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

                                   FORM 10-K

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

                  For the fiscal year ended December 27, 1998

                                      OR

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

                       Commission file number: 000-22237

                                  PALEX, INC.
             (Exact name of registrant as specified in its charter)

             Delaware                            76-0520673
  (State or other jurisdiction                (I.R.S. Employer
of incorporation or organization)            Identification No.)

       1360 Post Oak Blvd., Suite 800
            Houston, Texas                         77056
(Address of principal executive offices)         (Zip Code)

      Registrant's telephone number, including area code:  (713) 350-6030

       Securities registered pursuant to Section 12(b) of the Act:  None

          Securities registered pursuant to Section 12(g) of the Act:
                         Common Stock, $0.01 par value
                                        
     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 this Form 10-K or any amendment to this
Form 10-K. [X]

     The aggregate market value of the voting stock held by non-affiliates of
the registrant on March 22, 1999 was $129,186,713. As of that date, 19,578,359
shares of the Company's Common Stock were outstanding.

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                                    PART I


ITEM 1.  BUSINESS
         --------
Introduction

     PalEx, Inc. ("PalEx" or "We") was formed in January 1996 to create a
national provider of pallets and related services. Concurrently with the closing
of our initial public offering in March 1997 (the "IPO"), we acquired three
businesses engaged in pallet manufacturing and recycling. Since that time, and
through December 27, 1998, we acquired 16 additional pallet companies, making us
the largest producer of new pallets and the largest pallet recycler in the U.S.
In the U.S., we provide a broad variety of pallet products and related services,
including the manufacture and distribution of new pallets, the recycling of
pallets (including used pallet retrieval, repair, remanufacture and secondary
marketing) and the processing and marketing of various wood-based by-products
derived from pallet recycling operations.  In Canada, we conduct pallet rental
and repair operations and pallet poling management services through SMG
Corporation, a Canadian subsidiary.  We currently conduct our pallet operations
from  59 facilities in Arkansas, Arizona, California, Florida, Georgia, Indiana,
Maine, Mississippi, Missouri, North Carolina, Ohio, Oklahoma, Pennsylvania,
South Carolina, Tennessee, Texas, Virginia and Wisconsin and the Canadian
provinces of Alberta, British Columbia, Manitoba, New Brunswick, Ontario, Quebec
and Saskatchewan. We intend to pursue additional acquisitions of pallet
companies as part of our growth strategy.

     In separate transactions in February 1998, PalEx acquired Acme Barrel
Company, Inc., Western Container, Limited Liability Company, Consolidated Drum
Reconditioning, Inc., Consolidated Container Corporation and Drum Service Co. of
Florida, Inc. (collectively, the "Container Group"), expanding our operations
into the industrial container management industry. As a result of these
acquisitions and three subsequent acquisitions through December 27, 1998, we are
now the largest reconditioner of steel drums in the U.S.  The Container Group is
also engaged in drum and intermediate bulk container leasing operations. Our
Container Group operates from 12 facilities in California, Colorado, Florida,
Georgia, Illinois, Kansas, Minnesota, North Carolina and Washington.  We intend
to pursue additional acquisitions of steel drum reconditioners, and to grow our
container leasing operations, as part of our growth strategy.

     We believe that we are in a position to capitalize on the significant
trends currently affecting product manufacturing and distribution practices
throughout the U.S., including the increasing reliance by shippers and logistics
agents on a smaller number of better capitalized, more sophisticated vendors.
We also anticipate that our acquisition of the Container Group will result in
synergies and economies of scale by allowing the combined enterprises to more
efficiently utilize their transportation fleets and systems, cross-sell services
and products to the combined enterprises' customers and combine duplicate
administrative functions.

     Our executive offices are located at 1360 Post Oak Blvd., Suite 800,
Houston, Texas 77056, and our telephone number at that address is 
(713) 350-6030.

Pallet Industry Overview

     Based on information supplied by industry sources, we estimate that the
U.S. pallet industry generated revenues of approximately $6 billion in 1996 and
is served by approximately 3,800 companies.  Most of these companies are small,
privately held entities operating in only one location and serving customers
within a limited geographic radius.  The industry generally is composed of
companies that manufacture new pallets and companies that repair and recycle
pallets.  We estimate, based on industry sources, that during 1996 approximately
450 million new wooden pallets were produced and approximately 85 million wooden
pallets were recycled.  We estimate there are more than two billion pallets in
circulation in the U.S. today.

     A pallet is a platform, usually made of wood, that is used for storing and
shipping goods.  Pallets are used in virtually all U.S. industries where
products are physically distributed, including the automotive, chemical,
consumer products, grocery, produce and food production, paper and forest
products, retail and steel and metals industries.  Pallets come in a wide range
of shapes and sizes.  Although most pallets are made of wood, they may also be
made 

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of steel, plastic, cardboard, molded wood fiber and other materials to satisfy
smaller niche markets. The wooden pallet has traditionally been the basis for
the design of storage racks, warehouse storage areas, forklifts, docks and
containers used in shipping goods.

     We believe that there are over 1,000 different sizes and specifications of
pallets used in North America. The grocery industry, which utilizes
approximately one-third of all new pallets produced, uses a standard size 48" x
40" pallet, although many other styles and specifications are also manufactured
for use in that industry. Other industries use pallets having specifications
that are appropriate for their particular needs. Based on information supplied
by industry sources, we believe that in 1996 over 90% of the pallets used were
of the traditional wooden type, fabricated from lumber and metal fasteners.

     The pallet industry has experienced significant changes and growth during
the past several years.  These changes are due, among other factors, to the
focus by FORTUNE 1000 businesses on improving the logistical efficiency of their
manufacturing and distribution systems.  This focus has caused many of these
businesses to attempt to reduce significantly the number of vendors serving them
in order to simplify their procurement and product distribution processes.  It
also has prompted large manufacturers and distributors to outsource key elements
of processes that are not within their core competencies and to develop just-in-
time procurement, manufacturing and distribution systems. With the adoption of
these systems, expedited product movement has become increasingly important and
the demand for a high quality source of pallets has increased. Palletized
freight facilitates movement through the supply chain, reducing costly loading
and unloading delays at distribution centers and warehouse facilities.  However,
the use of low-quality or improperly sized pallets may increase the level of
product damage during shipping or storage.

     These broad changes affecting U.S. industry have created significant demand
for higher quality pallets distributed through an efficient, more sophisticated
system.  Environmental and cost concerns have also accelerated the trend toward
increased reuse or "recycling" of previously used pallets, further increasing
the importance of higher quality new pallets, which can be reused more often and
are easier to recycle than lower quality pallets.

Steel Drum Reconditioning Industry Overview

     According to industry sources, steel drum recyclers and reconditioners
process an estimated 40 million drums annually, which represents approximately
$500 million in revenues and includes approximately 160 reconditioners. Fifty-
five gallon steel drums are part of the non-bulk industrial packaging industry
and are found in virtually every industrial facility. These drums are used to
transport and store products primarily for the petroleum, chemical, coatings,
agricultural and food processing industries.

     Companies that use steel drums can choose between new and reconditioned
steel drums.  Reconditioned steel drums are previously used drums that are
cleaned, repaired and refurbished and are a cost effective alternative to new
drums.  Steel drums can typically be reconditioned and reused six to eight times
and can then be scrapped and recycled. Similar to many other recycling
industries, drum reconditioners return a useful product to the market place and
solve a major disposal problem that would otherwise severely burden industry and
municipalities.

     There are two basic types of steel drums - open top and closed top.  Open
top drums are those containers with a removable top that is fastened to the drum
by a locking ring.  These drums are reconditioned in a thermal process that uses
high temperature furnaces.  Open top drums are generally used for agricultural
purposes and for viscous materials, such as paints, coatings, greases and
adhesives.  Closed top drums are those in which the top is an integral part of
the drum's construction. Closed top drums are typically used for solvents,
resins and most petroleum products.  These drums are reconditioned using a
chemical washing process.

     Steel drum reconditioners tend to be regionally located in the more
industrialized areas of the country and certain agricultural areas such as the
West Coast and Florida.  These companies are regionally located because of the
unfavorable freight costs of shipping empty drums long distances.

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Description of Services

     New Pallet Manufacturing.  New pallet manufacturing represented
approximately 54% of our revenues for the 1998 fiscal year ended December 27,
1998.  The manufacturing process at our new pallet facilities is generally the
most capital intensive part of our pallet business, with the majority of
assembly and construction being automated.  New pallets are manufactured from an
assortment of wood products, varying in type and quality, with construction
specifications being determined by the pallet's end use.  We believe
approximately 70% of the wood used in new pallets manufactured in North America
consists of hardwoods (including oak, poplar, alder and gum), with the balance
consisting of pine or other softwoods.

     We use sawing equipment that cuts large wood sections to specification.
The cut wood is then transported to assembly points where employees load the
side boards ("stringers") and deck boards into nailing machines that nail the
pallets together.  After construction is completed, pallets are transported to a
stacker for shipment or storage. More customized or smaller orders may be
manufactured by hand on assembly tables by two laborers using pneumatic nailers.
We typically manufacture pallets upon receipt of customer orders and generally
do not maintain a significant inventory of completed pallets.

     Pallet Repair, Remanufacture and Recycling.  Many new pallets are discarded
by pallet users after one trip. However, pallets can be recovered, repaired, if
necessary, and reused.  Pallet repair and recycling operations begin with the
retrieval or purchase of used pallets from a variety of sources.  The condition
and size of these pallets vary greatly.  Once obtained, the pallets are sorted
by size and condition.  A portion of the pallets may require no repair and can
be resold or returned immediately.  Repairable pallets have their damaged boards
replaced with salvaged boards or boards from new stock inventoried at the repair
facility. Pallets that cannot be repaired are dismantled, and the salvageable
boards are recovered for use in repairing and building other pallets.
Unsalvageable boards may be ground into wood fiber, which we sell for use as
landscaping mulch, fuel, animal bedding, gardening material and other uses.
Despite recent increasing automation, pallet recycling remains a labor intensive
process.  Pallet repair, remanufacturing and recycling represented approximately
17% of our revenues for the 1998 fiscal year.

     Drum Reconditioning.  Although the drum reconditioning process varies
slightly throughout the industry, two basic processes are used to recondition
steel drums, depending on whether the drums to be reconditioned are closed top
drums or open top drums.

     Closed top drums are typically used to transport and store oils, solvents
and flowable resins. These drums have secure tops that are an integral part of
the drum's construction and have 2" and 3/4" head openings in the top of the
drum.  Closed top drums are reconditioned by cleaning the interior of the drum
at a series of high-pressure alkaline and acid flush-and-rinse stations.
Pneumatic machinery reshapes the drum by removing dents and restoring chimes
(the top and bottom lid seals).  Pressure tests required by U.S. Department of
Transportation regulations are then performed to check each drum for leakage.
The old exterior coatings are stripped from the drums with an alkaline solution
and steel -shot blasting.  Next, new decorative coatings are applied and baked
on to provide a new durable exterior finish. The thermal treatment used on open
top drums can not be used on closed top drums unless the drum heads are removed.

     A steel drum with a fully removable head is referred to as an open top
drum.  This type of drum is used for a number of agricultural and industrial
applications, such as for storing and shipping citrus, berries, foodstuffs,
adhesives and coatings.  Open top drums are reconditioned using a thermal
process.  This process involves passing drums through a furnace that is heated
to approximately 1,200 degrees Fahrenheit which vaporizes residual materials
inside the drums.  Residual chemicals and compounds created from this process
are drawn into an afterburner and destroyed by temperatures approaching 1,850
degrees Fahrenheit.  Steel-shot blasting then strips old finishes from both the
interiors and exteriors of drums.  After this process, the drums pass through a
series of hydraulic and pneumatic equipment to restore each drum's shape and
integrity.  Finally, new interior protective and exterior decorative coatings
are baked onto the drums.

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     When closed top drums contain residues that can not be purged through the
standard procedures described above, the drums are converted to open top drums
by cutting off the heads of the drums.  The drums are then reconditioned as open
top drums and (1) are used as converted open top drums or (2) are reseamed and
have new heads installed so that they can be re-used as a slightly shorter
closed top drum.

     Waste separated from drums in the reconditioning process is packaged and
shipped to appropriate landfills or incinerated in accordance with strict
environmental controls.  Worn out drums that can no longer be reconditioned are
subjected to reconditioning cleaning processes so that they are acceptable raw
material for scrap metal processors.

     Drum reconditioning represented approximately 27% of our revenues for the
1998 fiscal year.

     Container Management.  Container management is the process of providing a
combination of services related to a customer's pallet or drum usage, including
the manufacture, repair, retrieval, delivery and storage of pallets or the
reconditioning, retrieval, delivery and storage of drums, as well as the
disposal of unusable pallets or drums and component parts.  In a typical
arrangement, we will contract with a customer to remove all pallets or drums
from a particular location and transport them to our repair or reconditioning
facility.  The pallets or drums are sorted and repaired or reconditioned as
needed and sold to third parties, returned to either the customer or its
supplier or placed in storage and made available for return to service ("depot
services").  In a typical arrangement, we will contract with a customer to
perform any or all of the management services available. Although in the early
stages of development, we believe there are significant opportunities to manage
customers' entire shipping container and platform requirements and that we are
in a unique position to develop and offer these services.

Acquisitions

     Since our initial three acquisitions in connection with our IPO in March
1997 and through December 27, 1998, we have purchased  16 pallet companies in
separate transactions,  four of which were accounted for as poolings-of-
interests.  The total purchase price for these acquired companies was
approximately 5.2 million shares of our Common Stock, approximately $55.4
million in cash and approximately $9.9 million principal amount of convertible
notes.

     In February 1998, PalEx Container Systems, Inc., our wholly owned
subsidiary ("PalEx Container Systems"), acquired five companies in separate
transactions,  four of which were accounted for as poolings-of-interests, to
create the Container Group.  Through December 27, 1998, we completed three
additional acquisitions of reconditioning companies to increase the size of the
Container Group. The total purchase price for the Container Group acquisitions
consisted of approximately 4.5 million shares of our Common Stock and
approximately $29.9 million in cash.

     During our 1998 fiscal year, we acquired a total of 19 companies.  Ten are
engaged in the pallet business in the United States,  eight are engaged in the
reconditioning and rebuilding of industrial steel containers in the U.S. and one
(SMG Corporation) is engaged in the rental of pallets in Canada.

Operations

     We centralize our consolidated financial reporting, cash management,
training, human resources, safety and merger and acquisition activities.  We
otherwise operate on a decentralized basis, with the management of each
operating region responsible for its day-to-day operations, profitability and
growth.  Regional management uses our "best practices" program, which seeks to
replicate acquired companies' best practices throughout PalEx with respect to
operations and processes, transportation and other logistical activities, worker
training and participation programs, financial controls and purchasing
information.  Our objective is to improve productivity, reduce operating costs
and improve customer satisfaction to stimulate internal growth.

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Sales and Marketing

     We currently sell to pallet and drum customers within the various
geographic regions in which we conduct operations.  Our primary sales and
marketing activities involve direct selling by our sales force and by members of
senior management to local and regional customers at the plant level and to
large accounts and target industries more broadly on a geographic basis. Because
pricing is a function of regional material and delivery costs, pricing is
established at the regional level.

     Because many of our customers need pallets and/or container management
services on a national scale, we continue the development and implementation of
our national sales and marketing plan to provide these services at many
locations throughout the U.S.  We seek to continue to develop a network of
facilities that will allow these customers to: (1) centralize purchases of new
and recycled pallets, reconditioned drums and container management services; (2)
obtain convenient and dependable service and a consistent supply of uniform
quality pallets, reconditioned drums and container management services; (3)
achieve greater efficiencies in their shipping platform and container use; and
(4) meet corporate recycling goals.  We have developed relationships with
several national customers and intend to attempt to provide services to these
and numerous other customers on a local, regional and national basis.  The
shipping platform and container management needs of national companies are not
uniform, and we intend to tailor our national programs for each customer.  These
programs include a combination of sourcing, retrieving, repairing and recycling
pallets and drums according to individual customer requirements.

Customers

     We seek to efficiently serve large numbers of customers across diverse
markets and industries to provide a stable and diversified base for ongoing
sales of products and services in all our operations.

