audit. 

         We conducted our audit 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 audit provides 
a reasonable basis for our opinion.

         In our opinion, the financial statements referred to above present 
fairly, in all material respects, the consolidated results of operations and 
cash flows of Wahlco Environmental Systems, Inc. for the year ended December 
31, 1994, in conformity with generally accepted accounting principles.  Also, 
in our opinion, the related financial statement schedule, when considered in 
relation to the basic financial statements taken as a whole, presents fairly 
in all material respects the information set forth therein for the year ended 
December 31, 1994.

         The accompanying consolidated financial statements have been 
prepared assuming that Wahlco Environmental Systems, Inc. will continue as a 
going concern. As more fully described in Note 1, the Company has incurred 
recurring operating losses, had a working capital deficiency and has been 
dependent on advances from its parent as well as proceeds from the sale of 
marketable securities and fixed assets to fund its cash flow requirements. 
These conditions raise substantial doubt about the Company's ability to 
continue as a going concern. Management's plans in regard to these matters 
are also described in Note 1.  The consolidated financial statements do not 
include any adjustments to reflect the possible future effects on the 
recoverability and classifications of assets, including goodwill and 
intangibles, or the amounts and classification of liabilities that may result 
from the possible inability of Wahlco Environmental Systems, Inc. to continue 
as a going concern.

                                  Ernst & Young LLP
February 24, 1995
Orange County, California

                                       26
<PAGE>

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>

                                                                         December 31,
--------------------------------------------------------------------------------------------
ASSETS                                                                 1996         1995
--------------------------------------------------------------------------------------------
<S>                                                                 <C>          <C>
CURRENT ASSETS:
   Cash and cash equivalents                                        $   1,853    $   3,840  
   Restricted cash and cash equivalents                                 1,050        1,307  
   Accounts receivable                                                 12,069       15,935  
   Cost and estimated earnings in excess of
      billings on uncompleted contracts                                 2,148        6,839  
   Inventories                                                          4,738        8,711  
   Other current assets                                                 1,365        1,580  
--------------------------------------------------------------------------------------------

   TOTAL CURRENT ASSETS                                                23,223       38,212  
Property, plant and equipment, net                                      5,190        5,921  
Other assets                                                            1,407        2,386  
--------------------------------------------------------------------------------------------
                                                                    $  29,820    $  46,519  
--------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

CURRENT LIABILITIES:
   Notes payable                                                    $     373    $   2,744  
   Accounts payable                                                     9,622        8,932  
   Accrued payroll and payroll related liabilities                      1,589        1,944  
   Billings in excess of costs and estimated earnings
      on uncompleted contracts                                          1,356        2,376  
   Current portion of long-term debt                                      228          204  
   Taxes payable                                                          317          391  
   Other accrued liabilities                                            4,575        8,908
--------------------------------------------------------------------------------------------
   TOTAL CURRENT LIABILITIES                                           18,060       25,499  


Long-term debt                                                         12,145        7,948  
Other liabilities                                                       2,435        3,689  
Deferred income taxes                                                       -        2,016  
Commitments and contingencies
STOCKHOLDERS' EQUITY (DEFICIT):
   Preferred stock, $.01 par value; 10,000,000 shares authorized,           -            -  
      None issued or outstanding
   Common stock, $.01 par value; 50,000,000 shares authorized,            
      17,649,000 shares issued and outstanding                            176          176  
   Capital in excess of par value                                      90,735       90,534
   Retained deficit                                                   (91,684)     (80,875)
   Foreign currency translation adjustment                             (2,047)      (2,468)
--------------------------------------------------------------------------------------------
      TOTAL STOCKHOLDERS' EQUITY (DEFICIT)                             (2,820)       7,367  
--------------------------------------------------------------------------------------------
                                                                    $  29,820    $  46,519  
--------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------

</TABLE>

See notes to consolidated financial statements.

                                      27

<PAGE>

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

<TABLE>
<CAPTION>
Years ended December 31,                                  1996            1995            1994    
-----------------------------------------------------------------------------------------------
<S>                                                 <C>             <C>              <C>
REVENUES:
    Product sales                                   $   36,346      $   49,558       $  51,750 
    Rental, service and other                            6,705          10,542          18,147 
-----------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------
                                                        43,051          60,100          69,897 
-----------------------------------------------------------------------------------------------
COSTS AND EXPENSES:
    Cost of revenues:
       Product sales                                    32,685          43,421          49,640 
       Rental, service and other                         6,412           8,099          15,015 
    Selling, general and administrative                 16,769          19,171          21,431 
    Restructuring and other intangibles write-downs        130            (590)          6,213 
    Goodwill amortization and write-downs                    -           2,535          51,121 
-----------------------------------------------------------------------------------------------
                                                        55,996          72,636         143,420 
-----------------------------------------------------------------------------------------------

Operating loss                                          (12,945)       (12,536)        (73,523)
-----------------------------------------------------------------------------------------------
OTHER INCOME (EXPENSE):
    Interest and other income                               875            359           1,069 
    Interest and other expense                           (1,663)        (2,125)         (2,394)
-----------------------------------------------------------------------------------------------
                                                           (788)        (1,766)         (1,325)
-----------------------------------------------------------------------------------------------

Loss before income taxes                                (13,733)       (14,302)        (74,848)

Benefit from income taxes                                (2,924)        (2,950)         (8,699)
-----------------------------------------------------------------------------------------------

Net loss                                            $   (10,809)    $  (11,352)      $ (66,149)

-----------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------
Net loss per share                                  $     (0.61)    $    (0.64)      $   (3.75)
-----------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------

Weighted average common shares outstanding               17,649         17,649          17,649 
-----------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.

                                       28
<PAGE>

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                            CAPITAL         RETAINED       FOREIGN  
                                                          IN EXCESS         EARNINGS      CURRENCY             TOTAL
                                       COMMON STOCK          OF PAR     (ACCUMULATED   TRANSLATION      STOCKHOLDERS'
                                   SHARES        AMOUNT       VALUE         DEFICIT)    ADJUSTMENT   EQUITY (DEFICIT)
----------------------------------------------------------------------------------------------------------------------
<S>                              <C>            <C>         <C>         <C>            <C>              <C> 
 Balance, December 31, 1993      17,649,000     $  176      $ 78,188    $    (3,374)   $   (2,337)      $   72,653 
 Net loss                                -          -             -         (66,149)           -           (66,149)
 Change in foreign currency
   translation adjustment
   (net of deferred taxes                                                                         
   of $96)                               -          -             -              -            174              174 
----------------------------------------------------------------------------------------------------------------------
 Balance, December 31, 1994      17,649,000        176        78,188        (69,523)       (2,163)           6,678 
 Net loss                                -          -             -         (11,352)           -           (11,352)
 Contribution to capital, net
   of deferred taxes                     -          -         11,750             -             -            11,750
 Stock option programs                   -          -            596             -             -               596
 Change in foreign currency
   translation adjustment
   (net of deferred taxes
   of $164)                              -          -             -              -           (305)             (305)
----------------------------------------------------------------------------------------------------------------------
 Balance, December 31, 1995      17,649,000        176        90,534        (80,875)       (2,468)           7,367 
 Net loss                               -           -             -         (10,809)           -           (10,809)
 Stock option programs                   -          -            201             -             -               201
 Change in foreign currency
   translation adjustment
   (net of deferred taxes                                                                         
   of $227)                              -          -             -              -            421              421
----------------------------------------------------------------------------------------------------------------------
 Balance, December 31, 1996      17,649,000     $  176      $ 90,735    $   (91,684)   $   (2,047)      $   (2,820) 
----------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------
</TABLE>
See notes to consolidated financial statements.