     Our customers include companies in the automotive, chemical, consumer
products, grocery, produce and food production, petroleum, paper and forest
products, retail, and steel and metals industries.  They are both regional and
national in scale.  Because a significant part of our products and services are
sold to customers engaged in the produce and citrus industries, our sales
volumes in certain regions tend to be seasonal.

     In April 1998, we notified our largest customer, CHEP USA ("CHEP"), that we
were terminating all of our existing agreements with CHEP.  CHEP operates a
national pallet leasing program that provides 48" x 40" pallets primarily to
grocery and consumer products customers throughout the U.S. for a daily fee.  We
manufactured and repaired pallets for CHEP and provided a variety of logistical
services with respect to CHEP's pallet pool, including the storage and just-in-
time delivery of pallets.  We ceased supplying CHEP with new pallets and
provided advance notice (generally, 10 to 60 days) under contractual
arrangements to discontinue repair and depot services for CHEP.  Approximately
26% of our revenues during the 1997 fiscal year, and approximately 8% of our
revenues during the 1998 fiscal year, were from our services to CHEP.

     Our business with CHEP had become far less profitable in recent periods
prior to the termination than it had been historically.  When we were unable to
successfully address this situation with CHEP, we determined that it was in our
best long-term interest to terminate our relationship with CHEP and redirect our
resources toward higher margin businesses.

     The termination of our relationship with CHEP adversely affected the
operations of certain of our facilities in the southeastern and western United
States.  We developed a restructuring plan to close, curtail or convert
operations at facilities related to CHEP production to alternative business
activities.  As of the end of the 1998 fiscal year, three CHEP-related
manufacturing facilities have been closed, one was sold and two more were
consolidated into one facility.  Two other CHEP-related facilities were
converted to manufacture non-CHEP products.  We also terminated approximately
400 production-related employees at CHEP-related facilities during 1998.  Our
results of operations for the 1998 fiscal year include an after-tax charge to
continuing operations of approximately $1.2 million for an inventory valuation
adjustment and for disputed accounts receivable, lease cancellation fees and
penalties and severance costs.  We also determined the termination of the CHEP
relationship required the application of Statement of Financial Accounting
Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of."  Accordingly, the results of operations
for the 1998 fiscal year also include an

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after-tax charge of approximately $0.8 million for plant closure and asset
abandonment costs for the eight CHEP-related facilities. We believe that all
CHEP-related restructuring was complete as of the end of 1998 fiscal year.

Management Information and Controls

     Our consolidated accounting and financial reporting activities are
centralized in Bartow, Florida, while basic accounting activities are conducted
at the regional level.  We believe that our current information systems hardware
and software are adequate to meet current and perceived needs for financial
reporting and internal management control information and other necessary
information.  We believe this system enhances our ability to: (1) monitor each
regional operation; (2) prepare both operations and capital asset budgets and
budget variances; (3) assimilate newly acquired operations through standard
reporting mechanisms; (4) implement operational and productivity measurements
and benchmarking; and (5) conduct individual customer profitability analysis.

Raw Materials

     Pallets.  The primary raw materials used in new pallet manufacturing are
lumber and plywood. We have long-term relationships with our lumber and plywood
vendors.  We believe that these relationships, as well as our ability to pursue
larger volume purchases, will help to ensure adequate lumber supplies at
competitive prices in the future.  During the 1998 fiscal year, we purchased
lumber and plywood from over  120 vendors. One of these vendors accounted for
approximately 8% and another for approximately 5% of our total lumber purchases
during the 1998 fiscal year.  We do not believe that the loss of either of these
vendors would materially adversely affect our financial condition or results of
operations.  We intend to continue to pursue a strategy of purchasing and
upgrading low-grade and alternative sources of lumber as well as exploiting
pricing aberrations and market trends to take advantage of lower prices in the
marketplace as they occur.

     Pallet prices are closely related to the changing costs and availability of
lumber, the principal raw material used in the manufacture and repair of wooden
pallets.  Typically, lumber prices fall in oversupplied lumber markets, enabling
small pallet manufacturers with limited capital resources to procure lumber and
initiate production of low-cost pallets.  This depresses pallet prices overall
and adversely affects our revenues and operating margins.  While we believe that
we will benefit from strong relationships with multiple lumber suppliers, we
cannot assure you that we will be able to secure adequate lumber supplies in the
future.  Lumber supplies and costs are affected by many factors outside our
control, including governmental regulation of logging on public lands, lumber
agreements between Canada and the U.S. and competition from other industries
that use similar grades and types of lumber.  In addition, adverse weather
conditions may affect our ability to obtain adequate supplies of lumber at a
reasonable cost. In 1997, we experienced higher lumber costs resulting from high
demand and the impact of wet weather on the harvesting of hardwood timber in the
southeast regions of the U.S.

     We try to take advantage of the price volatility of lumber by buying
additional quantities of lumber when prices are favorable and storing the
inventory for later use. We also are able to buy low-quality lumber and upgrade
this lumber at our own plants. Although we have studied the broad use of
alternative materials for the manufacture of pallets (such as plastic), we
believe that there is not currently an available alternative raw material that
possesses the tensile strength, recyclability and low cost of wood. We continue
to evaluate alternatives to wood and are receptive to their future use in pallet
production.

     We source the majority of our pallets for reconstruction from businesses
that use pallets and from trucking companies.  Businesses that receive and ship
a significant amount of goods are generally good sources for used pallets.
Often the pallets they receive are damaged or do not meet their size or other
specifications for internal systems or shipping.  As a result, these businesses
accumulate pallets that can be recycled.  We identify these sources through
establishing relationships with pallet users and by direct solicitation,
telemarketing and advertising.  We generally achieve timely pallet removal by
placing a trailer at a source that loads unwanted pallets onto the trailer.  We
then remove the load of pallets at the same time we deliver recycled pallets to
the pallet user. In some cases, we are paid a tipping fee for hauling away the
used pallets or are allowed to take the pallets away at no charge; in other
cases, we buy the used pallets.

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     Drum Reconditioning.  Drum demand in certain regions of the United States
has required more drums to be shipped outside of the region than are shipped
into the region.  Consequently, the acquisition costs of used drums, the primary
raw materials for reconditioned drums, in these regions are significantly higher
since the used drum deficit must be replaced by collecting and shipping used
drums from over 250 miles away.  The West Coast and Southeast are regions that
tend to be net exporters of open top drums because of their emphasis on
agriculture.  The Midwest, on the other hand, tends to be a significant
accumulator of drums because of its greater industrial content and usage of
petroleum products, coatings and chemicals.

Competition

     Pallets.  We believe that the principal competitive factors in the pallet
industry are price, quality of services and reliability.  With over 3,800
industry participants, the pallet industry has been, and is expected to remain,
extremely fragmented and highly competitive.  Though several companies have
attempted to establish national pallet operations, most of our competitors are
small, privately held companies that operate in only one location and serve
customers within a limited geographic area. Competition on pricing is often
intense, and we may face increasing competition from pallet leasing or other
pallet systems providers that market to new pallet purchasers as less expensive
alternatives.  CHEP's pallet leasing system competes with new pallet sales to
the grocery and wholesale distribution industries and may expand into other
industries in the future. In addition, pallet manufacturing and recycling
operations are not highly capital intensive and the barriers to entry in such
businesses are minimal. Certain other smaller competitors may have lower
overhead costs and, consequently, may be able to manufacture or recycle pallets
at lower costs than us. Other companies with significantly greater capital and
other resources than PalEx (including CHEP) may enter or expand their operations
in the pallet manufacturing and recycling businesses in the future, which could
change the competitive dynamics of the industry. In the past, we have competed,
and will continue to compete, with lumber mills in the sale of new pallets.
These mill competitors typically view pallet manufacturing as an opportunity to
use the lower grade lumber that would otherwise be waste. In addition, while we
estimate, based on industry sources, that non-wooden pallets currently account
for less than 10% of the pallet market, we cannot assure you that we will not
face increasing competition from pallets fabricated from non-wooden components
in the future.

     Drum Reconditioning.  Drum reconditioning businesses generally compete on
three criteria: price; manufacturing responsiveness; and delivery performance.
Customers typically give less than 24 hours notice for a majority of their
orders. This practice requires reconditioners to maintain flexibility in their
manufacturing capacity across product lines, carry sufficient levels of
inventory to meet customer demands and develop distribution systems with rapid
pick-up and delivery capabilities.  Although the primary competitive criteria
are price, the increasing movement toward just-in-time delivery increases the
importance of customer service.

     Transportation and regulatory requirements are also key competitive factors
in the drum reconditioning industry. Due to the high costs of transporting
drums, the competitive range of a reconditioning facility is approximately 250
miles. In addition, drum reconditioning operations are subject to significant
regulatory oversight, which makes it difficult to open new facilities.  For
instance, as previously discussed, open top drum reconditioning operations
require the use of large furnaces, which require regulatory permits that are
increasingly difficult to obtain. According to industry sources, less than five
new furnace permits have been granted to drum reconditioners in the last 10
years in the U.S.

Employees

     At March 22, 1999, we had approximately 3,600 employees, approximately 700
of which were employees of the Container Group.  Approximately 300 employees of
the Container Group at three locations are covered by collective bargaining
agreements. We have not experienced any work stoppage and believe that our
relationship with our employees is satisfactory.

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Regulation

     General.  All of our businesses are subject to evolving environmental,
health, safety and transportation laws and regulations at the federal, state and
local levels.  These regulations are administered by the U.S. Environmental
Protection Agency ("EPA") and various other federal, state and local
environmental, zoning, health and safety agencies.  Many of these agencies
periodically examine our operations to monitor compliance with such laws and
regulations.

     The Container Group's businesses are subject to extensive regulations
governing location, design, operations, monitoring, site maintenance and
corrective actions. In order to construct and operate a furnace for open top
drum reconditioning, the Container Group must obtain and maintain one or more
construction or operating permits and licenses and, in certain instances,
applicable zoning approvals. Obtaining the necessary permits and approvals is
difficult, time-consuming and expensive. Maintaining the necessary permits is
also a significant effort. Once obtained, operating permits are subject to
modification and revocation by the issuing agency.  In addition, many drums
received by the Container Group for reconditioning may have contained products
classified as a solid waste, a hazardous substance or a hazardous waste by
applicable laws or regulations. The Container Group must ensure that these drums
are "empty" as determined by EPA regulations at the time they are received at
facilities of the Container Group. The Container Group does not accept drums
that are not "empty" because they are classified as hazardous wastes and must be
handled and disposed of in an expensive manner in accordance with stringent
regulatory requirements.

     Compliance with current and future regulatory requirements may require us,
as well as others in the steel drum reconditioning industry, to make significant
capital and operating expenditures from time to time.  We make a continuing
effort to anticipate regulatory, political and legal developments that might
affect operations, especially the operations of the Container Group, but we will
not always be able to do so.  We cannot predict the extent to which any
legislation or regulation that may be enacted, amended, repealed, interpreted or
enforced in the future may affect the operations of the Container Group or other
of our businesses.  These actions could adversely affect our operations or
impact our financial condition or earnings for one or more fiscal quarters or
years.

     Governmental authorities have the power to enforce compliance with
regulations and permit conditions, to obtain injunctions or to impose civil or
criminal penalties in case of violations.  During the ordinary course of its
operations, the Container Group or other of our subsidiaries may from time to
time receive citations or notices of violations or orders from such authorities.
When we receive citations or notices, our subsidiaries will work with the
authorities to address their concerns.  Failure to be in full compliance with
applicable governmental requirements could lead to civil or criminal penalties,
curtailed operations, facility closures or the inability to obtain or retain
necessary operating permits.  In addition, our subsidiaries could be responsible
for the remediation of an off-site source through their status as a transporter
of certain chemicals.

     As a result of changing government and public attitudes in the area of
environmental regulation and enforcement, we anticipate that changing
requirements in health, safety and environmental protection laws will require
the Container Group to continually modify or replace various facilities and
alter methods of operation at costs that may be substantial.  The Container
Group incurs substantial expenditures in the operation of its businesses in
order to comply with the requirements of environmental laws. These expenditures
relate to waste stream containment and treatment, facility upgrades and
corrective actions. The majority of these expenditures are made in the normal
course of the Container Group's businesses and neither materially adversely
affect our earnings nor place us at any competitive disadvantage.  Although, to
our knowledge, we are currently in compliance in all material respects with all
applicable federal, state and local laws, permits, regulations and orders
affecting our operations where noncompliance would result in a material adverse
effect on our financial condition, results of operations or cash flows, we
cannot assure you that we will not have to expend substantial amounts for
environmental matters in the future.

     The Container Group expects to grow in part by acquiring other existing
drum reconditioning operations.  Although we conduct due diligence
investigations of the past waste management practices and the environmental
condition of the businesses that the Container Group acquires, we cannot assure
you that, through our investigation, we will identify or quantify all potential
environmental problems or risks.  As a result, the Container Group may have

                                       9
<PAGE>
 
acquired, or may in the future acquire, properties that have environmental
problems and related liabilities.  We seek to mitigate these risks by obtaining
environmental representations and indemnities from the sellers of the acquired
businesses or by requiring remediation of known environmental contamination
before acquisition.  We cannot, however, assure you that we will be able to rely
on any such actions if an environmental liability exists.

     Federal Regulation.  The primary U.S. federal statutes affecting our
businesses are summarized below.  These statutes regulate activities such as
discharges of hazardous substances and waste to the air and water and
permitting, as well as handling and disposal practices for solid and hazardous
wastes.

     The Solid Waste Disposal Act ("SWDA"), as amended by the Resource
Conservation and Recovery Act of 1976, as amended ("RCRA").  SWDA and its
implementing regulations establish a framework for regulating the handling,
transportation, treatment and disposal of hazardous and nonhazardous waste. They
also require states to develop programs to ensure the safe disposal of solid
waste in landfills.  Container residues may be hazardous waste under RCRA or the
corresponding state regulations and as such require special handling,
transporting, storing and disposal of not only the residues but also the
containers.  We, as well as other entities with drum reconditioning operations,
could incur significant costs in complying with such regulations; however, we do
not believe that the costs of complying with these standards will have a
material adverse effect on our operations.

     The Comprehensive Environmental Response, Compensation, and Liability Act
of 1980, as amended ("CERCLA"). CERCLA, among other things, provides for the
cleanup of sites from which there is a release or threatened release of a
hazardous substance into the environment and the recovery of natural resource
damages. Courts have interpreted CERCLA to impose strict, retroactive, joint and
several liability for the costs of cleanup and for damages to natural resources
upon the present and former owners or operators of facilities or sites from
which there is a release or threatened release of hazardous substances with
limited defenses. Generators of hazardous substances and transporters are also
strictly liable.  As a practical matter, at sites where there are multiple
responsible parties for a cleanup, the costs of cleanup are typically allocated
according to a volumetric or other standard among the parties. Under the
authority of CERCLA and its implementing regulations, detailed requirements
apply to the manner and degree of remediation of facilities and sites where
hazardous substances have been or are threatened to be released into the
environment.  Also, CERCLA imposes substantial penalties for failure to report
the release of a hazardous substance.

     Liability under CERCLA is not dependent upon the intentional disposal of
"hazardous wastes," as defined under RCRA.  Liability can be imposed upon the
release or threatened release, even as a result of lawful, unintentional, and
non-negligent action, of any one of more than 700 "hazardous substances,"
including very small quantities of such substances.  CERCLA requires the EPA to
establish a National Priorities List ("NPL") of sites at which hazardous
substances have been or are threatened to be released and which require
investigation or cleanup. Because of the extremely broad definition of
"hazardous substances," the same is true of other industrial properties with
which our subsidiaries or their predecessors have been, or with which they may
become, associated as an owner or operator. Consequently, if there is a release
or threatened release of such substances into the environment from a site
currently or previously owned or operated by a subsidiary of PalEx, we could be
liable under CERCLA for the cost of removing such hazardous substances at the
site, remediation of contaminated soil or groundwater and damages to natural
resources, even if those substances were deposited at the facilities before our
subsidiaries acquired or operated them.

     The Federal Water Pollution Control Act of 1972 (the "Clean Water Act").
The Clean Water Act regulates the discharge of pollutants into streams, rivers,
lakes or the ocean from a variety of sources, including nonhazardous solid waste
disposal sites.  The Clean Water Act regulates storm water runoff and indirect
discharges and our subsidiaries are required to apply for and obtain discharge
permits, conduct sampling and monitoring, and, under certain circumstances,
reduce the quantity of pollutants in those discharges.  The Clean Water Act
provides civil, criminal and administrative penalties for violations of its
provisions.

     The Clean Air Act. The Clean Air Act provides for the federal, state and
local regulation of the emission of air pollutants.  These regulations impose
emission limitations and monitoring and reporting requirements on several of our
operations, including the operations of the Container Group's open top drum
reconditioning furnaces. The 

                                       10
<PAGE>
 
costs of compliance with the Clean Air Act permitting and emission control
requirements are not anticipated to have a material adverse effect on us.

     State and Local Regulation.  The states in which we operate have their own
laws and regulations that may be more strict than comparable federal laws and
regulations governing hazardous and nonhazardous solid waste disposal, water and
air pollution, releases and cleanup of hazardous substances and liability for
such matters.  The states also have adopted regulations governing the permitting
and operation of furnaces such as those used in the open top drum reconditioning
operations of the Container Group.  The Container Group's facilities and
operations are likely to be subject to many, if not all, of these types of
requirements.

     Zellwood Superfund Site.  In February 1998, a wholly owned subsidiary of
PalEx acquired Drum Service Co. of Florida, a steel drum reconditioning company
with a facility in Florida ("DSF").  In 1982, DSF was notified by the EPA and
the Florida Department of Environmental Regulation ("DER") that DSF had been
identified as a potentially responsible party ("PRP") with respect to the
Zellwood Groundwater Contamination Site in Orange County, Florida (the "Zellwood
Site").  The Zellwood Site was designated a "Superfund" environmental clean-up
site after the DER discovered arsenic contamination in a shallow monitoring well
adjacent to the site. The DSF facility is located on a portion of the 57 acres
constituting the Zellwood Site. We believe that DSF and its former shareholders
were among approximately 25 entities and individuals identified as PRPs by the
EPA.

     Between March 1990 and July 1996, the EPA issued various unilateral
administrative orders and notices to DSF and the other PRPs regarding the
Zellwood Site.  Those orders and notices demanded reimbursement from the PRPs of
approximately $2 million of the EPA's costs related to the Zellwood Site and
requested the PRPs to accept financial responsibility for additional clean-up
efforts.  During that time, the EPA estimated that the cost of the selected
remedy for soil at the Zellwood Site would be approximately $1 million and the
cost of the selected remedy for groundwater at the Zellwood Site would be
approximately $5.1 million.  DSF and the other PRPs did not agree to the EPA's
demands or agree to fund any additional clean-up.  In April 1997, the EPA issued
an order unilaterally withdrawing its previous orders.

     On June 12, 1998 a suit was filed by the EPA in United States District
Court in Orlando, Florida, against DSF and certain other PRPs with respect to
the Zellwood Site.  The EPA is seeking reimbursement of costs incurred at the
Zellwood Site during the past 17 years and a declaratory judgment for future
response costs.

     DSF has maintained comprehensive general liability insurance coverage over
the past 25 years and has notified various insurers of the EPA's claims
regarding the Zellwood Site.  A number of those relevant insurance policies did
not contain an exclusion for pollution.  DSF has notified the insurers that
issued these policies of the EPA's claims regarding the Zellwood Site and the
commencement of the lawsuit.  In 1992, DSF settled a claim with one insurer for
an amount that covered a substantial portion of the costs DSF had incurred at
that time in dealing with the EPA and the DER.  DSF has identified other
umbrella liability policies for which coverage may also be available and has
been approached by the insurer under two of those policies seeking a settlement.
In addition, the former shareholders of DSF have agreed with DSF and us to bear
liabilities and expenses with respect to the Zellwood Site, to the extent such
liabilities and expenses exceed our insurance recoveries.

     DSF and several other PRPs are currently negotiating with the EPA to settle
the lawsuit.  DSF intends to vigorously defend the lawsuit and pursue its
insurance coverage with respect to losses and expenses incurred in connection
with the Zellwood Site. Although there can be no assurance as to any ultimate
liability of DSF under the EPA's lawsuit, the amount of recoveries from other
PRPs or the insurance coverage, or the amount of insurance recoveries, we
believe that DSF's insurance coverage, recoveries from other PRPs and the
obligations of DSF's former shareholders will be adequate to cover any liability
or expenses of DSF arising from the lawsuit.  We will continue to determine the
availability of additional insurance coverage for this matter.

     Casmalia Site. In November 1998, Container Services Company ("CSC"), a
subsidiary of PalEx Container Systems, Inc., which acquired Consolidated Drum
Reconditioning Co., received notice from the EPA that it had been identified as
a de minimis PRP with respect to the Casmalia Disposal Site in Santa Barbara
County, California ("Casmalia Site").

                                       11
<PAGE>
 
     The Casmalia Site was a licensed hazardous waste disposal facility from
1974 to 1989.  In 1989, the EPA refused to reissue Casmalia's RCRA permit on the
grounds that the operator of the site was in violation of the preexisting permit
and other environmental laws and regulations.  As a result of the owner/operator
abandoning efforts to properly close and clean up the site, the EPA took
emergency action.  There are approximately 10,000 generators who legally sent
(according to EPA estimates) approximately 4.5 billion pounds of waste to the
Casmalia Site.  EPA estimates that the clean up of this site will cost
approximately $500 million and will take over 30 years to complete.

     The EPA has entered into a partial settlement with 50 major PRPs and is
currently in negotiations with over 50 other major PRPs.  In October 1998, the
EPA sent out general notices to 750 de minimis PRPs, including CSC.  In
addition, it is expected that the EPA will send out several hundred additional
notice letters to de minimis PRPs.  The EPA estimates that the original 750 de
minimis PRPs are responsible for an aggregate of about 10% of the volume of
waste shipped to the Casmalia Site.

     Based on CSC's alleged contribution of waste to the Casmalia Site, the EPA
has offered to settle its claims against CSC for approximately $300,000, which
represents a 100% premium over EPA's estimate of CSC's proportionate share of
the estimated clean up costs.  In return for settlement, CSC will be granted
contribution protection against lawsuits by other PRPs who contributed waste to
the Casmalia Site.  CSC is currently reviewing EPA's settlement offer and
estimates of CSC's contribution of waste to the site.  In addition, CSC has
joined a joint defense group of over 140 other de minimis PRPs for the primary
purpose of negotiating a reduction in, and the terms of, the EPA's settlement
offer.

Risk Factors

     We Terminated Our Relationship with CHEP.  In April 1998, we notified our
largest customer, CHEP USA, that we were terminating all of our existing
agreements with CHEP.  Approximately 26% of our revenues during the 1997 fiscal
year and approximately 8% of our revenues during the 1998 fiscal year were
attributable to CHEP.  We developed a restructuring plan to close, curtail or
convert operations at facilities related to CHEP production to alternative
business activities.  As of the end of the 1998 fiscal year, three CHEP-related
manufacturing facilities have been closed, one was sold and two more were
consolidated into one facility.  Two other CHEP-related facilities were
converted to manufacture non-CHEP products.  We also terminated approximately
400 production-related employees at CHEP-related facilities during 1998.  Our
results of operations for the 1998 fiscal year include an after-tax charge to
continuing operations of approximately $1.2 million for an inventory valuation
adjustment and for disputed accounts receivable, lease cancellation fees and
penalties and severance costs. The results of operations for the 1998 fiscal
year also include an after-tax charge of approximately $0.8 million for plant
closure and asset abandonment costs for the eight CHEP-related facilities.  We
believe that all CHEP-related restructuring was complete as of the end of 1998
fiscal year.  We cannot assure you that we will be able to completely replace
the revenues attributable to CHEP or that any replacement business will be more
profitable than CHEP's business.

     We Have a Limited Combined Operating History.  PalEx was formed in January
1996 and conducted no operations prior to the acquisition of our three founding
companies in March 1997.  From March 1997 through December 27, 1998, we acquired
27 companies, and we intend to continue to make acquisitions.  In most cases,
the managers of the acquired companies have continued to operate their companies
after being acquired by us.  We cannot assure you that we will be able to
successfully integrate these companies into our operations or that any
successful integration could occur without substantial costs, delays or other
problems.  In addition, we cannot assure you that our executive management group
will be able to oversee the combined entity and effectively implement our
operating or growth strategies in each of the markets that we serve.  Finally,
we cannot assure you that the pace of our acquisitions will not adversely affect
our efforts to integrate acquisitions and manage those acquisitions profitably.

     We are Subject to Supply and Demand for Lumber.  Pallet prices are closely
related to the changing costs and availability of lumber, the principal raw
material used in the manufacture and repair of wooden pallets.  Typically,
lumber prices fall in oversupplied lumber markets, enabling small pallet
manufacturers with limited 

                                       12
<PAGE>
 
capital resources to procure lumber and initiate production of low-cost pallets.
This depresses pallet prices overall and adversely affects our revenues and
operating margins. The majority of the lumber used in the pallet industry is
hardwood, which is only grown in certain regions of the country and which is
difficult to harvest in adverse weather. As a result, pricing is volatile. While
we purchase plywood and lumber from numerous vendors, and believe that we will
benefit from strong relationships with multiple lumber suppliers, we cannot
assure you that we will be able to secure adequate lumber supplies in the
future. Lumber supplies and costs are affected by many factors outside our
control, including (1) weather, (2) governmental regulation of logging on public
lands, (2) lumber agreements between Canada and the U.S. and (3) competition
from other industries that use similar grades and types of lumber. For example,
in 1997, we experienced higher lumber costs resulting from the impact of wet
weather on the harvesting of hardwood timber in the southeast U.S. To the extent
we encounter adverse lumber prices or are unable to procure adequate supplies of
lumber, our financial condition and results of operations could be materially
adversely affected.

     Various Factors May Affect Internal Growth. Our ability to generate
internal earnings growth will be affected by, among other factors, our ability
to:

      .   expand the range of services offered to customers;
      .   attract new customers;
      .   increase volumes purchased by existing customers;
      .   hire and retain employees;
      .   obtain raw materials at acceptable prices;
      .   open additional facilities; and
      .   reduce operating and overhead expenses.

     We Rely on Acquisitions for Growth. One of our principal growth strategies
is to increase our revenues and the markets we serve through the acquisition of
additional pallet manufacturing and recycling and drum reconditioning companies.
We cannot assure you that we will be able to identify or acquire additional
businesses or integrate and manage such additional businesses successfully.
Acquisitions may involve a number of risks, including:

      .   adverse short-term effects on our reported operating results;
      .   diversion of our management's attention;
      .   dependence on retention, hiring and training of key personnel;
      .   risks associated with unanticipated problems or legal liabilities; and
      .   amortization of acquired intangible assets.

Some or all of these risks could have a material adverse effect on our financial
condition or results of operations. In addition, if consolidation becomes more
prevalent in the industries in which we operate, then the prices for attractive
acquisition candidates may increase and the number of attractive acquisition
candidates may decrease. In any event, we cannot assure you that businesses
acquired in the future will achieve sales and profitability that justify the
investment.

     We May Require Additional Financing in the Future.  We intend to continue
to use our Common Stock for a portion of the consideration for acquisitions, but
the market price of our Common Stock has not been at a level that is adequate
for this purpose. If our Common Stock does not maintain a sufficient valuation
or potential acquisition candidates are unwilling to accept our Common Stock as
part of the consideration for the sale of their businesses, we may be required
to utilize more of our cash resources, if available, in order to pursue our
acquisition program. If we do not have sufficient cash resources, our growth
could be limited unless we are able to obtain additional capital through future
debt or equity financings. Using cash to complete acquisitions and finance
internal growth could substantially limit our financial flexibility, using debt
could result in financial covenants that limit our operations and financial
flexibility and using equity may result in significant dilution of the ownership
interests of our then existing stockholders. We cannot assure you that we will
be able to obtain financing if and when it is needed or that, if available, it
will be available on terms we deem acceptable. As a result, we may be unable to
pursue our acquisition strategy successfully.

                                       13
<PAGE>
 
     We are a party to a credit agreement with BankOne, Texas, N.A. and a
syndicate of banks (the "Credit Facility") that allows us to borrow up
to $150.0 million to be used for general corporate purposes, future
acquisitions, capital expenditures and working capital. The Credit Facility
requires us to comply with various affirmative and negative covenants (including
maintenance of certain financial ratios) that could limit our operational and
financial flexibility. The amount available to be borrowed under the Credit
Facility for acquisitions or to refinance acquired company indebtedness varies
from time to time depending on the level of, on a pro forma basis reflecting
consummated acquisitions, our capital expenditures, consolidated tangible
assets, net worth, earnings before interest, taxes, depreciation and
amortization and total indebtedness and related interest expense. At March 22,
1999, we had borrowing capacity under our credit facility of approximately $3.0
million.

     Weather Conditions May Adversely Affect Demand.  We sell a significant
portion of our products and services to customers who ship agricultural
products.  Severe weather, particularly during the harvesting seasons, may cause
a reduction in demand from agricultural customers, adversely affecting our
revenues and results of operations.  A heavy freeze or other weather adversely
affecting the citrus and produce industries could have a significant negative
impact on our financial condition and results of operations.  In addition,
adverse weather conditions may affect our ability to obtain adequate supplies of
lumber at a reasonable cost.

     Our Operating Results May Fluctuate Significantly Due to Seasonal Factors
and for Other Reasons.  Our businesses can be subject to seasonal variations in
operations and demand.  Our operations experience the greatest demand for new
pallets and reconditioned drums during the citrus and produce harvesting seasons
(generally October through May), with significantly lower demand from the citrus
and produce industries in the summer months.  Moreover, yearly results can also
fluctuate significantly, particularly in the southeast and western regions of
the country as a result of the size of the citrus and produce harvests, which,
in turn, largely depend on the occurrence and severity of freezing weather.
Quarterly results may also be materially affected by other factors, including:

     .   the timing of acquisitions;
     .   the timing and magnitude of acquisition assimilation costs;
     .   costs of opening new facilities;
     .   gain or loss of a material customer;
     .   variation in product mix; and
     .   weather conditions.

In addition, our revenues and gross margins can fluctuate significantly with
variations in lumber prices.  Accordingly, our performance in any particular
quarter may not be indicative of the results that can be expected for any other
quarter or for the entire year.

     There Are Risks Associated with Labor Relations.  At March 22, 1999, we had
approximately 3,600 employees.  Approximately 300 employees of the Container
Group are members of various labor unions.  Our inability to negotiate
acceptable contracts with these unions as existing agreements expire could
result in strikes by the affected workers and increased operating costs as a
result of higher wages or benefits paid to union members.  If the unionized
employees were to engage in a strike or other work stoppage, or other employees
were to become unionized, we could experience a significant disruption of our
operations and higher ongoing labor costs.  This could have a material adverse
effect on our business and results of operations.

     We May Not Be Able to Manage Our Growth.  We expect to continue to grow
both internally and through acquisitions.  Our management expects to expend
significant time and effort in evaluating, completing and integrating
acquisitions and opening new facilities.  We cannot assure you that our systems,
procedures and controls will be adequate to support our operations as they
expand.  Any future growth also will impose significant added responsibilities
on members of senior management, including the need to identify, recruit and
integrate new senior level managers and executives.  We cannot assure you that
we will identify and retain the needed additional management.  If we are unable
to manage our growth efficiently and effectively, or are unable to attract and
retain additional qualified management, then our financial condition and results
of operations could be materially adversely affected.

                                       14
<PAGE>
 
     Our Markets Are Highly Competitive.  The markets for pallet manufacturing
and recycling services and drum reconditioning services are highly fragmented
and competitive. Competition on pricing is often intense.  We may face
increasing competition from pallet leasing or other pallet systems providers,
which are marketed as less expensive alternatives to new pallet purchasers.
CHEP's pallet leasing system competes with new pallet sales to the grocery and
wholesale distribution industries and may expand into other industries in the
future.  In addition, pallet manufacturing and recycling operations are not
highly capital intensive and the barriers to entry in these businesses are
minimal.  Certain other smaller competitors may have lower overhead costs and,
consequently, may be able to manufacture or recycle pallets or provide drum
reconditioning services at lower costs than us.  Other companies with
significantly greater capital and other resources than PalEx (including CHEP)
may enter or expand their operations in the pallet manufacturing and recycling
businesses in the future, which could change the competitive dynamics of the
industry.  In the past, we have competed, and will continue to compete, with
lumber mills in the sale of new pallets.  These mill competitors typically view
pallet manufacturing as an opportunity to use the lower grade lumber that would
otherwise be waste.