                                       29
<PAGE>

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>

Years ended December 31,                                    1996         1995           1994
-----------------------------------------------------------------------------------------------
<S>                                                      <C>          <C>            <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net loss                                               $(10,809)    $ (11,352)    $ (66,149)
   Adjustments to reconcile net loss to 
    net cash provided by
      (used in) operating activities:                      
      Depreciation and amortization                          1,406         1,692         3,008
      Non-current asset write-downs                              -         2,405        54,106
      Deferred income taxes                                 (2,924)       (3,422)       (4,635)
      Loss (gain) on sale of fixed assets                      (83)          625          (406)
      Deferred compensation                                    311           596              -
      Changes in current assets and 
       liabilities net of effects from acquisitions: 
         Accounts receivable                                 4,982         1,124          (644)
         Refundable income taxes                                 -           883         8,640
         Costs and estimated earnings in excess of 
            billings on uncompleted contracts                5,254         2,016          (695)
         Inventories                                         4,596        (4,168)        4,447
         Other current assets                                  317            17          (459)
         Accounts payable                                       24        (1,799)        2,025
         Accrued payroll and payroll related liabilities      (425)          615          (554)
         Billings in excess of costs and estimated
           earnings on uncompleted contracts                (1,134)          314           492
         Income taxes payable                                  (87)         (252)            -
         Other accrued liabilities                          (5,520)          368         3,242
-----------------------------------------------------------------------------------------------
         NET CASH PROVIDED BY (USED IN) OPERATING 
           ACTIVITIES                                       (4,092)      (10,338)        2,418

CASH FLOWS FROM INVESTING ACTIVITIES:
   Proceeds from sales of marketable securities                  -             -         7,182
   Purchase of property, plant and equipment                  (402)         (648)       (1,679)
   Proceeds from dispositions of property, plant 
     and equipment                                              46         2,799         3,645
   Change in other assets                                      774         1,375          (776)
-----------------------------------------------------------------------------------------------
         NET CASH PROVIDED BY INVESTING ACTIVITIES             418         3,526         8,372

CASH FLOWS FROM FINANCING ACTIVITIES:                                                       
   Advances from WESAC                                       2,738         3,248             -
   Payments to WESAC                                             -        (1,000)            -
   Borrowing on notes payable                                   11         3,206             -
   Payments on notes payable                                  (714)         (922)      (14,000)
   Borrowings on long-term debt                                 53            65             -
   Payments on long-term debt                                 (280)         (336)       (1,949)
   Payments to Pacific Diversified Capital Company               -          (372)            -
   Advances from Pacific Diversified Capital Company             -         1,267         7,997
-----------------------------------------------------------------------------------------------
        NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES  1,808         5,156        (7,952)

Effect of exchange rate changes on cash                       (378)         (318)         (506)
-----------------------------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents            (2,244)       (1,974)        2,332
Cash and cash equivalents, beginning of year                 5,147         7,121         4,789
-----------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year                     $ 2,903      $  5,147       $ 7,121
-----------------------------------------------------------------------------------------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
  Cash (paid for) received from income taxes               $  (107)      $ 1,221       $12,247
-----------------------------------------------------------------------------------------------
  Cash (paid for) interest                                  $ (541)     $ (1,088)      $  (608)
-----------------------------------------------------------------------------------------------

</TABLE>

See notes to consolidated financial statements.

                                      30

<PAGE>                                       
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

(Dollars in thousands, except share and per share data)

1. ORGANIZATION, OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES 

ORGANIZATION

     Wahlco Environmental Systems, Inc. ("the Company") was incorporated on 
February 6, 1990 as a Delaware corporation and issued ten shares of common 
stock to Pacific Diversified Capital Company ("PDC"), a wholly-owned 
subsidiary of San Diego Gas & Electric Company ("SDG&E"). On April 25, 1990, 
the Company issued an additional 14,259,990 shares of common stock to PDC in 
exchange for all of the outstanding stock of Wahlco, Inc. ("Wahlco"), at that 
time a wholly-owned subsidiary of PDC. For financial reporting purposes, the 
exchange was accounted for as a reorganization of companies under common 
control and the historical cost basis of Wahlco carried over to the Company. 
 
     Wahlco's predecessor, known as Wahlco, Inc. ("the Predecessor Company"), 
was acquired by PDC in October 1987 for a purchase price of $40,000 and 
contingent consideration based on certain Wahlco earnings levels. On March 1, 
1990, Wahlco, PDC and the shareholders of the Predecessor Company entered 
into an Earnout Payment Agreement which fixed the amount of the contingent 
consideration provided for in the October 1987 merger agreement at $10,750 
plus accrued interest of $171 through the settlement date of May 1990. The 
payment of this obligation was accounted for as additional purchase price, 
increasing goodwill.

     In May 1990, the Company issued 3,389,000 shares of common stock in its 
initial public offering. Total proceeds to the Company, net of underwriters' 
discount and expenses related to the offering, were approximately $37,881. As 
a result of the offering, PDC's ownership interest in the Company was reduced 
to approximately 81%.

     On May 15, 1995, PDC entered into a purchase agreement with WES 
Acquisition Corporation ("WESAC"), an affiliate of Wexford Capital 
Corporation, under which WESAC purchased $4,900 of the Company's outstanding 
debt to PDC, and PDC contributed to the capital of the Company the remaining 
approximately $20,000 the Company owed to PDC. Pursuant to the same 
agreement, WESAC agreed to purchase PDC's 81 percent stock interest in the 
Company. The share transfer was approved under the Hart-Scott-Rodino 
Antitrust Act on June 2, 1995, and the purchase of the stock interest was 
completed on June 6, 1995. 

OPERATIONS

     The Company designs, manufactures, and sells air pollution control and 
power 

                                       31

<PAGE>

plant efficiency equipment, combined cycle gas turbine products, metallic 
bellows, and related services to electric utilities, independent power 
producers, cogeneration plants, and industrial manufacturers worldwide. Under 
separate licensing agreements, the Company manufactures and installs products 
for the control of volatile organic compounds. The Company also provides 
mechanical plant installation services and rents mechanical equipment to 
users in the U. K. The Company operates through several distinct 
subsidiaries, which focus on specific geographical regions or products. These 
entities, located throughout the United States and other geographical 
locations, are coordinated through common corporate management.

     The Company's business is affected by world, national and local economic 
conditions and events, legislation, government negotiations, competition, 
exchange and interest rates and changing technology.

     The Company sells its products primarily to large utility and other 
industrial customers worldwide. Credit is extended based on an evaluation of 
the customer's financial condition, and collateral generally is not required.

     The Company incurred net losses of $10,809 in 1996, and $11,352 in 1995, 
and $66,149 in 1994, and a net cash inflow (outflow) from operations of 
$(4,092) in 1996, and $(10,338) in 1995, and $2,418 in 1994. The cash flow 
deficits in 1996 and 1995 were funded through borrowings from WESAC and 
Silicon Valley Bank as described below and more fully in Note 6. The 1994 
cash inflow was primarily associated with a decrease in refundable taxes of 
$8,640 resulting from the receipt of tax benefits of $12,500 from PDC.

     In October 1995, the Company entered into a loan and security agreement 
with Silicon Valley Bank ("SVB") under which SVB provided the Company with a 
$4,000 working capital loan through September 1996. In May 1996, the Company 
revised the terms of the credit line with SVB. Under the renegotiated terms, 
SVB agreed to provide a $3,000 line of credit, without covenants, to the 
Company through October 25, 1996. WESAC agreed to collateralize its guarantee 
of the Company's outstanding loan balance of  $1,900 with cash, and to 
similarly collateralize any additional principal and interest borrowings up 
to the maximum of $3,000. 

     In October 1996, the Silicon Valley Bank agreement was further modified, 
so that (i) the maturity date was extended to May 1998, and (ii) the interest 
rate on funds borrowed by the Company was reduced from about 11% to about 
5.5%, since WESAC had deposited cash collateral equivalent to the funds 
borrowed with Silicon Valley Bank. Borrowings under the loan totaled $1,927
at December 31, 1996, which included $1,700 of cash borrowings and $227 cash 
collateral for letters of credit issued under this loan arrangement.

     In August 1996, the Company reached an agreement with WESAC, pursuant to 
which WESAC agreed to lend the Company up to $1,600. The loan bears interest 
at an annual rate of 13%; matures on January 1, 1997; and is secured by all 
of the assets of the Company. The Company had drawn $1,500 against this loan 
as of December 31, 1996. The

                                       32

<PAGE>

maturity of this loan has been extended as described below.

     In October 1996, the Company announced a capital restructuring plan that 
will reduce the Company's debt and provide additional working capital. The 
capital restructure plan, subject to final documentation and stockholder 
approval, involves converting $5,000 of WESAC debt into 12% preferred stock. 
The preferred stock will be convertible into 10,958,904 common shares, 
representing a per share conversion price of $0.45625, the average closing 
price of the common stock for the thirty trading days prior to October 18, 
1996. Quarterly dividends on the preferred stock can be paid in additional 
preferred stock in lieu of cash, at the option of the Company.