     While we estimate, based on industry sources, that non-wooden pallets
currently account for less than 10% of the pallet market and that non-steel
drums currently only account for approximately 30% of the 55-gallon drum market,
we cannot assure you that we will not face increasing competition in the future
from pallets fabricated from non-wooden components and 55-gallon drums
fabricated from non-steel components.

     We May Issue Preferred Stock in the Future; Delaware Law May Discourage
Takeover Attempts.  Our Board of Directors is empowered to issue Preferred Stock
without stockholder action.  The existence of this "blank-check" Preferred Stock
could render more difficult or discourage an attempt to obtain control of PalEx
by means of a tender offer, merger, proxy contest or otherwise, even if such a
transaction would provide greater value to our stockholders than if we remained
independent.  The rights of the holders of our Common Stock will be subject to,
and may be adversely affected by, the rights of the holders of any Preferred
Stock that may be issued in the future.  Certain provisions of the Delaware
General Corporation Law may also discourage takeover attempts that have not been
approved by the Board of Directors.

     We Are Dependent on Key Personnel.  Our operations are dependent on the
continued efforts of our executive officers and on senior management.
Furthermore, we will likely be dependent on the senior management of companies
that may be acquired in the future.  Although we have entered into an employment
agreement with each of our executive officers, we cannot assure you that any
individual will continue in his current capacity for any particular period of
time.  The loss of key personnel, or the inability to hire and retain qualified
employees could have an adverse effect on our business, financial condition and
results of operations.  We do not intend to carry key-person life insurance on
any of our employees.

     Our Existing Management is Able to Exercise Control over PalEx. Our
executive officers, directors and key employees (including officers of our
subsidiaries who were the principal stockholders of the subsidiaries prior to
their acquisition by us), and entities and persons affiliated with them,
beneficially owned, as of March 22, 1999, 57% of the outstanding shares of our
Common Stock.  These persons, if acting in concert, will be able to continue to
exercise control over our affairs, to elect the entire Board of Directors and to
control the disposition of any matter submitted to a vote of stockholders.

     We Have Potential Exposure to Environmental Liabilities.  Our operations
are subject to various environmental laws and regulations, including those
dealing with handling and disposal of waste products, fuel storage and air
quality.  As a result of past and future operations at our subsidiaries'
facilities, we may be required to incur remediation costs and other expenses
related thereto. In addition, although we intend to conduct appropriate due
diligence with respect to environmental matters in connection with future
acquisitions, we cannot assure you that we will be able to identify or be
indemnified for all potential environmental liabilities relating to any acquired
business. See "Business - Regulation."

     In February 1998, a wholly owned subsidiary of PalEx acquired DSF, a steel
drum reconditioning company with a facility in Florida.  In 1982, DSF was
notified by the EPA and DER that DSF had been identified as a PRP with respect
to the Zellwood Groundwater Contamination Site in Orange County, Florida.  The
Zellwood Site was designated a "Superfund" environmental clean-up site after the
DER discovered arsenic contamination in a shallow 

                                       15
<PAGE>
 
monitoring well adjacent to the site. The DSF facility is located on a portion
of the 57 acres constituting the Zellwood Site. We believe that DSF and its
former shareholders were among approximately 25 entities and individuals
identified as PRPs by the EPA.

     Between March 1990 and July 1996, the EPA issued various unilateral
administrative orders and notices to DSF and the other PRPs regarding the
Zellwood Site.  Those orders and notices demanded reimbursement from the PRPs of
approximately $2 million of the EPA's costs related to the Zellwood Site and
requested the PRPs to accept financial responsibility for additional clean-up
efforts.  During that time, the EPA estimated that the cost of the selected
remedy for soil at the Zellwood Site would be approximately $1 million and the
cost of the selected remedy for groundwater at the Zellwood Site would be
approximately $5.1 million.  DSF and the other PRPs did not agree to the EPA's
demands or agree to fund any additional clean-up.  In April 1997, the EPA issued
an order unilaterally withdrawing its previous orders.

     On June 12, 1998 a suit was filed by the EPA in United States District
Court in Orlando, Florida, against DSF and certain other PRPs with respect to
the Zellwood Site.  The EPA is seeking reimbursement of costs incurred at the
Zellwood Site during the past 17 years and a declaratory judgment for future
response costs.

     DSF has maintained comprehensive general liability insurance coverage over
the past 25 years and has notified various insurers of the EPA's claims
regarding the Zellwood Site.  A number of those relevant insurance policies did
not contain an exclusion for pollution.  DSF has notified the insurers that
issued these policies of the EPA's claims regarding the Zellwood Site and the
commencement of the lawsuit.  In 1992, DSF settled a claim with one insurer for
an amount that covered a substantial portion of the costs DSF had incurred at
that time in dealing with the EPA and the DER.  DSF has identified other
umbrella liability policies for which coverage may also be available and has
been approached by the insurer under two of those policies seeking a settlement.
In addition, the former shareholders of DSF have agreed with DSF and us to bear
liabilities and expenses with respect to the Zellwood Site, to the extent such
liabilities and expenses exceed our insurance recoveries.

     DSF and several other PRPs are currently negotiating with the EPA to settle
the lawsuit.  DSF intends to vigorously defend the lawsuit and pursue its
insurance coverage with respect to losses and expenses incurred in connection
with the Zellwood Site. Although there can be no assurance as to any ultimate
liability of DSF under the EPA's lawsuit, the amount of recoveries from other
PRPs or the insurance coverage, or the amount of insurance recoveries, we
believe that DSF's insurance coverage, recoveries from other PRPs and the
obligations of DSF's former shareholders will be adequate to cover any liability
or expenses of DSF arising from the lawsuit.  We will continue to determine the
availability of additional insurance coverage for this matter.

     In November 1998, CSC, a subsidiary of PalEx Container Systems, Inc.,
received notice from the EPA that it had been identified as a de minimis PRP
with respect to the Casmalia Disposal Site in Santa Barbara County, California.

     The Casmalia Site was a licensed hazardous waste disposal facility from
1974 to 1989.  In 1989, the EPA refused to reissue Casmalia's RCRA permit on the
grounds that the operator of the site was in violation of the preexisting permit
and other environmental laws and regulations.  As a result of the owner/operator
abandoning efforts to properly close and clean up the site, the EPA took
emergency action.  There are approximately 10,000 generators who legally sent
(according to EPA estimates) approximately 4.5 billion pounds of waste to the
Casmalia Site.  EPA estimates that the clean up of this site will cost
approximately $500 million and will take over 30 years to complete.

     The EPA has entered into a partial settlement with 50 major PRPs and is
currently in negotiations with over 50 other major PRPs.  In October 1998, the
EPA sent out general notices to 750 de minimis PRPs, including CSC.  In
addition, it is expected that the EPA will send out several hundred additional
notice letters to de minimis PRPs.  The EPA estimates that the 750 original de
minimis PRPs are responsible for an aggregate of about 10% of the volume of
waste shipped to the Casmalia Site.

                                       16
<PAGE>
 
     Based on CSC's alleged contribution of waste to the Casmalia Site, the EPA
has offered to settle its claims against CSC for approximately $300,000, which
represents a 100% premium over EPA's estimate of CSC's proportionate share of
the estimated clean up costs.  In return for settlement, CSC will be granted
contribution protection against lawsuits by other PRPs who contributed waste to
the Casmalia Site.  CSC is currently reviewing EPA's settlement offer and
estimates of CSC's contribution of waste to the site.  In addition, CSC has
joined a joint defense group of over 140 other de minimis PRPs for the primary
purpose of negotiating a reduction in, and the terms of, the EPA's settlement
offer.

     Our Stock Price May be Volatile.  Our Common Stock is quoted and traded on
the Nasdaq National Market, although we cannot assure you that an active trading
market for the Common Stock will continue.  The market price of our Common Stock
may be subject to significant fluctuations from time to time in response to
numerous factors, including variations in our reported financial results and
changing conditions in the economy in general or in our industry in particular.
In addition, the stock markets experience significant price and volume
volatility from time to time, which may affect the market price of our Common
Stock for reasons unrelated to our performance.

     There are Substantial Shares Eligible for Future Sale; Our Stock Price May
be Adversely Affected. The market price of our Common Stock may be adversely
affected by the sale, or availability for sale, of substantial amounts of our
Common Stock in the public market.  As of March 22, 1999, we had approximately
19.6 million shares of Common Stock outstanding.  We have approximately 12.3
million shares that are freely tradable.  Approximately 6.3 million additional
shares are eligible for resale pursuant to Rule 144 and Rule 145 of the
Securities Act of 1933, as amended (the "Securities Act"). These shares are
owned by our officers, officers of our subsidiaries and former owners of
acquired businesses.

     We Do Not Intend to Pay Cash Dividends for the Foreseeable Future.  We
intend to retain our earnings for continued development of our businesses and do
not intend to pay cash dividends on our Common Stock in the foreseeable future.
In addition, the Amended Credit Facility includes, and any additional credit
facilities obtained in the future may include, restrictions on our ability to
pay dividends without the consent of the lender.

     We May be Adversely Affected If Our Information Systems Are Not Year 2000
Compliant.  We use software and related technologies throughout our businesses
that will be affected by the "Year 2000 Issue," which is common to most
businesses.  The Year 2000 Issue relates to the inability of information systems
and computer software programs to properly recognize and process date-sensitive
information after the beginning of the year 2000. We are in the process of
modifying the software in our information technology systems so that all of our
software will be Year 2000 compliant. We believe that we and our vendors will be
able to modify all of our software in time to minimize any detrimental effects
to our operations. We cannot assure you, however, that either we or our software
vendors will complete all modifications to all material information technology
systems in a timely manner.  We continue to study our non-information technology
systems that may be affected by the Year 2000 Issue, including those non-
information technology features that we use directly in our manufacturing
processes.  We will continue to consider the likelihood of a material business
interruption due to the Year 2000 Issue and, if necessary, implement an
appropriate contingency plan.  Our failure, or the failure of our vendors or our
customers, to have Year 2000 compliant systems in place could have a material
adverse affect on our financial condition and results of operations.

                                       17
<PAGE>
 
ITEM 2.   PROPERTIES

     At December 27, 1998, we operated 59 pallet facilities and 12 drum
reconditioning facilities in 23 states.  We own 24 of these facilities and lease
47.  Most of our facilities offer more than one pallet-related or drum-related
service.  Our corporate headquarters are located in Houston, Texas.  The chart
below summarizes the locations of our facilities as of December 27, 1998:
<TABLE>
<CAPTION>
 
  State            Total Number   Number of    Number of    Number of Drum     Number of
   or                  of         New Pallet   Recycling    Reconditioning       Pallet
Province            Facilities    Facilities   Facilities   Facilities      Leasing Facilities
--------           ------------   ----------   ----------   --------------  ------------------
<S>                  <C>          <C>          <C>          <C>             <C> 
Alberta                 2                                                            2
Arizona                 2              1           1
Arkansas                3              2           1
British Columbia        1                                                            1
California              4              2           1              1
Colorado                1                                         1
Florida                 4              1           1              2
Georgia                 4              3                          1
Illinois                2                                         2
Indiana                 2              1           1
Kansas                  1                                         1
Maine                   1              1
Manitoba                1                                                           1
Minnesota/1/            2                                         2
Mississippi             1              1
Missouri                1                          1
New Brunswick           1                                                           1
North Carolina          5              4                          1
Ohio                    4              2           2
Oklahoma                1              1
Ontario                 2                                                           2
Pennsylvania            2                          2
Quebec                  1                                                           1
Saskatchewan            2                                                           2
South Carolina          1                          1
Tennessee               2              2
Texas                  13              8           5
Virginia                1                          1
Washington              1                                         1
Wisconsin               3              3
</TABLE>
---------
1    One of these facilities includes our IBC leasing operation

     The Company's interests in its owned and leased properties are pledged as
security for the repayment of amounts due under the Amended Credit Facility. We
believe that our properties are generally adequate for our present needs.
Further, we believe that suitable additional or replacement space will be
available when required.

                                       18
<PAGE>
 
ITEM 3.  LEGAL PROCEEDINGS
         -----------------
     We have from time to time been a party to litigation arising in the normal
course of our business. Most of that litigation involves claims for personal
injury or property damage incurred in connection with our operations. We believe
that none of these actions will have a material adverse effect on our financial
condition or results of operations.

     On June 12, 1998 a suit was filed by the EPA in United States District
Court in Orlando, Florida, against DSF and certain other PRPs with respect to
the Zellwood Site. The EPA is seeking reimbursement of costs incurred at the
Zellwood Site during the past 17 years and a declaratory judgment for future
response costs. See "Business--Regulation."

     DSF has maintained comprehensive general liability insurance coverage over
the past 25 years and has notified various insurers of the EPA's claims
regarding the Zellwood Site. A number of those relevant insurance policies did
not contain an exclusion for pollution. DSF has notified the insurers that
issued these policies of the EPA's claims regarding the Zellwood Site and the
commencement of the lawsuit. In 1992, DSF settled a claim with one insurer for
an amount that covered a substantial portion of the costs DSF had incurred at
that time in dealing with the EPA and the DER. DSF has identified other umbrella
liability policies for which coverage may also be available and has been
approached by the insurer under two of those policies seeking a settlement. In
addition, the former shareholders of DSF have agreed with DSF and us to bear
liabilities and expenses with respect to the Zellwood Site, to the extent such
liabilities and expenses exceed our insurance recoveries.

     DSF and several other PRPs are currently negotiating with the EPA to settle
the lawsuit. DSF intends to vigorously defend the lawsuit and pursue its
insurance coverage with respect to losses and expenses incurred in connection
with the Zellwood Site. Although there can be no assurance as to any ultimate
liability of DSF under the EPA's lawsuit, the amount of recoveries from other
PRPs or the insurance coverage, or the amount of insurance recoveries, we
believe that DSF's insurance coverage, recoveries from other PRPs and the
obligations of DSF's former shareholders will be adequate to cover any liability
or expenses of DSF arising from the lawsuit. We will continue to determine the
availability of additional insurance coverage for this matter.

     In November 1998, CSC, a subsidiary of PalEx Container Systems, Inc.,
received notice from the EPA that it had been identified as a de minimis PRP
with respect to the Casmalia Site in Santa Barbara County, California.

     The Casmalia Site was a licensed hazardous waste disposal facility from
1974 to 1989. In 1989, the EPA refused to reissue Casmalia's RCRA permit on the
grounds that the operator of the site was in violation of the preexisting permit
and other environmental laws and regulations. As a result of the owner/operator
abandoning efforts to properly close and clean up the site, the EPA took
emergency action. There are approximately 10,000 generators who legally sent
(according to EPA estimates) approximately 4.5 billion pounds of waste to the
Casmalia Site. EPA estimates that the clean up of this site will cost
approximately $500 million and will take over 30 years to complete.

     The EPA has entered into a partial settlement with 50 major PRPs and is
currently in negotiations with over 50 other major PRPs. In October 1998, the
EPA sent out general notices to 750 de minimis PRPs, including CSC. In addition,
it is expected that the EPA will send out several hundred additional notice
letters to de minimis PRPs. The EPA estimates that the 750 original de minimis
PRPs are responsible for an aggregate of about 10% of the volume of waste
shipped to the Casmalia Site.

     Based on CSC's alleged contribution of waste to the Casmalia Site, the EPA
has offered to settle its claims against CSC for approximately $300,000, which
represents a 100% premium over EPA's estimate of CSC's proportionate share of
the estimated clean up costs. In return for settlement, CSC will be granted
contribution protection against lawsuits by other PRPs who contributed waste to
the Casmalia Site. CSC is currently reviewing EPA's settlement offer and
estimates of CSC's contribution of waste to the site. In addition, CSC has
joined a joint 

                                       19
<PAGE>
 
defense group of over 140 other de minimis PRPs for the primary purpose of
negotiating a reduction in, and the terms of, the EPA's settlement offer.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
         ---------------------------------------------------
Not Applicable.

                                       20

<PAGE>
 
                                    PART II


ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
         ---------------------------------------------------------------------
     Our Common Stock has traded on the Nasdaq National Market since March 20,
1997, the date of our IPO, under the symbol "PALX." The following table sets
forth the high and low sales prices for our Common Stock from December 29, 1997
through December 27, 1998. (During 1997, we changed our fiscal year-end to the
last Sunday of each December from a fiscal year ending on November 30.)