     As part of the restructuring plan, WESAC extended the maturity of the 
August 1996 $1,600 facility and the Silicon Valley Bank loan. Both facilities 
mature in May 1998. WESAC also agreed to provide the Company with a new 
$2,400 standby line of credit.

     As of March 31, 1997, the Company had not drawn the remaining $100 
thousand available under the August 1996 term loan or any funds on the $2.4 
million line.

     The Company believes that the extension of the existing facilities with 
WESAC and Silicon Valley Bank, along with the new line of credit, will be 
adequate to fund the Company's operations during 1997. However, significant 
changes in the Company's anticipated level of business and other events could 
substantially  increase the Company's cash requirements above those now 
anticipated, and thereby materially and adversely affect the Company's 
results of operations and financial condition. Therefore, the Company is 
continuing to seek additional sources of financing and to evaluate various 
strategies, including seeking new capital to meet its working capital 
requirements. There can be no assurance, however, that the Company will be 
successful in these efforts.

     All of the above conditions raise substantial doubt about the Company's 
ability to continue as a going concern. The consolidated financial statements 
do not include any adjustments to reflect the possible future effects on the 
recoverability and classification of assets or the amount and classification 
of liabilities that may result from the possible inability of the Company to 
continue as a going concern.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

     The consolidated financial statements include the accounts of the 
Company and its subsidiaries. All material intercompany accounts and 
transactions have been eliminated.

                                       33

<PAGE>

USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS

     The preparation of financial statements in conformity with generally 
accepted accounting principles requires management to make estimates and 
assumptions that affect the reported amounts of assets and liabilities and 
disclosure of contingent assets and liabilities at the date of the financial 
statements and the reported amounts of revenues and expenses during the 
reporting period. Actual results could differ from those estimates. 

REVENUE RECOGNITION

     Revenues from most of the Company's large contracts are recognized using 
the percentage-of-completion method. Under this method, revenues are 
recognized in the same proportion as the percentage of costs incurred during 
the period to estimated total costs for each contract. Changes in job 
performance, job conditions, estimated profitability and final contract 
settlements may result in revisions to revenue recognition and are recognized 
in the period in which the revisions are determined. It is reasonably 
possible that the revenues and estimated costs on certain contracts may 
change in the near term.

     Revenues from other products are recognized on a completed contract 
basis, where revenues and their associated costs are recognized when the 
contract is complete or when the product is shipped.

     Revenues from rental and service contracts are recognized over the 
respective lease or service period.

     Cost of revenues includes all direct materials, labor costs and  
indirect costs related to contract performance such as indirect labor, 
warranty, supplies, tools, repairs and depreciation. 

     Selling, general and administrative costs are charged to expense as 
incurred. 

CASH EQUIVALENTS

     The Company considers all highly liquid investments with maturities, at 
the date of purchase, of three months or less to be cash equivalents.

RESTRICTED CASH 

     At December 31, 1996, $1,050 of cash was pledged to the Company's 
various banks as collateral for the letters of credit and other bank 
guarantees. 

INVENTORIES

     Inventories are stated at the lower of cost (first-in, first-out method) 
or market.

                                       34

<PAGE>

PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment is stated at cost and depreciated over the 
following estimated useful lives, predominantly using the straight-line 
method:

    Buildings and improvements         5 to 35 years
    Machinery and equipment            3 to 15 years

GOODWILL AND OTHER INTANGIBLE ASSETS

     Management routinely evaluates  events or conditions that might indicate 
impairment of value or require a reduction in the amortization period of the 
Company's goodwill and other intangible assets. As discussed above, the 
Company's financial performance has been below expectations during the last 
three years. It continues to experience intensifying competition and margin 
pressure in its major markets, and has restructured its operations in 
response to these factors. As a result, management took substantial 
write-downs against goodwill and other intangibles during the quarter ended 
June 30, 1994, reduced the amortization period from 40 to 20 years effective 
June 1, 1994 and wrote-off the remaining goodwill during the fourth quarter 
of 1995. (See note 5).

     In March, 1995, the Financial Accounting Standards Board issued 
Statement of Financial Accounting Standards No. 121 ("FAS 121") which changed 
the method of accounting for long-lived assets, whereby long-lived assets 
that are expected to be held and used in operations should be carried at the 
lower of cost or the fair value of the asset and long-lived assets to be 
disposed of should be reported at the lower of carrying amount or fair value 
less cost to sell. In evaluating long-lived assets held for use, an 
impairment loss is recognized if the sum of the expected future cash flows 
(undiscounted and without interest charge) is less than the carrying amount 
of the asset. Once a determination has been made that an impairment loss 
should be recognized for long-term assets expected to be held and used, 
various assumptions and estimates are used to determine fair value. 
Subsequent to the write-off of goodwill in the fourth quarter of 1995, the 
Company adopted the provisions of FAS 121, effective December 31, 1995. No 
additional write downs of assets were required under FAS 121 in 1996 or 1995. 
It is reasonably possible that the estimates used to determine the fair value 
of certain long-lived assets will change in the near term.

INCOME TAXES

     The Company prepares a consolidated Federal income tax return. The 
effective tax rate is different than the Federal statutory rate principally 
due to losses from the Company's operations which cannot be utilized and from 
certain state taxes. The Company files separate state, Puerto Rican and 
foreign income tax returns.

                                       35

<PAGE>

     The Company accounts for income taxes under the method prescribed by FAS 
No. 109. Deferred income taxes reflect the net tax effects of temporary 
differences between the carrying amounts of assets and liabilities for 
financial reporting purposes and the amounts used for income tax purposes.

     Prior to the acquisition by WESAC, the Company's U.S. operations were 
consolidated into the tax return of its 81% parent, PDC. A tax sharing 
agreement with PDC dated April 2, 1990, enabled the Company to receive tax 
benefits from its taxable losses. This tax sharing agreement between the 
Company and PDC terminated on the closing of the equity sale to Wexford, 
retroactive to January 1, 1995. The Company has not and is not expected to 
enter into a similar tax sharing arrangement with WESAC.

NET LOSS PER SHARE

     Net loss per share is computed using the weighted average number of 
common shares outstanding. Common stock equivalents were antidilutive in each 
of the years 1996, 1995, and 1994.

FOREIGN CURRENCY TRANSLATION

     Assets and liabilities of the Company's foreign subsidiaries, which are 
principally located in the United Kingdom and Italy, are translated at 
year-end rates of exchange, and revenues and expenses are translated at 
average monthly rates of exchange. Gains and losses resulting from foreign 
currency transactions (transactions denominated in  other than the 
subsidiary's functional currency) are included in operations and are not 
significant. The change in the Foreign Currency Translation Adjustment, which 
is included in stockholders' deficit, was primarily due to a strengthening of 
the foreign currencies against the U.S. dollar.

PRODUCT WARRANTY COSTS

     Provision for estimated warranty expense is recorded at the time of sale 
and periodically adjusted to reflect actual experience. The Company reported 
warranty expense provisions of $1,794, $1,137 and $981 in 1994, 1995, and 
1996, respectively. Costs charged against the warranty reserve at WEP, Inc. 
have been reduced significantly over the past three years, from $1,410 in 1994, 
to $700 in 1995, and to $335 in 1996. Significant warranty costs have been 
incurred since 1992 to re-design and correct toggle type diverters, acquired 
at the time of the purchase of Bachmann.

RECLASSIFICATIONS

     Certain amounts in the 1995 and 1994 consolidated financial statements 
have been reclassified to conform with the 1996 presentation.

                                       36
<PAGE>

2.  BALANCE SHEET COMPONENTS

                                                     1996                1995 
-------------------------------------------------------------------------------

Inventories:                                      
   Raw materials                                  $   1,375           $   1,910
   Work in process                                    3,152               6,579
   Finished goods                                       211                 222
-------------------------------------------------------------------------------
                                                  $   4,738           $   8,711
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------

Other accrued liabilities:
   Commissions                                    $     944           $   1,030
   Warranty                                           1,279                 826
   Restructuring                                        249                 375
   Accrued contract costs                               646               5,032
   Other                                              1,457               1,645
-------------------------------------------------------------------------------
                                                  $   4,575           $   8,908
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------

Property, plant and equipment, at cost:
   Land                                           $     270           $     270
   Buildings and improvements                         4,290               4,308
   Machinery and equipment                           11,301              11,629
   Construction in progress                               0                  26
-------------------------------------------------------------------------------
                                                     15,861              16,233
   Less accumulated depreciation and amortization   (10,671)            (10,312)
-------------------------------------------------------------------------------
                                                  $   5,190           $   5,921
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------

3.  DISPOSALS OF SUBSIDIARIES

              In May 1995, the Company initiated the closure of the 
manufacturing plant in Puerto Rico, where it assembled flue gas conditioning 
("FGC") systems, and transferred the manufacture of these systems to Santa 
Ana, California.  On October 20, 1995, Wahlco, Inc. sold the manufacturing 
facility in Puerto Rico for $1,550.  The facility was operated by a 
subsidiary, Wahlco International, Inc.

              On January 19, 1994, Wahlco Power Products, Inc. ("WPPI") sold 
substantially all of the assets associated with the manufacture of its tube 
shield products for $600 and a 6 percent royalty payable quarterly, with a 
minimum royalty payment per year of $100 for four years.  Subsequent to 
receipt of the first $100 payment, the remaining royalty obligation was set 
aside for a cash settlement of $240 in May 1995.


                                      37

<PAGE>

              The WPPI air preheater line and other equipment used in the 
manufacture of heater baskets was sold on October 7, 1994 to ABB Air 
Preheater, Inc. ("ABB"), in conjunction with the settlement of a lawsuit. The 
amount paid to the Company by ABB to settle the lawsuit and sell the 
manufacturing line and associated equipment was $1,500 in cash and a 
commitment to provide $1,000 in heater basket product to fill future orders.  
The Company sold the WPPI plant and remaining equipment in May 1995 for 
$1,270.

              The Company sold the machinery, equipment and stock inventory 
at Wahlco Engineered Products, Pty. Ltd., its Australian subsidiary, for 
approximately $300 in August 1995. In May 1995, the Company closed the 
operations of Exergetic Systems, Inc., its performance monitoring subsidiary 
located in California, and sold nominal assets to the previous owner. 

4.  REORGANIZATION

              As part of a restructuring plan in 1994, the Company took 
charges totaling $2,906 for the closure of several facilities, and reserves 
totaling $1,469 for the termination of 169 employees were established.  
During 1996 and 1995, $534 and $578, respectively, were paid in benefits 
against reserves.

              The following data reflect the combined results of the 
subsidiaries identified for closure during 1994:

Years ended December 31,                       1996       1995       1994
-------------------------------------------------------------------------------
Revenues:
   Product Sales                             $   605   $   3,428   $   7,040 
   Service                                         -          30       3,256
-------------------------------------------------------------------------------
                                             $   605   $   3,458   $  10,296  
-------------------------------------------------------------------------------
Cost of Revenues: 
   Product Sales                             $   669   $   2,954   $   7,874 
   Service                                         -          34       3,472 
-------------------------------------------------------------------------------
                                             $   669   $   2,988   $  11,346  
-------------------------------------------------------------------------------
Operating loss before restructuring charges  $   431   $     745   $   5,747  
-------------------------------------------------------------------------------

5.  GOODWILL AND OTHER INTANGIBLE WRITE-DOWNS

              During 1995 and 1994, the Company evaluated the value of 
goodwill and intangibles, given intensifying competition and declining 
margins.  As a result of this analysis, the Company wrote-off goodwill 
totaling $2,406 during the fourth quarter of 1995, which represented the 
remaining goodwill at Wahlco, Inc. and Pentney of $1,772 and $634, 
respectively.  
                                      38

<PAGE>

In 1994, the Company recorded write-downs of $50,403 and $1,826 of goodwill 
and other intangibles, respectively,  during the quarter ended June 30, 1994. 
The write-down of goodwill consisted of $35,999 associated with its FGC and 
staged nitrogen oxide removal system businesses and $14,404 associated with 
its engineered products business.

              The other intangible write-downs in 1994 consisted primarily of 
$1,570 in gas flow diverter patents, which were no longer significant since 
the product had been redesigned. Other intangible write-downs were $165 and 
$91 associated with noncompete agreements with the previous owners of ESI and 
FSA, respectively. 

              As of December 31, 1995, the Company had no goodwill remaining 
on the balance sheet.  

6.  LINES OF CREDIT AND CAPITAL RESTRUCTURING PLAN 

         On October 25, 1995, the Company entered into a loan and security 
agreement with Silicon Valley Bank ("SVB") under which SVB provided the 
Company with a $4,000 working capital loan through September 1996. Working 
capital draws by the Company under this facility were guaranteed by WESAC, up 
to the limit of the line.  Borrowings under the loan totaled $1,927 at 
December 31, 1996, which included $1,700 of cash borrowings and $227 of cash 
collateral for letters of credit issued under this loan arrangement.

         On May 9, 1996, the Company revised the terms of the credit line 
with SVB.  Under the renegotiated terms, SVB agreed to provide a $3,000 line 
of credit, without covenants, to the Company through October 25, 1996.  WESAC 
agreed to collateralize its guarantee of the Company's outstanding loan 
balance of  $1,900 with cash, and to similarly collateralize any additional 
principal and interest borrowings up to the maximum of $3,000.  As 
consideration for posting the collateral, the Company agreed to pay WESAC a 
fee in the form of a note for $150 payable in two years at 15% interest.  

         On October 25, 1996, the Silicon Valley Bank agreement was further 
modified, so that (i) the maturity date was extended to May 1998, and (ii) 
the interest rate on funds borrowed by the Company was reduced from about 11% 
to about 5.5%, since WESAC deposited cash collateral equivalent to the funds 
borrowed with Silicon Valley Bank.  As part of the loan and security 
agreement in October 1995 and the renegotiation in October 1996, the Company 
issued warrants to SVB to purchase 175,000 shares of the Company's Common 
Stock at $2.29 per share, which warrants expire on October 26, 2000.

         On August 28, 1996,  the Company reached an agreement with WESAC, 
pursuant to which WESAC agreed to lend the Company up to $1,600.  The loan 
bears interest at an annual rate of 13%, and is secured by all of the assets 
of the Company.  Interest and a commitment fee of $32 payable to WESAC are 
capitalized.  In further consideration for making the loan, the Company 
agreed to issue to WESAC or its designee five year warrants 

                                      39
<PAGE>

to purchase the Company's common stock as the funds are drawn down.  Each 
warrant covers the number of shares of common stock equal to the quotient of 
(i) the dollar amount of the draw down divided by (ii) $0.47, the approximate 
closing price of the common stock on August 16, 1996. The warrants become 
exercisable on issuance at $0.47 per share.  The Company had drawn $1,500 
against this loan as of December 31, 1996, and issued warrants covering 
3,404,255 shares of common stock to four WESAC partnerships which provided 
the funds.  The loan matured on January 1, 1997 but was extended as described 
below.

         The warrants described above have been determined to have nominal 
value and have not been separately recorded in equity.

         On October 18, 1996, the Company announced a capital restructuring 
plan that will reduce the Company's debt and provide additional working 
capital.  The capital restructure plan, subject to final documentation and 
stockholder approval, involves converting $5,000 of WESAC debt into 12% 
preferred stock.  The preferred stock will be convertible into 10,958,904 
common shares, representing a per share conversion price of $0.45625, the 
average closing price of the common stock for the thirty trading days prior 
to October 18, 1996.  Quarterly dividends on the preferred stock can be paid 
in additional preferred stock in lieu of cash, at the option of the Company.

         The impact on the Company's capital structure of  the conversion of 
WESAC debt into preferred stock, as described above, is as follows:

               Proforma Impact of Converting Debt into Preferred Stock
                  Consolidated Balance Sheet at December 31, 1996

                                        PRIOR TO        AFTER
                                       CONVERSION     CONVERSION
                                       ----------     ----------
         Long-term debt                 $12,145         $7,145
         Stockholders' equity           $(2,820)        $2,180

         As part of the restructuring plan, WESAC extended the maturity of 
the August 1996 $1,600 facility and the Silicon Valley Bank loan.  Both 
facilities mature in May 1998.  WESAC also agreed to provide the Company with 
a new $2,400 standby line of credit.