<TABLE>
<CAPTION>
<S>                                                                      <C>         <C>
                                                                           Low         High
                                                                         -------      -------
First Quarter (from December 29, 1997 through March 29, 1998)            $11.125      $15.000
Second Quarter (from March 30, 1998 through June 28, 1998)               $ 9.250      $13.375
Third Quarter from (June 29, 1998 through September 27, 1998)            $ 5.625      $ 9.875
Fourth Quarter (from September 28, 1998 through December 27, 1998)       $ 5.875      $ 9.750
</TABLE>

     On March 22, 1999, the last reported sale price of our Common Stock on the
Nasdaq National Market was $8.72 per share.  On that date, we had 169 holders of
record of our Common Stock.

     We intend to retain all of our earnings, if any, to finance the expansion
of our business and for general corporate purposes, including future
acquisitions, and do not anticipate paying any cash dividends on our Common
Stock for the foreseeable future. In addition, our revolving credit facility
includes, and any additional lines of credit established in the future may
include, restrictions on our ability to pay dividends without the consent of the
lender.

     Set forth below is certain information concerning all sales of securities
by us that were not registered under the Securities Act of 1933, as amended (the
"Securities Act") and that have not been previously reported in our Quarterly
Reports on Form 10-Q.

     On September 30, 1998, we issued a warrant for the purchase of up to
250,000 shares of our Common Stock to Batchelder & Partners, Inc. for
professional advisory services at an exercise price of $11.375 per share. The
warrant, which may be exercised in whole or in part upon the consummation of
certain defined transactions, expires in May 2005. Neither the warrant nor the
shares of Common Stock for which it is exercisable were registered under the
Securities Act in reliance on the exemption provided by Section 4(2) of the
Securities Act.

     We acquired the capital stock of Charlotte Steel Drum Corporation and
substantially all of the assets of Atlas Container Corporation on October 23,
1998 and October 30, 1998, respectively, for aggregate consideration consisting
of approximately $3.7 million in cash and 319,810 shares of our Common Stock.
The shares of Common Stock were issued without registration under the Securities
Act in reliance on the exemption provided by Section 4(2) of the Securities Act.

     On January 2, 1998 and March 20, 1998, we issued convertible promissory
notes in connection with acquisitions of the assets of American Pallet
Recyclers, Inc. and Pallet Outlet Company, Inc. On March 18, 1998 and July 14,
1998, we issued convertible promissory notes in connection with acquisitions of
Capital Pallet Incorporated and Duckert Pallet Co., Inc. These convertible notes
may be converted into a total of 703,346 shares of our Common Stock. The notes
bear interest at various annual rates and are generally convertible after the
first anniversary of issuance. Neither the convertible notes nor the shares of
Common Stock into which they are convertible were registered under the
Securities Act in reliance on the exemption provided by Section 4(2) of the
Securities Act.

                                       21
<PAGE>
 
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA
         ------------------------------------

     The following historical financial information should be read in
conjunction with the audited historical Consolidated Financial Statements of
PalEx, Inc. and Subsidiaries and the Notes thereto included in Item 8 -
"Financial Statements and Supplementary Data." The historical financial
information for the fiscal years ended 1994 through 1998 reflects the historical
statements of Fraser, the accounting acquiror, restated for the effects of the
business combinations with the Pooled Companies, the 1998 Pooled Companies, the
remaining Founding Companies and the Purchased Companies (which terms are
defined in Item 7 - "Management's Discussion And Analysis of Financial
Condition - Results of Operations") from their respective acquisitions dates.

<TABLE>
<CAPTION>
                                                                                              Fiscal Year      Fiscal Year
                                           Fiscal years Ended November 30,                      Ended            Ended 
                                       ------------------------------------   Transition      December 28,     December 27, 
                                          1994         1995         1996      Period (1)        1997             1998
                                       ----------   ----------   ----------   ----------     -----------      -----------
Income Statement Data:                  (in thousands, except share and per share data)
<S>                                   <C>           <C>          <C>          <C>          <C>              <C>
PalEx(2):                                                                                                
Revenues                               $  116,942   $  125,707   $  145,030   $    3,828     $   222,993      $   319,691
Gross profit(9)                            17,735       20,512       23,165          707          34,909           58,894
Selling, general and administrative                                                                      
 expenses                                  12,350       13,333       14,063          749          20,135           33,042
Pooling expenses                                -            -            -            -               -            1,841
Compensation differential                       -            -            -            -           1,020            1,062
Goodwill amortization                           -            -            -            -             593            2,977
Restructuring charge(9)                         -            -            -            -               -              949
Plant closure costs and asset                                                                            
 abandonment loss(9)                            -            -            -            -               -            1,369
Income (loss) from operations               5,385        7,179        9,102          (42)         13,161           17,654
Interest expense, net(3)                     (930)      (1,451)      (1,230)         (24)         (1,817)          (8,563)
Net income (loss)                      $    2,979   $    4,134   $    6,039   $      (66)    $     6,640      $     3,986
                                       ==========   ==========   ==========   ==========     ===========      ===========
Net income (loss) per share - basic    $      .32   $      .44   $      .64   $     (.01)    $       .43      $       .21
Net income (loss) per share - diluted  $      .32   $      .44   $      .64   $     (.01)    $       .42      $       .21
Shares used in computing net income 
 (loss) per share - basic               9,433,414    9,433,414    9,433,414    9,433,414      15,561,489       18,937,354
Shares used in computing net income                                                                      
 (loss) per share - diluted             9,433,414    9,433,414    9,433,414    9,433,414      15,914,157       19,310,295
                                                                                                         
Pro Forma (unaudited)(4):                                                                                
Revenues                                                                                                      $   379,854
Gross profit                                                                                                       74,017
Selling, general and administrative                                                                      
 expenses(5)                                                                                                       43,178
Goodwill amortization(6)                                                                                            4,250
Restructuring charge(9)                                                                                               949
Plant closure costs and asset abandonment loss(9)                                                                   1,369
Income from operations                                                                                             24,271
Interest income (expense), net(7)                                                                                 (10,737)
Net income                                                                                                    $     6,512
                                                                                                              ===========
Net income per share                                                                                                 $.32
                                                                                                              ===========
Shares used in computing pro forma                                                                       
 net income per share(8)                                                                                       20,658,574
                                                                                                              ===========
</TABLE>

                                       22
<PAGE>
 
<TABLE>
<CAPTION>
                                                 November 30,                       
                                     ---------------------------------              December 28,      December 27,
                                      1994          1995        1996                    1997              1998
                                     -------       -------     -------                --------          --------
<S>                                   <C>          <C>         <C>                    <C>               <C>
Balance Sheet Data:                                                           
PalEx                                                                         
Working capital                      $ 3,004       $ 6,613     $ 7,630                $ 35,705          $ 54,672
Total assets                          48,933        50,857      57,868                 120,005           292,438
Total debt, including current        
 portion                              21,770        21,212      18,648                  32,880           155,772
Stockholders' equity                  16,956        19,400      24,443                  67,437            95,280
</TABLE>
(1)  Because we changed our fiscal year-end to the last Sunday of each December
     from the year ending on November 30, a one month transition period (the
     "Transition Period") beginning on December 1, 1996, and ending on December
     31, 1996 is presented herein for comparability of financial statements
     between the periods presented.

(2)  Fraser has been identified as the accounting acquiror for financial
     statement presentation purposes. The results of operations of the Pooled
     Companies and the 1998 Pooled Companies are included along with those of
     Fraser for each year presented. The acquisition of the Purchased Companies
     is included in the results of operations from their respective dates of
     acquisition.

(3)  Includes interest expense and other income (expense), net.

(4)  The unaudited pro forma income statement data assume that the 1998
     Purchased Companies were closed on January 1, 1998, and are not necessarily
     indicative of the results we would have obtained had these events actually
     occurred at that time or of our future results. The 1998 Purchased
     Companies were not under common control or management during the periods
     presented above and, therefore, the data presented may not be comparable to
     or indicative of post-combination results to be achieved by us. The
     unaudited pro forma income statement data is based on preliminary
     estimates, available information and certain assumptions that we deem
     appropriate and should be read in conjunction with the other financial
     statements and notes thereto included elsewhere in this Annual Report on
     Form 10-K.

(5)  The unaudited pro forma income statement data for the fiscal year ended
     December 27, 1998 includes approximately $4.3 million in pro forma
     reductions in salary and benefits of certain former owners of our acquired
     subsidiaries to which they have agreed prospectively, the effect of
     revisions of certain lease agreements between certain stockholders and us
     as a result of our purchase of the related assets and pooling expenses
     incurred in conjunction with the 1998 Pooled Companies.

(6)  Reflects amortization of the goodwill recorded as a result of the
     acquisitions accounted for under the purchase method of accounting over a
     30-year period.

(7)  Includes interest expense and other income (expense), net, and reflects the
     reduction of interest expense attributed to the repayment of debt with
     proceeds from the IPO, the increase in interest expense attributed to
     incremental borrowings and the change in interest expense on refinanced
     indebtedness of the companies we have acquired, assuming the application of
     the rate of interest available to us through our line of credit.

                                       23
<PAGE>
 
(8)  For the year ended December 27, 1998 includes (i) 5,910,000 shares issued
     to the owners of the Founding Companies, (ii) 6,784,957 shares issued in
     connection with the acquisition of the Pooled Companies and the 1998 Pooled
     Companies, (iii) 50,000 shares issued to our management, (iv) 1,021,389
     shares issued to Main Street Capital Partners, L.P., (v) 3,000,000 shares
     sold in the IPO, (vi) 142,500 shares issued to the Founding Companies
     profit sharing plans, (vii) 2,923,746 shares issued as part of the
     acquisition of the Purchased Companies, (viii) 450,000 shares sold pursuant
     to the overallotment and (ix) 376,982 weighted average shares attributable
     to stock options equivalent shares and stock options exercised during 1998.

(9)  The results of operations for our year ended December 27, 1998 include
     charges of approximately $1.2 million for inventory revaluation adjustment,
     approximately $0.9 million for restructuring costs and expenses and
     approximately $1.4 million for plant closure costs and asset abandonment
     loss related to the termination of our relationship with CHEP. For further
     discussion, see Managements Discussion and Analysis of Financial Condition
     and Results of Operations - Termination of CHEP Relationship.

                                       24
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         ---------------------------------------------------------------
         RESULTS OF OPERATIONS
         --------------------- 

     The following discussion should be read in conjunction with the financial
statements and related notes thereto and "Item 6 - Selected Financial Data"
appearing elsewhere in this Annual Report on Form 10-K. This Annual Report
includes, and any Quarterly Report on Form 10-Q or any Current Report on Form 8-
K filed by us or any other written or oral statements made by us or on our
behalf may include, forward-looking statements reflecting our current views with
respect to future events and financial performance. The words "anticipate,"
"estimate," "expect," and similar expressions are intended to identify forward-
looking statements. These forward-looking statements are subject to numerous
risks and uncertainties, including (but not limited to) the successful
integration and profitable management of acquired businesses, improvement of
operating efficiencies, the availability of working capital and financing for
internal growth initiatives, capital growth projects and future acquisitions,
the availability of attractive acquisition opportunities, our ability to grow
internally through expansion of services and customer bases and reduction of
overhead, conditions in lumber markets, seasonality, weather conditions and
other risk factors. Should one or more of these risks or uncertainties
materialize, or should assumptions underlying the anticipated or estimated
results prove incorrect, actual results may vary materially from those
anticipated or estimated. Although cautionary statements are made in this Annual
Report related to factors that may affect future operating results, a more
detailed discussion of these factors is set forth above in "Business - Risk
Factors."

     As described above in "Business - Introduction," in 1998, we acquired the
Container Group in eight separate acquisitions. Those acquisitions have resulted
in the expansion of our business to steel drum reconditioning and management
services. The following discussion and analysis of our financial condition and
results of operations focuses on our pallet and drum segments.

Introduction

     Our revenues are derived from: (1) the manufacture and sale of new pallets;
(2) the reconditioning and repair of steel drums, leasing of intermediate bulk
containers ("IBCs") and provision of management services to users of steel drums
and IBCs; (3) the repair, remanufacture and sale of recycled pallets and the
provision of pallet management services; and (4) pallet and container leasing,
retrieval, repair and management services.

     New pallet sales accounted for approximately 54% of our consolidated
revenues for the 1998 fiscal year, which ended December 27, 1998. A substantial
portion of the cost of a new pallet is lumber, and new pallet sales prices are
strongly influenced by the cost, availability and type of lumber used. As a
result, changes in lumber prices can significantly impact our revenues and
margins. New pallet manufacturing is generally considered to be a mature
industry characterized by moderate growth rates.

     The reconditioning and repair of steel drums accounted for approximately
27% of our consolidated revenues for the 1998 fiscal year.  The steel drum
reconditioning and repair industry has barriers to entry by new competitors,
including compliance with environmental standards and high capital requirements.
Consequently, competition is generally stable or declining in the industry,
which provides surviving industry participants with the opportunity to acquire
market share via pricing strategy.

     The repair, remanufacture and sale of recycled pallets and recycled pallet
management services accounted for approximately 17% of our consolidated revenues
for the 1998 fiscal year. These activities are more labor intensive and require
fewer raw materials than manufacturing new pallets. Recycling operations
generally generate higher gross profits as a percentage of revenues than new
pallet sales.

     Canadian pallet leasing, retrieval, repair and management services and IBC
leasing in the United States accounted for approximately 2% of our consolidated
revenues for the 1998 fiscal year.

                                       25
<PAGE>
 
     We recognize revenue upon the delivery of a product or service to a
customer.  We do not generally maintain significant finished goods inventory.
Cost of sales for pallets are predominantly variable, such as the cost of
lumber, labor, fasteners, transportation, equipment maintenance and utilities.
Fixed costs in pallet cost of sales include depreciation of equipment,
supervisory labor and direct overhead. A significant number of our pallet
production employees are paid on a production or "piecework" basis, which we
believe provides incentives for increased productivity. Cost of sales for
reconditioned steel drums contain higher fixed costs, a reflection of the
capital intensity of the business.  Fixed costs of sales for reconditioned steel
drums include depreciation, transportation and facility repairs.  Variable costs
to recondition steel drums include chemicals and coatings, hardware, labor and
raw drums.

     Although we sell products to a broad range of industries, approximately 7%
of our revenues for the 1998 fiscal year were attributable to the agricultural
industry in the southeastern and western regions of the U.S., with the citrus
and produce industries constituting the largest component of these revenues.
Revenue associated with these industries is highly seasonal, concentrated in the
period from October through May. Moreover, severe weather, particularly during
the harvesting seasons, may cause a reduction in demand from agricultural
customers, adversely affecting our revenues and results of operations. Adverse
weather conditions may also affect our raw material costs.

Termination of CHEP Relationship

     During the last quarter of 1997 and the first part of the first quarter of
1998, various members of our management had numerous discussions with
representatives of our largest customer, CHEP, regarding numerous issues
affecting the profitability of the products we manufactured for CHEP and the
pricing of new pallets, the uncertainty of CHEP production requirements, the
absence of fees for extra services provided to CHEP, quality control and the
opening of new facilities that would be primarily dedicated to performing
services for CHEP. We manufactured new, high-grade pallets for CHEP, which in
turn leased these pallets to its customers. These pallets were part of a 
"closed-loop" materials handling and management system that included recovery of
the pallet from the end user, aggregating them in PalEx-operated depots, where
they were sorted, repaired and returned to CHEP's customers.

     In addition, during this same period we began renegotiating the prices CHEP
was being charged for new pallets to more accurately reflect constantly changing
lumber prices. After subsequent discussion and communications, we recognized
that these issues would not be resolved to the mutual satisfaction of CHEP and
us. Accordingly, we notified CHEP that effective on April 29, 1998 we would
cease supplying CHEP with new pallets and provided advance notice (generally, 10
to 60 days) under contractual arrangements to discontinue repair and depot
services for CHEP.