         The Company believes that the extension of the existing facilities 
with WESAC and Silicon Valley Bank, along with the new line of credit, will 
be adequate to fund the Company's operations during 1997.  However, 
significant changes in the Company's anticipated level of business and other 
events could substantially  increase the Company's cash requirements above 
those now anticipated, and thereby materially and adversely affect the 
Company's results of operations and financial condition.  Therefore, the 
Company is continuing to seek additional sources of financing and to evaluate 
various strategies, including seeking new capital to meet its working capital 
requirements.  There can be no assurance, however, that the Company will be 
successful in these efforts.

                                      40
<PAGE>

Selected data, with respect to the SVB facility and the former line of 
credit, is shown below:

                                          1996          1995            1994
------------------------------------------------------------------------------
Balance at December 31                $    1,700     $    1,700      $       -
Interest rate at December 31                5.5%          10.5%              -
Maximum amount outstanding            $    1,700     $    1,700      $  14,000
Average amount outstanding            $    1,700     $      312      $   3,583
Weighted average interest rate             9.54%           8.97%         5.91%
------------------------------------------------------------------------------

              The average amounts outstanding and weighted average interest 
rates during each year are based on daily balances outstanding.

              Equipment and facility notes in Italy and the Corporate office 
of $305 and $68, respectively, total to the caption, notes payable.

7.  LONG-TERM DEBT

              Long-term debt consists of the following at December 31:

                                                              1996        1995
--------------------------------------------------------------------------------

7.9525% note payable, due in fifty-four monthly
   installments of $19 (principal and interest) through
   June 2000, secured by related lease payments (Note 11)  $     702    $    874

Secured term loan from WESAC, bearing interest at
   13.0% and due May, 1998.                                    5,763       5,061

Secured term loan from WESAC, bearing interest at
   13.0% and due May, 1998.                                    2,372       2,087

Secured loan from Silicon Valley Bank, bearing interest at
   5.5% and due May 1998.                                      1,700           -

Secured term loan from WESAC, bearing interest at
   13.0% and due May, 1998.                                    1,585           -

Other credit agreements                                          251         130
--------------------------------------------------------------------------------
                                                              12,373       8,152
Less current portion                                           (228)       (204)
--------------------------------------------------------------------------------
                                                           $  12,145    $  7,948
--------------------------------------------------------------------------------

                                      41
<PAGE>

         The fair value of each of the long-term debt instruments discussed 
above, as well as the notes payable discussed in Note 6, approximate the 
carrying amounts within an insignificant difference based on current market 
interest rates for similar instruments.

         Under an agreement reached between the Company and WESAC on March 
22, 1996, interest due and payable from WESAC is compounded.  This agreement 
commenced with interest due and payable for the fourth quarter of 1995 and 
extends through the maturity date. The above secured loan balances with WESAC 
include compounded interest of $1,304 and $248, as of December 31, 1996 and 
1995, respectively, under this agreement.

         Principal payments due on long-term debt for the years subsequent to 
December 31, 1996 are as follows:

    1997                                  $    228 
    1998                                    11,812 
    1999                                       237 
    2000                                        96
----------------------------------------------------------------------
    Total                                 $ 12,373 
----------------------------------------------------------------------
----------------------------------------------------------------------

8.  INCOME TAXES

         The benefit from income taxes consists of the following:

Years ended December 31,               1996           1995           1994
-------------------------------------------------------------------------------
Federal
  Current                           $     -         $     -        $(4,446)
  Deferred                           (2,266)         (2,286)        (4,039) 

State
  Current                                 -               -            420   
  Deferred                             (658)           (664)          (653) 

Puerto Rico
  Current                                 -               -             18  
  Deferred                                -               -              1   

Foreign
  Current                                 -               -              -   
  Deferred                                -               -              -   

-------------------------------------------------------------------------------
Benefit from income taxes           $(2,924)        $(2,950)       $(8,699)
-------------------------------------------------------------------------------
The benefit from income taxes differs from the amount obtained by applying 
the statutory tax rate as follows:

                                        42

<PAGE>

<TABLE>
<CAPTION>
Years ended December 31,                                             1996       1995        1994
--------------------------------------------------------------------------------------------------
<S>                                                              <C>         <C>         <C>
Federal benefit at statutory rate                                 $ (4,669)   $ (4,863)   $(25,828)
Federal benefit not allowable (pre-acquisition)                          -       1,326           -
Goodwill amortization                                                    -         735      14,812
State taxes, net of Federal impact                                    (498)       (703)       (232)
Limitation on benefit from current year net operating losses         1,327           -           -
Puerto Rican earnings (benefited) taxed at lower rates                   -          44        (249)
Foreign losses without current benefit                               1,816       1,032       5,046
Reduction in Federal and state tax liabilities no longer required     (900)       (106)     (1,443)
Investment loss in foreign affiliates and other                          -        (415)       (805)
--------------------------------------------------------------------------------------------------
Benefit from income taxes                                         $ (2,924)   $ (2,950)   $ (8,699)
--------------------------------------------------------------------------------------------------
</TABLE>

              The Company had a tax sharing agreement with PDC which 
terminated on the closing of the equity sale to WESAC.  The Company will not 
enter into a similar tax sharing agreement with WESAC. The tax effect of the 
WESAC purchase transaction resulted in a net deferred tax liability for the 
Company, which was offset against paid in capital.

              Significant components of the Company's deferred tax assets and 
liabilities as of December 31, 1996 and 1995 are as follows:

Deferred tax assets                                        1996            1995
-------------------------------------------------------------------------------
   Accruals                                           $   1,681      $      496
   Organization and start up costs                            -               -
   Net operating loss carry forwards                      4,904           2,748
   Other                                                      -             284
-------------------------------------------------------------------------------
       Total deferred tax assets                          6,585           3,528
   Valuation allowance                                  (2,423)               -
-------------------------------------------------------------------------------
       Net deferred tax assets                            4,162           3,528
-------------------------------------------------------------------------------
Deferred tax liabilities
-------------------------------------------------------------------------------
   Depreciation                                           1,088             165
   Basis adjustments on purchased assets                  3,074           5,379
-------------------------------------------------------------------------------
       Total deferred tax liabilities                     4,162           5,544
-------------------------------------------------------------------------------
Net deferred tax assets (liabilities)                 $       0      $  (2,016)
-------------------------------------------------------------------------------

              The Company has provided residual Puerto Rico tollgate tax on 
approximately

                                      43

<PAGE>

$11,000 of undistributed earnings as of December 31, 1995 and will be 
obligated to pay tollgate taxes estimated at approximately $1,000 over the 
next several years, which has been included in other liabilities in the 
accompanying balance sheet.
    
9.  RELATED PARTY TRANSACTIONS 

         Included in other assets at December 31, 1996 and 1995 are $110 and 
$432, respectively, of non-interest bearing relocation loans to officers, 
employees and certain former employees, which become due in 1998 and are 
secured by second trust deeds on each individual's primary residence. The 
amount of discount and imputed interest income related to these notes is not 
material.

10.  LEASING ACTIVITIES

         The Company leases buildings, certain office space, vehicles, 
equipment and manufacturing facilities under non-cancelable operating leases 
which require annual aggregate rental payments as follows:

      1997                          $ 1,145 
      1998                            1,111 
      1999                            1,124 
      2000                            1,135 
      2001                              774 
----------------------------------------------------------------------
      Total                         $ 5,289
----------------------------------------------------------------------
----------------------------------------------------------------------

         Total rental expense for the years ended December 31, 1996, 1995 and 
1994 was $1,296, $1,251 and $1,341, respectively.

         During 1993, the Company sold a customer equipment lease contract to 
its equipment lease lender. The transaction resulted in revenue of 
approximately $800, the elimination of the Company's net investment in 
equipment leases and a reduction of the related long-term debt of 
approximately $3,200. The lease lender has the right to have the Company buy 
back the equipment at a definitive amount under certain circumstances, as 
defined.  As of December 31, 1996, the total amount due, had one of these 
events occurred, would have been $2,699, of which $702 is included in 
long-term debt (see note 7). 

         A security interest in service contract payments has been provided 
to a lender as collateral for a loan (see note 7).

                                    44

<PAGE>

11.  EMPLOYEE BENEFIT PLANS 

         The Company has a defined contribution plan established under 
Internal Revenue Code Section 401(k) covering substantially all eligible 
domestic employees. In addition, as a result of certain acquisitions, the 
Company has adopted several foreign defined contribution plans covering 
substantially all eligible foreign employees. Employer contributions to the 
plans are made to an individual account for each participant based on a 
prescribed percentage of the employee's voluntary contribution, in accordance 
with the plans. Retirement benefits to the employees are based solely on the 
amount available in each participant's account at the time of retirement or 
termination of employment. The Company's contributions to the plans for the 
years ended December 31, 1996, 1995, and 1994 were $324, $419, and $437, 
respectively.

12.  STOCK-BASED COMPENSATION PLAN

         The Company has one stock option plan, the 1990 Stock Appreciation 
Rights Plan, now known as the Second Amended and Restated 1990 Stock 
Incentive Plan (the "Amended Plan").  The Company accounts for the Amended 
Plan under APB No. 25, under which the Company recognized compensation cost 
of $201 and $596 in 1996 and 1995, respectively.

         During 1994, the stockholders approved an amendment to the Amended 
Plan, which increased the number of Stock Appreciation Rights ("SARs") 
available to 1,764,900 from 882,450 and extended the plan to April 23, 1997.

         During 1995, the stockholders approved a further  amendment to the 
Amended Plan which increased the number of shares available for grant to 
2,647,350 from 1,764,900, eliminated the minimum purchase price for 
non-qualified stock options which had been established at 100% of the fair 
market value of the Company's Common Stock on the grant date and increased 
the maximum number of shares that may be subject to options granted to any 
one person in any one-year period from 50,000 to 1,000,000.

         Information with respect to the Amended Plan follows:         

<TABLE>
<CAPTION>
                                Rights and                               Number of  
                                Options Available   Number      Rights   Stock      Option 
                                for Issuance        of Rights   Prices   Options    Price  
----------------------------------------------------------------------------------------------
<S>                             <C>                 <C>       <C>        <C>        <C>
Outstanding at December 31, 1993          178,290   664,160   4.50-13.00    40,000    7.25
Granted                                                   -            -         -       -
Canceled                                            (96,650)  4.50-13.00         -    7.25 
----------------------------------------------------------------------------------------------
Outstanding at December 31, 1994        1,157,390   567,510   4.50-13.00    40,000    7.25     
Granted                                                   -            - 2,069,920  0.49-2.50 
Canceled                                           (124,600)           -         -        -
----------------------------------------------------------------------------------------------

</TABLE>

                                                   45

<PAGE>
<TABLE>
<CAPTION>
<S>                               <C>       <C>        <C>           <C>         <C> 
Outstanding at December 31, 1995   94,520    442,910   $4.50-13.00   2,109,920    0.49-7.25 
Granted                                         -                      345,048              
Canceled                                    (145,510)                 (220,612)             
--------------------------------------------------------------------------------------------
Outstanding at December 31, 1996  115,594    297,400   $4.50-13.00   2,234,356    0.49-7.25 
--------------------------------------------------------------------------------------------
Exercisable                                  297,400   $4.50-13.00   1,716,417   $0.49-7.25 
--------------------------------------------------------------------------------------------
</TABLE>

     Had compensation cost for these plans been determined consistent with 
FASB Statement No. 123, the Company's net loss and earnings per share would 
have been the following pro forma amounts:

                                      1996          1995          1994
                                    --------      --------      --------
Net Loss:         As Reported       $(10,809)     $(11,352)     $(66,149)
                  Pro Forma          (11,554)      (12,084)      (66,149)

Primary EPS:      As Reported       $  (0.61)     $  (0.64)     $  (3.75)
                  Pro Forma            (0.65)        (0.68)        (3.75)

    Because the Statement 123 method of accounting has not been applied to 
options granted prior to January 1, 1995, the resulting pro forma 
compensation cost may not be representative of that to be expected in future 
years. 

    A summary of the status of the Company's option plan at December 31, 
1994, 1995 and 1996, and changes during the years then ended is presented in 
the table and narrative below:

<TABLE>
<CAPTION>
                                         1996                     1995                     1994
                                 --------------------     --------------------      -----------------
                                   Shares     Wtd Avg       Shares    Wtd Avg       Shares    Wtd Avg
                                   (000)     Ex Price       (000)     Ex Price      (000)    Ex Price
                                 ---------   --------     ---------   --------      ------   --------
<S>                              <C>         <C>          <C>         <C>           <C>        <C>   
Outstanding at beg. of year      2,119,920     $.807         40,000     $7.25       40,000     $7.25 

Granted                            335,048         -      2,079,920         -            0         0 

Exercised                                0         0              0         0            0         0 

Forfeited                         (220,612)    0.490              0         0            0         0 

Expired                                  0         0              0         0            0         0 
                                 ---------                ---------                 ------           
Outstanding at end of year       2,234,356     $.764      2,119,920     $.807       40,000     $7.25 
                                 ---------                ---------                 ------           
Exercisable at end of year       1,716,417                  510,593                 40,000           

Weighted average fair value
   of options granted                          $0.53                    $0.94                      -

</TABLE>


                                      46

<PAGE>

          The options granted vest through 2000 and expire from 2000 to 2006.

          A total of 1,624,356 options outstanding at December 31, 1996 have 
an exercise price of $0.49 per share, 580,000 shares have an exercise price 
of $.992 per share and 30,000 shares have an exercise price of $1.875 per 
share. A total of 2,079,920 options were granted in 1995 which have a 
weighted average remaining contractual life of 8.2 years; 335,048 options 
were granted in 1996 which have a weighted average remaining contractual life 
of 9.6 years.

          The fair value of each grant is estimated on the date of grant 
using the Black-Scholes option pricing model with the following weighted 
average assumptions. Risk-free interest rates ranged from 5.7 to 6.3 percent 
for options granted in 1995, and ranged from 5.9 to 6.6 percent for options 
granted in 1996. Expected dividend yields of 0 percent were assumed for all 
options. Expected option lives of 8.2 and 9.6 years were assumed for the 1995 
and 1996 options, respectively, and expected volatility was 62% and 76% for 
options granted in 1995 and 1996, respectively.

13.  BUSINESS SEGMENT, GEOGRAPHIC AREA AND MAJOR CUSTOMER INFORMATION

          The Company operates in several industries: the after-boiler 
market, the gas-turbine power-generation  market, and the market for 
elimination of volatile organic compounds. The Company markets and sells most 
of its products through a coordinated worldwide sales force which interacts 
with both electric utilities and industrial customers in connection with the 
reduction and control of air pollution, gas flow control, energy efficiency, 
and the control of volatile organic compounds.

          The following table shows financial information by geographic area. 
"Other" consists principally of Canada and Australia:

-----------------------------------------------------------------------------
1996                       United States     Europe       Other       Totals
-----------------------------------------------------------------------------
Revenues                     $ 20,404      $  22,042    $   605     $  43,051
Operating loss                 (7,160)        (5,555)      (230)      (12,945)
Loss before income taxes       (8,392)        (5,495)       154       (13,733)
Identifiable assets            16,049         13,675         96        29,820
-----------------------------------------------------------------------------
1995
-----------------------------------------------------------------------------
Revenues                     $ 21,550      $  35,122    $ 3,428     $  60,100
Operating loss                 (9,826)        (2,341)      (369)      (12,536)
Loss before income taxes      (11,267)        (2,864)      (171)      (14,302)
Identifiable assets            22,638         22,999        882        46,519
-----------------------------------------------------------------------------
1994
-----------------------------------------------------------------------------
Revenues                     $ 34,246      $  31,296    $ 4,355     $  69,897
Operating loss                (57,064)       (12,623)    (3,836)      (73,523)
Loss before income taxes      (58,748)       (12,290)    (3,810)      (74,848)
Identifiable assets            37,911         19,202      1,817        58,930 
-----------------------------------------------------------------------------

Export sales were as follows:

---------------------------------------------------------------------
Years ended December 31,                 1996        1995        1994
---------------------------------------------------------------------

Canada                                $   413      $   685        680
Europe                                    997        3,228        973
Asia                                    2,869        3,451      3,479
Africa and Other                        1,932        1,331      1,511
---------------------------------------------------------------------
                                      $ 6,211  $   $ 8,695      6,643
---------------------------------------------------------------------
---------------------------------------------------------------------

          There were no sales to individual customers constituting 10% or 
more of total revenues in 1996, 1995 or 1994.

                                      47
<PAGE>

14.  COMMITMENTS AND CONTINGENCIES 

          As security for performance and advances on long-term contracts, 
the Company at December 31, 1996 is contingently liable in the amount of 
approximately $1,277 under standby letters of credit and bank guarantees. 