     The termination of our relationship with CHEP adversely affected the
operations of certain of our facilities in the southeastern and western United
States.  We developed a restructuring plan to close, curtail or convert
operations at facilities related to CHEP production to alternative business
activities.  As of December 27, 1998, three CHEP-related manufacturing
facilities have been closed, one was sold and two more were consolidated into
one facility. Two other CHEP-related facilities were converted to manufacture
non-CHEP products.  We also terminated approximately 400 production-related
employees at CHEP-related facilities during 1998.

     During the 1998 fiscal year, approximately 8% of our consolidated revenues
were attributable to CHEP. Sales to CHEP for the years ended November 30, 1996
and December 28, 1997 were approximately 21% and 26% of consolidated revenues,
respectively.

Results of Operations

     Fraser has been identified as the accounting acquiror for financial
statement presentation purposes.

     Subsequent to the acquisition of the Founding Companies and our IPO and
during fiscal 1997, PalEx acquired five additional companies. During the 1998
fiscal year, we acquired a total of 19 companies. Of the 1998 acquisitions, ten
are engaged in the pallet business in the United States, eight are engaged in
the reconditioning and rebuilding of industrial steel containers in the U.S. and
one (SMG Corporation) is engaged in the rental of pallets in Canada.

                                       26
<PAGE>
 
     The following table lists our acquisitions through December 27, 1998:

                                                                 DATE OF 
               COMPANY ACQUIRED                                ACQUISITION 
               ----------------                                -----------

Founding Companies (1):
----------------------
Fraser Industries, Inc. ("Fraser")                               3/25/97
Ridge Pallets, Inc. ("Ridge")                                    3/25/97
Interstate Pallet Co., Inc. ("Interstate")                       3/25/97

Pooled Companies (2):                                    
--------------------
Sheffield Lumber & Pallet Company, Inc. ("Sheffield")             8/1/97
Sonoma Pacific Company ("Sonoma")                                 8/1/97
New London Pallet ("New London")                                10/14/97
Bay Area Pallet ("Bay Area")                                    10/31/97

Other 1997 fiscal year acquisitions (3):                 
---------------------------------------
Summers Pallet Manufacturing, Inc. ("Summers")                  11/20/97

1998 Pooled Companies (4):                               
-------------------------
Acme Barrel Company, Inc. ("Acme")                               2/23/98
Western Container, Limited Liability Company ("Western")         2/23/98
Drum Service Co. of Florida ("DSF")                              2/27/98
Consolidated Container Corporation ("CCC")                       2/27/98

1998 Purchased Companies (5):
----------------------------
American Pallet Recyclers, Inc. ("APR")                           1/2/98
Consolidated Drum Reconditioning, Inc. ("CDR")                   2/12/98
Capital Pallet, Incorporated ("Capital")                         3/18/98
Pallet Outlet Company, Inc. ("POC")                              3/20/98
Southern Pallets, Inc. ("Southern")                              3/25/98
Shipshewana Pallet Co., Inc. ("Shipshewana")                     5/21/98
Gilbert Lumber Inc. ("Gilbert")                                  6/11/98
Valley Pallets, Inc. ("Valley")                                  6/17/98
Duckert Pallet Co., Inc. ("Duckert")                             7/14/98
Continental Associated Investments ("Continental")               7/27/98
McCook Drum & Barrel Co., Inc. ("McCook")                         8/4/98
Isaacson Lumber Company ("Isaacson")                             8/31/98
SMG Corporation ("SMG")                                          9/11/98
Charlotte Steel Drum ("CSD")                                    10/23/98
Atlas Drum ("Atlas")                                            10/30/98
______________
(1)  We acquired the Founding Companies concurrently with the closing of our
     IPO.
(2)  We acquired the Pooled Companies in the 1997 fiscal year (ended December
     28, 1997) following our IPO. We accounted for each of these acquisitions as
     a pooling-of-interests.
(3)  We accounted for the 1997 acquisition of Summers as a purchase.
(4)  We acquired the 1998 Pooled Companies in the 1998 fiscal year and accounted
     for each of these acquisitions as a pooling-of-interests.
(5)  The 1998 Purchased Companies were acquired in the 1998 fiscal year and were
     accounted for as purchases. (We sometimes refer to the 1998 Purchased
     Companies, together with Summers, as the "Purchased Companies".)

                                       27
<PAGE>
 
     The following table sets forth certain selected financial data and that
data as a percentage of our revenues for the periods indicated (dollars in
thousands):

<TABLE>
<CAPTION>
                                                                               Year ended
                                     ----------------------------------------------------------------------------------------
                                         November 30, 1996                  December 28, 1997             December 27, 1998
                                     -----------------------            -----------------------      ------------------------
<S>                                  <C>               <C>              <C>               <C>        <C>               <C>
Revenues                             $145,030          100.0%           $222,993          100.0%     $319,691           100.0%
Cost of goods sold                    121,865           84.0             188,084           84.3       259,562            81.2
Inventory  valuation adjustment             -              -                   -              -         1,235              .4
                                     --------          -----            --------          -----      --------           -----
Gross profit                           23,165           16.0              34,909           15.7        58,894            18.4
Selling, general and
 administrative expenses               14,063            9.7              20,135            9.0        33,042            10.3
Pooling expenses                            -              -                   -              -         1,841              .6
Compensation differential                   -              -               1,020             .5         1,062              .3
Goodwill amortization                       -              -                 593             .3         2,977              .9
Restructuring charge                        -              -                   -              -           949              .3
Plant closure costs and asset
 abandonment loss                           -              -                   -              -         1,369              .4
                                     --------          -----            --------          -----      --------           -----
Income from operations                  9,102            6.3              13,161            5.9        17,654             5.5
Interest expense                       (1,576)          (1.1)             (1,722)           (.8)       (8,468)           (2.7)
Other income (expense), net               346             .2                 (95)             -           (95)              -
                                     --------          -----            --------          -----      --------           -----
Income before taxes                     7,872            5.4              11,344            5.1         9,091             2.8
Income taxes                            1,833            1.2               4,704            2.1         5,105             1.6
                                     --------          -----            --------          -----      --------           -----
Net income                           $  6,039            4.2%           $  6,640            3.0%     $  3,986             1.2%
                                     ========          =====            ========          =====      ========           =====
</TABLE>
Year Ended December 27, 1998 Compared to Year Ended December 28, 1997

     Revenues increased approximately $96.7 million, or 43.4%, to approximately
$319.7 million from approximately $223.0 million. Revenues attributable to the
1998 Purchased Companies were approximately $94.7 million. Revenues for the
Founding Companies and the Pooled Companies and Summers, adjusted for the
comparable period in 1998 for which there were no revenues in 1997, decreased
approximately $23.0 million from 1997 to 1998. CHEP sales decreased
approximately $32.4 million from 1997 to 1998. Approximately $9.4 million of the
decrease in sales attributable to CHEP was replaced in 1998 after the
termination of our CHEP relationship with increased sales to other customers.

     Revenues from new and recycled pallet sales increased approximately $19.2
million and $47.5 million, respectively, in 1998 over 1997. Revenues from pallet
leasing and related services increased approximately $4.6 million in 1998 over
1997. Revenues from reconditioned drum sales increased approximately $25.4
million in 1998 over 1997. All of these increases were primarily attributable to
the revenues of the 1998 Purchased Companies.

     Gross profit as a percentage of revenues increased to 18.4% for 1998
compared to 15.7% for 1997. The Company's consolidated sales mix now consists of
a higher percentage of sales of recycled pallets and reconditioned drums, which
have higher gross margins.

     Selling, general and administrative expenses increased 64.1% to
approximately $33.0 million in 1998 from approximately $20.1 million in 1997 and
were 10.3% and 9.0% of revenues, respectively. Approximately $10.5 million of
this increase was attributable to the acquisitions of the 1998 Purchased
Companies and approximately $2.4 million was associated with the costs of being
a public company.

     The results of operations for 1998 included charges of approximately $1.8
million and $1.1 million for pooling expenses and compensation differential,
respectively. Compensation differential is the difference between previous
owners' compensation before their companies were acquired by PalEx and the
amounts they contractually 

                                       28
<PAGE>
 
agreed to be paid afterward. There were no pooling expenses for 1997.
Compensation differential for 1997 was approximately $1.0 million.

     Goodwill amortization increased in 1998 to approximately $3.0 million from
approximately $0.6 million because of the additional companies we acquired
during 1998 that were accounted for as purchases.

     The results of operations for 1998 include after-tax charges of
approximately $1.2 million for costs associated with the conversion or closure
of facilities and approximately $0.8 million for plant closure and asset
abandonment losses related to the termination of our relationship with CHEP.

     Interest expense increased in 1998 to approximately $8.5 million from
approximately $1.7 million in 1997. The increase in interest expense was
primarily attributable to the additional indebtedness incurred in conjunction
with the acquisitions of the 1998 Purchased Companies and the refinanced debt of
the 1998 Pooled Companies.

     Federal and state income taxes have been provided on the earnings of
Fraser, the Pooled Companies and the 1998 Pooled Companies for 1997 and on
Ridge, Interstate and Summers from their respective dates of acquisition.  The
provision for income taxes for 1997 also includes a charge of approximately $0.5
million, representing deferred income taxes for Fraser at the time of our IPO.
This charge was not previously recorded because of Fraser's status under
Subchapter S of the Internal Revenue Code.  Our effective income tax  rate was
56.2% of pretax income for 1998, primarily due to nondeductible amortization of
goodwill and costs and expenses incurred in conjunction with those companies
acquired as poolings-of-interests.

     As a result of the foregoing, net income for 1998 decreased approximately
$2.6 million to approximately $4.0 million from approximately $6.6 million in
1997.

Year Ended December 28, 1997 Compared to November 30, 1996

     Revenues increased approximately $78.0 million, or 53.8%, to approximately
$223.0 million in 1997 from approximately $145.0 million in 1996. Of this
increase, approximately $45.4 million was attributable to the acquisition of
Ridge and Interstate and approximately $21.4 was attributable to an increase in
new pallet sales. Approximately $11.2 million of the increase was attributable
to an increase in unit sales of reconditioned drums.

     Gross profit as a percentage of revenues remained relatively unchanged at
15.7% in 1997 compared to 16.0% in 1996. The slight decrease in gross profit
percentage was partially attributable to increased lumber costs during the year.
Gross margins for reconditioned drums were slightly lower due to market driven
price pressures.

     Selling, general and administrative expenses increased 43.2% to
approximately $20.1 million in 1997 from approximately $14.1 million in 1996 and
were 9.0% and 9.7% of sales, respectively. The amount of increase was primarily
attributable to increased costs associated with being a public company and the
acquisitions of Ridge, Interstate and Summers.

     Goodwill amortization in 1997 is attributable to the acquisition of Ridge, 
Interstate and Summers.

     Interest expense increased to approximately $1.7 million in 1997 from
approximately $1.6 million in 1996 as a result of the increase in indebtedness
in 1997.

     As a result of the foregoing, net income increased to approximately $6.6
million in 1997 from approximately $6.0 million in 1996.

Liquidity and Capital Resources

     On March 25, 1997, we completed our IPO, which involved the sale of
3,000,000 shares of our Common Stock at a price to the public of $7.50 per
share. The net proceeds from our IPO (after deducting underwriting discounts,
commissions and offering expenses) were approximately $20.5 million. Of this
amount, approximately $1.2 million was used to pay the cash portion of the
purchase prices relating to the acquisitions of the Founding Companies, with the
remainder being used to repay certain indebtedness of the Founding Companies. On
April 22, 

                                       29
<PAGE>
 
1997, we sold an additional 450,000 shares of our Common Stock at a price to the
public of $7.50 per share (generating net proceeds to us of $3.1 million after
underwriting discounts and commissions) pursuant to the exercise of an over-
allotment option we granted to the underwriters in connection with our IPO. The
net proceeds from the sale of these shares were used to repay debt borrowed
under our Credit Facility, as discussed below.

     We have a credit facility with BankOne, Texas, N.A. and a syndicate of
other banks (the "Credit Facility"). The Credit Facility provides us with a
revolving line of credit of up to $150.0 million, which can be used for general
corporate purposes, including acquisitions, the repayment or refinancing of
indebtedness of acquired companies, capital expenditures, letters of credit
(with a $10 million limit for standby letters of credit) and working capital.
Our Credit Facility matures, and all amounts outstanding thereunder will become
due and payable, on April 1, 2000.

     The Credit Facility was amended on December 28, 1998. Before that date,
advances under the Credit Facility bore interest at designated variable rates
plus margins ranging from 0 to 25 basis points, depending on the ratio of our
interest-bearing debt to our pro forma trailing earnings before interest, taxes,
depreciation and amortization for the previous four quarters. At our option,
advances could bear interest at a rate based on a designated London Interbank
Offered Rate ("LIBOR"), plus a margin ranging from 75 to 200 basis points,
depending on the ratio described in the preceding sentence.

     Since December 28, 1998, advances under the Credit Facility bear interest
at a defined base interest rate of the lenders, plus 50 basis points through
March 31, 1999 and increasing 50 basis points on that date and each quarter
thereafter until maturity. At our option, such advances may bear interest based
on a designated LIBOR rate, plus a margin of 275 basis points through March 31,
1999 and increasing 50 basis points on that date and each quarter thereafter
until maturity. Commitment fees of 50 basis points are payable on the unused
portion of the line of credit through March 31, 1999 and increase by 50 basis
points on that date and each quarter thereafter until maturity.

     The Credit Facility prohibits our payment of dividends, restricts our
incurrence or assumption of other indebtedness and requires us to comply with
certain financial covenants, including consolidated net worth, fixed charge
coverage, and funded debt and senior debt to earnings before interest, taxes,
depreciation and amortization ratios. We were in compliance with, or had
obtained waivers for, the covenants on December 27, 1998. Our indebtedness and
obligations under the Credit Facility are guaranteed by each of our
subsidiaries. In addition, this indebtedness and these obligations are secured
by pledges of all our, and our subsidiaries', real and personal property,
including pledges of all the outstanding stock of each of our U.S. subsidiaries
and 65% of the stock of our Canadian subsidiary.

     At March 22, 1999, we had borrowing capacity under our Credit Facility of
approximately $3.0 million.

     We issued approximately $9.9 million in subordinated convertible notes
payable (the "Convertible Notes") to certain former owners of the 1998 Purchased
Companies. The Convertible Notes, which bear interest at rates ranging from six
to eight percent, include provisions that allow conversion into shares of our
Common Stock beginning on the first anniversary date of the Convertible Notes
(the "Conversion Date") at conversion prices ranging from $10.78 to $15.86 per
share. If the Convertible Notes are not converted, they become due and payable
on their second anniversary. At the Company's option, the Convertible Notes may
be prepaid at any time following the Conversion Date.

     We intend to pursue additional acquisitions. The timing, size or success of
any acquisitions and the resulting additional capital commitments are
unpredictable. We expect to fund future acquisitions primarily through a
combination of issuances of additional equity, working capital, and cash flow
from operations and borrowings, including the unused portion of the Credit
Facility. To the extent new sources of financing are necessary to fund future
acquisitions, we cannot assure you that we can secure the additional financing
if and when it is needed or on terms deemed acceptable to us.

                                       30
<PAGE>
 
Seasonality

     The pallet manufacturing business is subject to seasonal variations in
operations and demand. We have a significant number of agricultural customers
and typically experience the greatest demand for new pallets from these
customers during the citrus and produce harvesting seasons (generally October
through May), with significantly lower demand in the summer months. Our third
quarter has traditionally been the quarter with lowest demand for pallets.

     Yearly results can fluctuate significantly in the agricultural regions
depending on the size of the citrus and produce harvests, which, in turn, are
subject to the occurrence and severity of freezing weather and changes in
rainfall. Adverse weather conditions may also affect our ability to obtain
adequate supplies of lumber at a reasonable cost and the demand for our
products. Our locations that predominantly service manufacturing and industrial
customers experience less seasonality. We believe that the effects of such
seasonality will diminish as we grow and expand our customer base internally and
through acquisitions.

     Our drum reconditioning business is seasonally impacted in the southeastern
and western United States by the agricultural industries. Reconditioned drum
sales are strongest during a period generally beginning in April and extending
through September, with preseason production for this period running from
January through March.

Year 2000 Issues

     The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define a specific year. Absent corrective
actions, a computer program that has date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result in
system failures or miscalculations causing disruptions to various activities and
operations.