          The Company and certain of its subsidiaries are parties to claims 
and litigation proceedings arising in the normal course of business.  
Although the legal responsibility and financial impact with respect to such 
claims and litigation cannot presently be ascertained, the Company does not 
believe that these matters will result in the payment by the Company of 
monetary damages that in the aggregate, would be material in relation to the 
consolidated financial position of the Company. It is reasonably possible that
the reserves provided for by the Company with respect to such claims and 
litigation could change in the near term.

15.  QUARTERLY FINANCIAL DATA (UNAUDITED)

                                                          Net Income
                                                            (Loss)
              Revenue   Gross Margin   Net Income (Loss)   Per Share
---------------------------------------------------------------------
1996
Quarters:
First        $ 13,388    $   2,812         $   (810)      $   (0.05)
Second         10,119           11           (4,058)          (0.23)
Third           9,123        1,243           (1,417)          (0.08)
Fourth         10,421         (112)          (4,524)          (0.25)
---------------------------------------------------------------------
  Total      $ 43,051    $   3,954         $(10,809)      $   (0.61)
---------------------------------------------------------------------
---------------------------------------------------------------------
1995
Quarters:
First        $ 15,908    $   3,711         $   (517)      $    (.03)
Second         14,459        2,587           (2,810)           (.16)
Third          14,556        2,927              111             .01
Fourth         15,177         (645)          (8,136)           (.46)
---------------------------------------------------------------------
  Total      $ 60,100    $   8,580         $(11,352)      $    (.64)
---------------------------------------------------------------------
---------------------------------------------------------------------

          During the second and fourth quarters of 1996, and the fourth 
quarter of 1995, the Company's gross margin, net loss and net loss per share 
were affected by write-downs and restructuring charges (see note 4).

                                      48
<PAGE>

               SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

             Wahlco Environmental Systems, Inc. and Subsidiaries

<TABLE>
<CAPTION>
                                                                   Additions
                                                                   ---------
                                     Balance at       Charged to Costs   Charged to Other                              Balance at
                                 Beginning of Period    and Expenses    Accounts - Describe  Deductions - Describe(1)  End of Year
                                 -------------------  ----------------  -------------------  ------------------------  -----------
<S>                              <C>                  <C>               <C>                  <C>                       <C>
Year ended December 31, 1996:
 Allowance for doubtful accounts      $1,277               $2,350                                 $421                     $3,206
 Inventory valuation reserve             286                  120                                  237                        169
 Restructuring reserve                   375                    0                                  126                        249
 Warranty reserve                        826                  981                                  528                      1,279
                                 ------------------   ---------------                        ---------------           -----------
  Total                               $2,764               $3,451                               $1,312                     $4,903
                                 ------------------   ---------------                        ---------------           -----------
                                 ------------------   ---------------                        ---------------           -----------


Year ended December 31, 1995: 
 Allowance for doubtful accounts       $923                  $870                                 $516                     $1,277
 Inventory valuation reserve          1,110                   141                                  965                        286
 Restructuring reserve                1,819                  (590)                                 854                        375
 Warranty reserve                     1,662                 1,137                                1,973                        826
                                 ------------------   ---------------                        ---------------           -----------
  Total                              $5,514                $1,558                               $4,308                     $2,764
                                 ------------------   ---------------                        ---------------           -----------
                                 ------------------   ---------------                        ---------------           -----------


Year ended December 31, 1994:
 Allowance for doubtful accounts      $507                   $865                                 $449                      $923
 Inventory valuation reserve           470                    849                                  209                     1,110
 Restructuring reserve               1,611                  4,386                                4,178                     1,819
 Warranty reserve                    1,184                  1,794                                1,316                     1,662
                                 ------------------   ---------------                        ---------------           -----------
  Total                             $3,772                 $7,894                               $6,152                    $5,514
                                 ------------------   ---------------                        ---------------           -----------
                                 ------------------   ---------------                        ---------------           -----------
</TABLE>

(1) Amounts charged off during the year.


                                       49


<PAGE>

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE.

         None.

                                        50
<PAGE>

                               PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
         
         The information required by this item regarding the Company's 
directors is included in the Company's Proxy Statement to be filed pursuant 
to Schedule 14A in connection with the Company's 1997 Annual Meeting of 
Stockholders under the section captioned "Election of Directors" and is 
incorporated herein by reference thereto.  Information regarding the 
Company's executive officers is set forth in Part I hereof, above, under the 
caption "Executive Officers" and is incorporated herein by reference thereto.

ITEM 11.  EXECUTIVE COMPENSATION.

         The information required by this item is included in the Company's 
Proxy Statement to be filed pursuant to Schedule 14A in connection with the 
Company's 1997 Annual Meeting of Stockholders under the sections captioned 
"Directors' Compensation" and "Executive Compensation" and is incorporated 
herein by reference thereto.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The information required by this item is included in the Company's 
Proxy Statement to be filed pursuant to Schedule 14A in connection with the 
Company's 1997 Annual Meeting of Stockholders under the section captioned 
"Security Ownership of Certain Beneficial Owners and Management" and is 
incorporated herein by reference thereto.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         The information required by this item is included in the Company's 
Proxy Statement to be filed pursuant to Schedule 14A in connection with the 
Company's 1997 Annual Meeting of Stockholders under the section captioned 
"Compensation Committee Interlocks and Insider Participation" and is 
incorporated herein by reference thereto.

                                      51

<PAGE>

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
<TABLE>
<CAPTION>

                                                                                     Page No.
                                                                                     --------

    <S>  <C>                                                                         <C>
    (a)  1.   Financial Statements, included in Part II of this report:                 

              Reports of Independent Public Accountants                                 25
                        
              Consolidated Balance Sheets at December 31, 1996 and 1995                  27

              Consolidated Statements of Operations for the Years ended                 28
              December 31, 1996, 1995 and 1994                  

              Consolidated Statements of Stockholders' Equity (Deficit) for the         29
              Years ended December 31, 1996, 1995 and 1994           

              Consolidated Statements of Cash Flows for the Years ended                 30
              December 31, 1996, 1995, and 1994                 

              Notes to Consolidated Financial Statements                                31

          2.  Financial Statement Schedules, included in Part II of this report:

              Schedule II Valuation and Qualifying Accountants                          49

              All other schedules for which provision is made in the applicable 
              accounting regulations of the Securities and Exchange Commission 
              are not required under the related instructions or are 
              inapplicable, and therefore have been omitted.

         3.   Reports on Form 8-K

              No reports on Form 8-K were filed during the last quarter of the 
              period covered by this report.

    (b)       Exhibits set forth in the following Exhibit Index are filed as a 
              part of this report.

</TABLE>

                                      52

<PAGE>

                                  EXHIBIT INDEX

Exhibit
Number             Description
-------            -----------
 3.1    Certificate of Incorporation of the Company. (1)

 3.2    Bylaws of the Company. (1)

10.4    Standard Industrial Lease, dated as of September 3, 1991, by and 
        between Triple R, a California general partnership ("Triple R"), and
        Wahlco Inc., a California corporation ("Wahlco CA").  (2)

10.5    First Addendum to Standard Industrial Lease, dated as of September 3,
        1991 between Triple R and Wahlco CA.  (2)

10.8    Second Amendment to Office Lease, dated as of December 16, 1991, by 
        and between BCG and WES.  (2) 

10.26   Grant of Industrial Tax Exemption by the Commonwealth of Puerto Rico
        to Wahlco International, Inc., a Delaware corporation ("Wahlco 
        International"), dated as of March 10, 1982.  (1)

10.27   Order of Conversion of Grant of Puerto Rico Industrial Tax Exemption
        to Wahlco International, dated as of October 29, 1987, and as amended
        on March 8, 1989.  (1)

10.32   Redemption and Indemnification Agreement, dated as of October 28, 
        1987, by and among PDC, Wahlco CA, Robert R. Wahler, as Trustee of 
        the Wahler Family Trust, Triple R, John H. McDonald, Westfore, a 
        California limited partnership and Corona Properties, a California 
        limited partnership.  (1)

10.36   Form of Indemnity Agreement between WES and each of its directors 
        and officers.  (1) (8)

10.71   WES 1990 Stock Appreciation Rights Plan.  (3) (8)

10.72   Installment Note, dated as of July 20, 1992, by and between Wahlco 
        CA and Sanwa Business Credit Corporation, a Delaware corporation 
        ("Sanwa").  (4) 