     We have conducted an evaluation of the actions necessary in order to ensure
that our computer systems will be able to function without disruption with
respect to the application of dating systems in the year 2000. The majority of
our information technology software with potential year 2000 concerns was
licensed from vendors that have either changed their product to remove the
effects of the Year 2000 Issue or have committed to us to have the necessary
changes made during 1999. Reviews and inquiries concerning software used in the
operation of our manufacturing equipment have been conducted as well. Our
operating businesses do not require extensive systems-oriented applications. The
pallet manufacturing business consists of harvesting, transporting, cutting,
assembling and delivering finished wood products. The drum reconditioning
business consists of collecting, reconditioning and delivering empty steel
containers. Isolated microprocessor-driven manufacturing equipment involved in
the pallet manufacturing and drum reconditioning processes have either been
conformed to year 2000 standards or are scheduled for conformity by the vendor
in 1999. We are unaware of any material disruptions to our manufacturing
operations that could occur because of year 2000 problems. We are also unaware
of any exposure to contingencies related to the Year 2000 Issue for the
products we have sold in the past. We do not anticipate the loss of any revenues
due to the Year 2000 Issue.

     As a result of our evaluations of the Year 2000 Issue, we are engaged in
the process of upgrading and replacing certain of our information and other
computer systems in order to be able to operate without disruption after 1999.
Our remedial actions are scheduled to be completed during the second and third
quarters of 1999. Based upon information currently available, we do not
anticipate that the costs of our remedial actions will exceed $250,000. We
incurred costs as of December 27, 1998 of less than $50,000 for remediation of
the Year 2000 Issue. We do not have a formal contingency plan, but believe we
will be able to create one in the second or third quarter of 1999, if we
determine any systems are at risk of being year 2000 non-compliant. However, we
can not assure you that the remedial actions we are implementing will be
completed by the time necessary to avoid year 2000 problems or that the cost,
which is based on our estimates, will not be material. Although we are assessing
the reliability of their year 2000 compliance, disruptions of the computer
systems of banks, vendors, customers or other third parties, 



                                       31
<PAGE>
 
whose systems are outside our control, could impair our ability to obtain
necessary raw materials or to sell to or service our customers. Disruption of
our computer systems, or the computer systems of our banks, vendors or
customers, as well as the cost of avoiding such disruption, could have a
material adverse effect upon our financial condition and results of operations.

                                       32
<PAGE>
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
          -----------------------------------------------------------
     At December 27, 1998, the fair value of our total variable rate debt was
estimated to be $145.9 million, which approximated carrying value based on our
current incremental borrowing rate for similar types of borrowing arrangements.
At this borrowing level, a hypothetical 10% adverse change in interest rates on
our debt would increase interest expense and decrease income before income taxes
by approximately $1.3 million.  This amount was determined by considering the
impact of the hypothetical interest rate increase on our borrowing cost at the
December 27, 1998 borrowing level.

     Although we conduct business in Canada, those operations are not material
to our consolidated financial position, results of operations or cash flows.
Additionally, foreign currency translation gains and losses were not material to
our results of operations for the 1998 fiscal year.  Accordingly, we are not
currently subject to material foreign currency exchange rate risks from the
effects that exchange rate movements of Canadian currency would have on our
future costs or on future cash flows we would receive from our Canadian
operations. We have not entered into any foreign currency exchange contracts or
other derivative financial instruments to hedge the effects of adverse
fluctuations in foreign currency exchange rates.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
         -------------------------------------------
  See Part IV, Item 14(a) 1 for information required for this item.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         ---------------------------------------------------------------
         FINANCIAL DISCLOSURE
         --------------------
  None.

                                       33
<PAGE>
 
                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
          --------------------------------------------------
     Our executive officers and directors are as follows:

      Name               Age             Position
      ----               ---             --------
Tucker S. Bridwell        46   Director(1)(2)
A. Joseph Cruz            52   President, Chief Operating Officer 
                                 (since November 1998) and Director 
                                 (since February 1998)
John E. Drury             54   Director(1)(2)
Casey A. Fletcher         44   Chief Accounting Officer and Secretary
Troy L. Fraser            49   President of Fraser Industries, Inc. and Director
Phillip M. Freeman        54   Executive Vice President (since November 1998)
A.E. Holland, Jr.         51   President of Ridge Pallets, Inc. and Director
Sam W. Humphreys          38   Chairman of the Board and Director(1)(2)
Vance K. Maultsby, Jr.    46   Chief Executive Officer
Elliot S. Pearlman        57   Chief Executive Officer of PalEx Container
                                  Systems, Inc. and Director
Edward E. Rhyne           38   Vice President and General Counsel
Stephen C. Sykes          54   President of Interstate Pallet Co., Inc. and 
                                  Director
 
     (1)  Member of the Audit Committee
     (2)  Member of the Compensation Committee

     Tucker S. Bridwell became a director of PalEx in March 1997 upon the
closing of our IPO.  Since October 1997, Mr. Bridwell has been President of
Mansefeldt Investment Corporation, a private investment firm.  Mr. Bridwell is
also the President of Topaz Exploration Company, an oil and gas exploration
company, a position he has held since 1980.  From 1992 until October 1997, Mr.
Bridwell was the President of Fred Hughes Motors, Inc., which owned ten new-car
franchises in the Abilene, Texas area.  From 1985 to 1992, Mr. Bridwell was
President of Ard Drilling Company, an oilfield drilling company, and served as
President of Texzona Corporation, a private investment company, from 1979 to
1980. From 1976 to 1979, Mr. Bridwell was Tax Manager with Condley & Company and
was an accountant with Price Waterhouse from 1974 to 1976.  Mr. Bridwell is a
Certified Public Accountant.

     A. Joseph Cruz became a director in February 1998 and President and Chief
Operating Officer of PalEx in November 1998.  Mr. Cruz previously served as
President of PalEx Container Systems since our acquisition of Consolidated Drum
Reconditioning, Inc. ("CDR"), in February 1998.  Prior to that acquisition, Mr.
Cruz was a 50% owner of CDR and its Chief Executive Officer since its was
acquired by Mr. Cruz and Mr. Freeman in 1986.

     John E. Drury became a director of PalEx in March 1997 upon the closing of
our IPO.  Mr. Drury is the Chairman and Chief Executive Officer of Waste
Management, Inc. ("Waste Management"), the largest solid waste company in North
America.  Waste Management was formerly known as USA Waste Services, Inc. ("USA
Waste") until July 1998.  Mr. Drury has held these positions since May 1994,
when USA Waste and Envirofil, Inc. ("Envirofil") merged together.  From February
1991 through April 1994, Mr. Drury was a Managing Director of Sanders Morris
Mundy, Inc., an investment banking firm.  From 1982 through January 1991, Mr.
Drury was President and Chief Operating Officer of Browning-Ferris Industries,
Inc. ("BFI"), where he was responsible for the 

                                       34
<PAGE>
 
worldwide operations of BFI. Mr. Drury is a partner in Main Street Merchant
Partners II, L.P. ("Main Street"), a merchant banking firm.

     Casey A. Fletcher became Chief Accounting Officer and Secretary of PalEx in
March 1997 upon the closing of our IPO.  From 1983 until our IPO and our
acquisition of Ridge Pallets, Inc. ("Ridge"), Mr. Fletcher was Ridge's
Controller and Chief Financial Officer.  Prior to his employment with Ridge, Mr.
Fletcher was associated with Arthur Young from 1976 to 1979.  Mr. Fletcher is a
Certified Public Accountant.

     Troy L. Fraser became a director of PalEx in March 1997 upon the closing of
our IPO.  Mr. Fraser served as our Chief Development Officer from March 1997 to
November 1998.  He became President of Fraser Industries, Inc. ("Fraser") in
1975 when he and his two brothers purchased Fraser from their father. In 1988,
Mr. Fraser was elected to the Texas House of Representatives where he served
three terms, and was named the National Republican Legislator of the Year in
1991.  In November 1996, Mr. Fraser was elected to the Texas State Senate.  In
1996, Mr. Fraser served as Vice President of the National Wooden Pallet and
Container Association ("NWPCA") and has served for two terms on the NWPCA's
Board of Directors.

     Philip M. Freeman became Executive Vice President in November 1998.  Mr.
Freeman previously served as Chief Operating Officer of PalEx Container Systems
since our acquisition of CDR in February 1998.  Prior to that acquisition, Mr.
Freeman was a 50% owner of CDR and its Chief Operating Officer since it was
acquired by Mr. Freeman and Mr. Cruz in 1986.

     A. E. Holland, Jr. became a director of PalEx in March 1997 upon the
closing of our IPO.  Mr. Holland served as our Chief Operating Officer from
March 1997 to November 1998.  He has over 25 years of experience in the pallet
industry.  Mr. Holland has been associated with Ridge since 1969 and has served
as President of Ridge since 1980.  Mr. Holland has served on the Board of
Directors of the NWPCA and was President of NWPCA from 1990 to 1991.  Mr.
Holland has served the Florida Chamber of Commerce as Treasurer, Chairman of the
Finance Committee and member of the State Strategic Planning Committee.

     Sam W. Humphreys has been a director of PalEx since January 1996 and became
non-executive Chairman of the Board in March 1997 upon the closing of our IPO.
Mr. Humphreys is a Managing Director of Main Street, a merchant banking firm.
From April 1994 until March 1997, Mr. Humphreys held various executive positions
with U.S. Delivery Systems, Inc. ("U.S. Delivery"), the largest same-day local
delivery company in the U.S., serving as Vice Chairman until shortly prior to
the IPO.  Prior to joining U.S. Delivery, Mr. Humphreys served from May 1993
until April 1994 as Senior Vice President and General Counsel of Envirofil,
which merged with USA Waste in April 1994.  Prior to assuming the Envirofil
position, Mr. Humphreys was a partner at Andrews & Kurth L.L.P., where he was
engaged in the private practice of law for more than five years.  Mr. Humphreys
is also a director of Aviation Sales Company, one of the world's largest
providers of aircraft spare parts.

     Vance K. Maultsby, Jr. became Chief Executive Officer of PalEx in December
1996. Mr. Maultsby served as our President from November 1996 until November
1998.  From 1993 to 1996, Mr. Maultsby was a partner with Ernst & Young LLP in
the Dallas, Texas office, where he managed the Dallas office of its Corporate
Finance Group.  From 1989 to 1992, Mr. Maultsby was chief executive officer of
Alemar Financial Company (later Alemar Cost Reduction, Inc.), which provided
financial advisory services to a variety of industries.  From 1985 to 1989, Mr.
Maultsby was an officer in the Corporate Finance Group for Stephens Inc., an
investment banking firm.  Prior to the position with Stephens Inc., Mr. Maultsby
was a partner with KPMG Peat Marwick, served as the National Director of its
Petroleum Industry Practice, was co-director of its Southwest Area Mergers and
Acquisitions Advisory Practice and practiced public accounting for more than
five years.  Mr. Maultsby is a Certified Public Accountant.

     Elliot S. Pearlman became Chief Executive Officer of PalEx Container
Systems and a director of PalEx when we acquired Acme Barrel Company, Inc.
("Acme") in February 1998.  Mr. Pearlman served as Acme's President and Chief
Executive Officer and was a principal stockholder from 1992 until our
acquisition of Acme.  Mr. Pearlman serves as a director of the Association of
Container Reconditioners and served as chairman of this association in 1996 and
1997.

                                       35
<PAGE>
 
     Edward E. Rhyne became Vice President and General Counsel of PalEx in June
1997.  Prior to his employment with us, Mr. Rhyne was a partner at Gardere &
Wynne, L.L.P., where he was engaged in the private practice of law as a
securities and mergers and acquisition lawyer for more than five years.

     Stephen C. Sykes became a director of PalEx in March 1997 upon the closing
of our IPO.  Mr. Sykes founded Interstate in 1979 and has served as its
President and Chief Executive Officer from its inception.  From 1974 to 1979,
Mr. Sykes was the Director of Transportation for the Virginia Division of Holly
Farms Poultry.  Mr. Sykes has been an active member of the NWPCA since 1981 and
served as its President from 1992 to 1993.

ITEM 11.  EXECUTIVE COMPENSATION
          ----------------------
Summary Compensation Table

     The following table summarizes the compensation paid to our Chief Executive
Officer, our four other most highly compensated executive officers as of the end
of the 1998 fiscal year for services rendered to us during the 1998 fiscal year
and one former executive officer who would have been among the most highly
compensated officers had he still been an executive officer at the end of the
1998 fiscal year (collectively, the "Named Executive Officers").

<TABLE>
<CAPTION>
                                              Annual         Long-Term
                                           Compensation     Compensation
    Name and                               ------------     ------------
    Principal                     Fiscal                Securities Underlying         All Other
    Position                       Year      Salary($)    Options/SARS(#)(1)      Compensation($)(2)
    --------                      ------    ---------   ---------------------     ------------------ 
<S>                                <C>       <C>            <C>                   <C>
Vance K. Maultsby, Jr.             1998      175,000                 -                  3,500
  Chief  Executive Officer         1997      138,542           200,000                      -
                                           
Edward E. Rhyne                    1998      168,100           110,000                      -
  Vice President and General       1997       89,017            90,000                      -
  Counsel                                  
                                           
Casey A. Fletcher                  1998      126,200                 -                  2,524
  Chief Accounting Officer and     1997       94,650                 -                  1,893
  Secretary                                                              
                                                                         
Troy L. Fraser                     1998      125,000                 -                  2,500
  President of Fraser              1997       98,234                 -                  1,667
  Industries, Inc. and Director                                           
                                                                         
A. Joseph Cruz                     1998      105,769                 -                  1,250
  President and Chief              1997            -                 -                      -
  Operating Officer                                                        
                                                                         
Philip M. Freeman                  1998      105,769                 -                  1,250
  Executive Vice President         1997            -                 -                      -
</TABLE>

(1)  Options to acquire shares of Common Stock under our 1996 Stock Option Plan,
     as amended (the "Stock Option Plan").

(2)  Consists of the Company's matching contribution under its 401(k) Plan.

                                       36
<PAGE>
 
Option Grants During 1998 Fiscal Year

     The following table sets forth the options we granted during the fiscal
year ended December 27, 1998 to the named executive officers pursuant to the
Stock Option Plan. We did not grant any stock appreciation rights during the
1998 fiscal year. Options granted to Named Executive Officers under the Stock
Option Plan in the 1998 fiscal year vest and become exercisable at the rate of
25% per year over a four-year period.

<TABLE>
<CAPTION>
                                                                                                    Potential Realizable
                                                                                                      Value at Assumed
                                                                                                        Annual Rates
                                                                                                       of Stock Price
                                                     Individual                                         Appreciation
                                                       Grants                                         for Option Term (1) 
                                      -------------------------------------                        ------------------------
<S>                   <C>           <C>                       <C>              <C>             <C>            <C>
                       Number of  
                       Securities     % of Total Options        Exercise or
                       Underlying     Granted to Employees       Base Price       Expiration                                 
Name                   Options (#)       in Fiscal Year            ($/Sh)            Date           5% ($)        10% ($) 
----                   -----------    --------------------      -----------       ----------        ------        -------
Edward E. Rhyne           10,000             0.7%                 $11.88          12/31/2007       $  3,417      $   75,781
Edward E. Rhyne          100,000             7.3%                 $ 7.00          10/30/2008       $521,671      $1,245,307
</TABLE>

(1)  The potential realizable values were determined based upon assumed
     prescribed rates of appreciation and are not intended to forecast the
     possible future appreciation, if any, of the value of our Common Stock.

Option Exercises During 1998 Fiscal Year and Fiscal Year End Option Values

     The following table provides information related to options exercised by
the Named Executive Officers during the 1998 fiscal year and the number and
value of options held at fiscal year-end.  We do not have any outstanding stock
appreciation rights.

                Aggregated Option Exercises in Last Fiscal Year
                       and Fiscal Year-End Option Values

<TABLE>
<CAPTION>
                                                                                             
                                                                     Number of Securities         Value of Unexercised
                                                                    Underlying Unexercised      In-the-Money Options at
                        Shares Acquired on                           Options at FY-End (#)               FY-End
Name                       Exercise (#)       Value Realized (1)   Exercisable/Unexercisable  Exercisable/Unexercisable (1)
----                    ------------------    ------------------   -------------------------  -----------------------------
<S>                     <C>                  <C>                   <C>                        <C>
Vance K. Maultsby, Jr.         -                    -                   50,000/150,000                  -/-
Edward E. Rhyne                -                    -                   22,500/177,500               -/$50,000
</TABLE>

(1)  Value is calculated on the basis of the difference between the option
     exercise price and the market value of the Common Stock on December 24,
     1998, the last trading day in our 1998 fiscal year ($7.50 per share).