10.73   Guaranty Agreement, dated as of July 20, 1992, by and between WES and
        Sanwa.  (4)

                                      53

<PAGE>

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

10.74   Security Agreement, dated as of July 20, 1992, by and between Wahlco 
        CA, and Sanwa, with accompanying Consent and Acknowledgment of WES, 
        as Guarantor.  (4)

10.78   First Amended and Restated WES 1990 Incentive Award Plan.  (4) (8)

10.117  Letter Agreement dated August 31, 1993, by and between WES, Wahlco 
        CA, Wahlco Power Products, Inc., a Delaware corporation ("Wahlco 
        Power Products"), Bachmann Companies, Inc., a Delaware corporation 
        and Sanwa.  (7)

10.157  Settlement Agreement, dated as of October 7, 1994, by and between 
        Wahlco Power Products and ABB Air Preheater, Inc.  ("ABB").  (12)

10.159  Mutual General Release, dated as of October 6, 1994, between Wahlco 
        Power Products and ABB.  (12) 

10.160  Promissory Note, dated as of December 15, 1994, by and between PDC 
        and WES. (14)

10.161  Letter, dated as of December 15, 1994, from PDC to WES regarding 
        the due date of the Promissory Notes.  (14)

10.162  Letter, dated as of January 31, 1995, from PDC to WES regarding the
        due date of the Promissory Notes.  (14)

10.163  Letter, dated as of March 15, 1995, from PDC to WES regarding the
        due date of the Promissory Notes.  (14)

10.164  Letter, dated as of April 14, 1995, from PDC to WES regarding the due
        date of the Promissory Notes.  (14)

10.165  Promissory Note, dated as of April 7, 1995, by and between PDC 
        and WES.  (14)

10.166  Assignment of Note, Loan Agreement and Collateral Documents.  (14)

10.167  Promissory Note, dated as of May 15, 1995, between WES and WESAC.
        (14)

                                      54

<PAGE>

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

10.168  Commitment letter, dated as of May 15, 1995, from WESAC to WES for 
        a secured term loan in the principal amount of $2 million.  (14)

10.170  Employment Agreement between WES and C. Stephen Beal dated as of 
        May 5, 1995.  (15)

10.172  Employment Agreement between WES and A. Noel DeWinter dated as of 
        May 16, 1995.  (8)

10.173  Employment Agreement between WES and Barry J. Southam dated June 1, 
        1995. (8)

10.174  Employment Agreement between WES and James J. Ferrigan dated June 1, 
        1995. (8)

10.175  Loan and Security Agreement between Wahlco, Inc. and Silicon Valley 
        Bank. (15)

10.176  Amendment and Forbearance Agreement, dated as of May 9, 1996, by and
        between Silicon Valley Bank and Wahlco, Inc.  (16)

10.177  Term Loan Agreement and Warrant Agreement and Form of Warrant between
        WES, Inc., and WESAC dated August 28, 1996.  (17)

10.178  Letter Agreement, dated March 12, 1997, by and between WES and WESAC.
        (18)

10.179  Letter Agreement, dated April 12, 1996, by and between WES and WESAC.
        (18)

10.180  Promissory Note, dated as of May 9, 1996, by and between WES and 
        WESAC.  (18)

10.181  Promissory Note, dated as of November 15, 1996, by and between WES 
        and WESAC.  (18)

10.182  Warrant Certificate, dated as of November 15, 1996, by and between 
        WES and Wexford Special Situations 1996, L. P.  (18)

                                      55

<PAGE>

Exhibit
Number             Description
-------            -----------
10.183  Warrant Certificate, dated as of November 15, 1996, by and between 
        WES and Wexford Special Situations 1996 Institutional, L. P.  (18)

10.184  Warrant Certificate, dated as of November 15, 1996, by and between 
        WES and Wexford Special Situations 1996 Limited.  (18)

10.185  Warrant Certificate, dated as of November 15, 1996, by and between 
        WES and Wexford - Euris Special Situations 1996, L. P.  (18)

10.186  Term Loan Agreement, dated as of July 28, 1995, between WESAC and 
        WES for a secured term loan in the principal amount of $2.0 
        million.  (18)

22      Subsidiaries of the Company.  (15)

(1) Previously filed with the Securities and Exchange Commission on as an 
exhibit to Registration Statement No. 33-33698, as amended, and incorporated 
herein by this reference.

(2) Incorporated herein by reference to the Annual Report on Form 10-K of 
Registrant for the year ended December 31, 1991.

(3) Incorporated herein by reference to the Quarterly Report on Form 10-Q of
Registrant for Quarter ended June 30, 1991.

(4) Incorporated herein by reference to the Quarterly Report on Form 10-Q of
Registrant for the Quarter ended September 30, 1992.

(5) Incorporated herein by reference to the Annual Report on Form 10-K of 
Registrant for Year ended December 31, 1992.

(6) Incorporated herein by reference to the Quarterly Report on Form 10-Q of
Registrant for Quarter ended June 30, 1993.

(7) Incorporated herein by reference to the Quarterly Report on Form 10-Q of
Registrant for Quarter ended September 30, 1993.

(8) Management contract or compensatory plan.

(9) Incorporated herein by reference to the Annual Report on Form 10-K of 
Registrant for Year ended December 31, 1993.

(10) Incorporated herein by reference to the Quarterly Report on Form 10-Q 
of Registrant for 

                                      56
<PAGE>

Quarter ended March 31, 1994.

(11) Incorporated herein by reference to the Quarterly Report on Form 10-Q 
of Registrant for the Quarter ended June 30, 1994.

(12) Incorporated herein by reference to the Quarterly Report on Form 10-Q 
of Registrant for Quarter ended September 30, 1994.

(13) Incorporated herein by reference to the Current Report on Form 8-K of 
Registrant, dated August 30, 1991.

(14) Incorporated herein by reference to the Annual Report on Form 10-K of 
Registrant for the year ended December 31, 1994.

(15) Incorporated herein by reference to the Annual Report on Form 10-K of 
Registrant for the year ended December 31, 1995.

(16) Incorporated herein by reference to the Quarterly Report on Form 10-Q 
of Registrant for Quarter ended June 30, 1996.

(17) Incorporated herein by reference to the Quarterly Report on Form 10-Q of 
Registrant for Quarter ended September 30, 1996.

(18) Filed herewith.


                                      57

<PAGE>

                                     SIGNATURES


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

DATE:  April 12, 1997            WAHLCO ENVIRONMENTAL SYSTEMS, INC.


                                 By: /s/ C. Stephen Beal
                                    -----------------------
                                     C. Stephen Beal
                                     President and
                                     Chief Executive Officer
    
                               POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each individual whose signature appears 
below constitutes and appoints each of C. Stephen Beal, A. Noel DeWinter and 
Roger M. Barzun jointly and severally his true and lawful attorneys-in-fact 
and agent with full power of substitution for him and in his name, place and 
stead in any and all capacities to sign on his behalf, individually and in 
each capacity stated below, to file any and all amendments to this Annual 
Report on Form 10-K with the Securities and Exchange Commission, granting 
unto said attorneys-in-fact and agents and each of them full power and 
authority to do and perform each and every act and thing requisite and 
necessary to be done in and about the premises as fully as he might or could 
do in person, hereby ratifying and confirming all that said attorneys-in-fact 
and agents, or any of them, or their substitute or substitutes may lawfully 
do or cause to be done by virtue thereof.

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

NAME                            TITLE/CAPACITY                   DATE

/s/ C. Stephen Beal     President & Chief Executive Officer       April 14, 1997
----------------------- (principal executive officer)
C. Stephen Beal         and Director

/s/ A. Noel DeWinter    Vice President & Chief Financial Officer  April 14, 1997
----------------------- (principal financial and accounting
A. Noel DeWinter        officer)
                          
/s/ Charles E. Davidson Director                                  April 14, 1997
-----------------------

                                          58
<PAGE>


/s/ Maarten D. Hemsley  Director                                  April 14, 1997
-----------------------
Maarten D. Hemsley



/s/ Paul H. Hunn        Director                                  April 14, 1997
-----------------------
Paul H. Hunn


/s/ Mark L. Plaumann    Director                                  April 14, 1997
-----------------------

/s/David R. A. Steadman Director                                  April 14, 1997
-----------------------

                                         59