Compensation of Directors

     Directors who are our employees do not receive additional compensation for
serving as directors. Each director who is not one of our employees receives a
fee of $1,000 for attendance at each Board of Directors meeting and $500 for
each committee meeting (unless held on the same day as a Board of Directors
meeting). Our directors are reimbursed for out-of-pocket expenses incurred in
attending meetings of the Board of Directors or Board committees, and for other
expenses incurred in their capacity as our directors. Each non-employee director
receives stock options under the Stock Option Plan to purchase 20,000 shares of
our Common Stock upon election to the Board of Directors and an annual grant of
5,000 options. These options vest six months after the date of the grant.

                                       37
<PAGE>
 
Employment Agreements

     We have entered into an employment agreement with each of the named
executive officers which prohibits such individual from disclosing our
confidential information and trade secrets and generally restricts these
individuals from competing with us. Each of the agreements has an initial term
of between one and three years and provides for an automatic annual extension at
the end of its initial term and is terminable by us for "cause" upon ten days
written notice and without "cause" by either party upon 30 days written notice.
All employment agreements provide that if the officer's employment is terminated
by us without "cause," the officer will be entitled to receive a lump-sum
severance payment at the effective time of termination equal to the base salary
at the rate then in effect for the greater of (1) the time period remaining
under the initial term of the agreement or (2) one year. In addition, such
employment agreements provide that in the event of termination without "cause,"
the time period during which such officer is restricted from competing with the
Company will be shortened to one year following such termination.

     The employment agreements of Messrs. Maultsby, Fraser, Fletcher and Rhyne
and certain other employees contain certain provisions concerning a change-in-
control of PalEx, including the following: (1) in the event five days' advance
notice of the transaction giving rise to the change in control is not received
by us and the officer, the change in control will be deemed a termination of the
employment agreement by us without "cause," and the provisions of the employment
agreement governing the same will apply, except that the severance amount
otherwise payable (discussed in the preceding paragraph) shall be tripled and
the provisions which restrict competition with us shall not apply; (2) in any
change-of-control situation, the officer may elect to terminate his employment
by giving five days' written notice prior to the anticipated closing of the
transaction giving rise to the change-in-control, which will be deemed a
termination of the employment agreement by us without "cause," and the
provisions of the employment agreement governing the same will apply, except
that the severance amount otherwise payable shall be doubled and the time period
during which the officer is restricted from competing with us will be shortened
to two years; and (3) the officer must be given sufficient time and opportunity
to elect whether to exercise all or any of his options to purchase our Common
Stock, including any options with accelerated vesting under the provisions of
the Stock Option Plan, such that the officer may acquire our Common Stock at or
prior to the closing of the transaction giving rise to the change-in-control, if
he so desires.

Employee Benefit Plans

     The Board of Directors has adopted, and our stockholders have approved, the
Stock Option Plan. The purpose of the Stock Option Plan is to provide directors,
officers, key employees and certain other persons who will be instrumental in
our success or the success of our subsidiaries with additional incentives by
increasing their proprietary interest in PalEx. The aggregate amount of our
Common Stock with respect to which options may be granted may not exceed 15% of
our outstanding Common Stock, as determined on each date an option is granted.

     The Stock Option Plan is administered by the Compensation Committee, which
is composed of non-employee directors (the "Committee"). Subject to the terms of
the Stock Option Plan, the Committee generally determines to whom options will
be granted and the terms and conditions of option grants. Options granted under
the Stock Option Plan may be either non-qualified stock options or may qualify
as incentive stock options.

     The exercise price of any option may not be less than the fair market value
of the underlying Common Stock as of the date of grant and no consultant may
receive an option in any year to purchase more than 51,000 shares of our Common
Stock. The Committee determines the period over which options become
exercisable, provided that all options become immediately exercisable upon death
of the grantee or upon a change-in-control (as defined in the Stock Option Plan)
of PalEx.

     The Stock Option Plan also provides for automatic option grants to
directors who are not otherwise employed by us or our subsidiaries. Upon
commencement of service, a non-employee director will receive a non-qualified
option to purchase 20,000 shares of our Common Stock, and continuing annually
non-employee directors will receive options to purchase 5,000 shares of our
Common Stock. Options granted to non-employee directors are fully exercisable
following the expiration of six months from the date of grant.

                                       38
<PAGE>
 
     Mr. Maultsby has been granted options to purchase 200,000 shares of Common
Stock under the Stock Option Plan all of which have an exercise price equal to
the initial public offering price. Mr. Maultsby's options vest annually in 25%
increments beginning in November 1997. Mr. Rhyne has been granted options to
purchase 65,000, 25,000, 10,000 and 100,000 shares of Common Stock under the
Stock Option Plan at a per share exercise price of $8.875, $11.375, $11.875 and
$7.00, respectively. Mr. Rhyne's options vest annually in 25% increments
beginning in (i) April 1998 as to the 65,000 shares subject to options granted
during April, 1997; (ii) December 1998 as to the 35,000 shares subject to
options granted during December 1997; and October 1999 as to his remaining
options.

Compensation Committee Interlocks and Insider Participation

     During the 1998 fiscal year, the Committee consisted of Messrs. Bridwell,
Drury and Humphreys. Each of Messrs. Bridwell, Drury and Humphreys are
independent directors.

     Main Street, a limited partnership in which Sam H. Humphreys was a general
partner and John E. Drury was a special limited partner, paid $1.25 million of
our expenses, including legal and accounting fees, incurred in connection with
our IPO and our acquisitions of Fraser, Interstate and Ridge.

     Tucker S. Bridwell received a payment from us of $50,000 and options to
purchase 20,000 shares of our Common Stock, exercisable at $7.50 per share
pursuant to the Stock Option Plan, for providing advice to Fraser in connection
with our acquisition of Fraser. Messrs. Bridwell and Drury received options to
purchase 20,000 shares of our Common Stock, exercisable at $7.50 per share
pursuant to the Stock Option Plan, in connection with their election to the
Board of Directors. In August 1998, each of Messrs. Bridwell, Drury and
Humphreys received options to purchase 5,000 shares of our Common Stock at an
exercise price of $8.75 as non-employee directors in accordance with the terms
of the Stock Options Plan, as described above. See "Executive Compensation -
Compensation of Directors" and "- Employee Benefit Plans."

                                       39
<PAGE>
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
          --------------------------------------------------------------
     The following table sets forth certain information as of March 22, 1999
with respect to the beneficial ownership of our Common Stock, which constitutes
our only outstanding class of voting securities, by (1) each person who, to our
knowledge, beneficially owned more than 5% of the Common Stock, (2) each of our
directors, (3) the named executive officers and (4) all our directors and
executive officers as a group. Except as indicated, beneficial ownership
includes the sole power to vote and to dispose of the securities in question.
Except as indicated below, none of our directors or executive officers owned any
other of our equity securities.

<TABLE>
<CAPTION>
                                              Beneficial Ownership (1)
                                           ----------------------------
Name of Beneficial Owner or Group            Shares    Percentage Owned
---------------------------------          ----------  ----------------
<S>                                        <C>            <C>
Tucker S. Bridwell(2)                         50,000            *
A. Joseph Cruz(3)                            530,766          2.7%
John E. Drury(4)                             192,227            *
Casey A. Fletcher(5)                         321,783          1.6%
Troy L. Fraser                             1,410,415          7.2%
A. E. Holland, Jr.                           318,583          1.6%
Sam W. Humphreys(6)                          455,000          2.3%
Vance K. Maultsby, Jr.(7)                    150,000            *
Elliott S. Pearlman(8)                     1,132,767          5.8%
Edward E. Rhyne(9)                            41,250            *
Stephen C. Sykes                             374,528          1.9%
All directors and executive officers                 
  as a group (10)  (12 persons)            4,977,319         25.1%
</TABLE>
---------
*  Less than 1%.

(1)  Includes shares beneficially owned by such persons, including shares
     underlying options granted under the Stock Option Plan.  If a person has
     the right to acquire beneficial ownership of any shares by exercise of
     options within 60 days after March 22, 1999, such shares are deemed
     beneficially owned by such person and are deemed to be outstanding solely
     for the purpose of determining the percentage of our Common Stock that such
     person owns.  Such shares are not included in the computations for any
     other person.
(2)  Includes options to purchase 45,000 shares that were exercisable on March
     22, 1999 or that become exercisable within 60 days of such date.
(3)  Includes 530,766 shares owned by CDRCO NW, L.L.C., a limited liability
     company in which Mr. Cruz holds a 50% ownership interest.
(4)  Includes options to purchase 25,000 shares that were exercisable on March
     22, 1999 or that become exercisable within 60 days of such date.
(5)  Includes 2,200 shares which are owned by Mr. Fletcher's two sons.  Mr.
     Fletcher disclaims beneficial ownership of such shares.
(6)  Includes options to purchase 5,000 shares that were exercisable on March
     22, 1999 or that became exercisable within 60 days of such date.
(7)  Includes options to purchase 100,000 shares that were exercisable on March
     22, 1999 or that become exercisable within 60 days of such date.  Mr.
     Maultsby also holds options to purchase an additional 100,000 shares that
     were not exercisable as of March 22, 1999.
(8)  Includes 867,802 shares and 156,869 shares owned by the Elliot S. Pearlman
     Living Trust dated August 7, 1992 and the Elliot S. Pearlman Living Trust
     dated July 2, 1996, respectively.

                                       40
<PAGE>
 
(9)   Includes options to purchase 41,250 shares that were exercisable on March
      22, 1999 or that become exercisable within 60 days of such date. Mr. Rhyne
      also holds options to purchase an additional 158,750 shares which were not
      exercisable as of March 22, 1999.
(10)  Excludes shares underlying options that were not exercisable as of March
      22, 1999 or within 60 days of such date.

Section 16(a) Beneficial Reporting Requirements

     Section 16(a) of the Securities Exchange Act of 1934 requires our directors
and executive officers, and persons who own more than ten percent of a
registered class of our equity securities ("Insiders"), to file with the
Securities and Exchange Commission (the "Commission") initial reports of
ownership and reports of changes in ownership of our Common Stock. Insiders are
required by the Commission's regulations to furnish us with copies of all
Section 16(a) reports filed by such persons. To our knowledge, based on our
review of the copies of such reports furnished to us during the 1998 fiscal
year, all Insiders complied with all applicable Section 16(a) filing
requirements.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
          ----------------------------------------------
     In connection with our acquisitions of Ridge, Fraser and Interstate, we
issued 82,500, 50,000 and 10,000 shares of our Common Stock to the Ridge
Pallets, Inc. Profit Sharing Plan, the Fraser Industries, Inc. Profit Sharing
Plan and the Interstate Pallet Co., Inc. Profit Sharing Plan (collectively, the
"Founding Company Plans"), respectively. Following the IPO, the Founding Company
Plans were consolidated into the PalEx, Inc. Retirement Savings Plan. Certain of
our officers and directors were participants in the Founding Company Plans and
benefit from the contribution of the Common Stock under the terms of such plans.

     In the 1998 fiscal year, Ridge sold approximately $481,000 of lumber to
Sunbelt Forest Products Corporation ("Sunbelt"), a chemical wood preserving
company that is owned by Mr. Holland and two other employees of Ridge. The sales
prices charged Sunbelt were competitive with those charged unaffiliated third
parties. If we transact business with Sunbelt in the future it will be on terms
that are comparable to those that would be applicable in transactions with
unaffiliated third parties.

     After our IPO, Interstate leased its operating facilities from Stephen C.
Sykes, President and former owner of Interstate and one of our directors. We
paid rent of approximately $52,000 for the lease of this facility in fiscal
1998. Mr. Sykes had the right to require us to purchase the property at its
appraised value. Mr. Sykes exercised his right, and we completed the acquisition
of this property in June 1998 for $1.4 million.

                                       41
<PAGE>
 
                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
          ---------------------------------------------------------------
(a)  The following documents are filed as part of this report:

     1.   Financial Statements:

          PalEx, Inc. and Subsidiaries:

          Report of independent certified public accountants
          Consolidated balance sheets
          Consolidated statements of operations
          Consolidated statements of comprehensive income
          Consolidated statements of changes in stockholders' equity
          Consolidated statements of cash flows
          Notes to consolidated financial statements

     2.   Financial Statement Schedules:

          Report of independent certified public accountants
          Schedule II - Valuation and qualifying accounts
 
     3.   Exhibits:

         Exhibit
           No.                      Description
         -------                    -----------
          3.1(1)  Amended and Restated Certificate of Incorporation
          3.2(1)  Bylaws
          4.1(1)  Specimen Common Stock Certificate
         10.1(2)  Asset Purchase Agreement, dated as of February 12, 1998, by
                  and among PalEx, Inc., Container Services Company NW
                  Acquisition, Inc., Container Services Company SW Acquisition,
                  Inc., Consolidated Drum Reconditioning Co., Inc., CDRCo. HC,
                  LLC, CDRCo. NW, LLC, CDRCo SW, LLC, Joseph Cruz and Philip
                  Freeman.
         10.2(2)  Acquisition Agreement and Plan of Reorganization, dated as of
                  February 23, 1998, by and among PalEx, Inc., Acme Acquisition,
                  Inc., Acme Barrel Company, Inc. and the stockholders named
                  therein.
         10.3(2)  Acquisition Agreement and Plan of Reorganization, dated as of
                  February 23, 1998, by and among PalEx, Inc., Acme Barrel
                  Company, Inc., ESP Realty Corp., Inc. and the Elliot Pearlman
                  Living Trust u/t/a dated July 2, 1996.
         10.4(2)  Acquisition Agreement and Plan of Reorganization, dated as of
                  February 23, 1998, by and among PalEx, Inc., Western Container
                  Acquisition, Inc., Environmental Recyclers of Colorado Inc.
                  and the individual optionees named therein.
         10.5(2)  Acquisition Agreement, dated as of February 23, 1998, by and
                  among PalEx, Inc., Western Container Acquisition, Inc. and
                  Barton A. Kaminsky.

                                       42

<PAGE>
 
         10.6(3)  Share Purchase Agreement, dated as of September 11, 1998, by
                  and among (a) PalEx, Inc., (b) 1313530 Ontario Inc., an
                  Ontario corporation that is wholly owned by PalEx, Inc., and
                  (c) 1271477 Ontario Limited, Rollem Holdings Inc., 1271478
                  Ontario Limited, 1296288 Ontario Limited, Save On Pallets
                  Ltd., Pallet Management Services Inc., The David E. Turner
                  Family Trust II, The David E. Turner Family Trust III, The
                  Enrico DiLello Family Trust II, The Enrico DiLello Family
                  Trust III, The Worden Teadsdale Family Trust, The Fraser
                  Campbell Family Trust II, The Fraser Campbell Family Trust
                  III, The John F. Campbell Family Trust II, The John F.
                  Campbell Family Trust, The Ronald Doering Family Trust, Fraser
                  Campbell, John F. Campbell, Enrice DiLello, Ronald Doering,
                  Susan Virginia Teadsdale, Worden Teadsdale, Clint Sharples and
                  David E. Turner.
         10.7(1)  Form of Employment and Noncompetition Agreement for Messrs.
                  Maultsby, Rhyne, Fletcher and Fraser (the terms of each
                  agreement are identical except for the level of compensation
                  provided for the respective individual) #
         10.8(1)  Form of Officer and Director Indemnification Agreement #
         10.9(1)  PalEx, Inc. 1996 Stock Option Plan #
        10.10(4)  Credit Agreement dated as of January 29, 1998 among PalEx,
                  Inc., the lenders party thereto and BankOne, Texas, N.A.
        10.11(4)  Form of Guaranty entered into by the Company's subsidiaries in
                  favor of Bank One, Texas, N.A.
        10.12(5)  Amended and Restated Secured Credit Agreement, dated as of
                  September 3, 1998, among PalEx, Inc., BankOne, Texas, N.A., as
                  Administrative Agent, and the lenders party thereto.
        10.13     Second Amendment to Amended and Restated Secured Credit
                  agreement, dated as of December 28, 1998, among PalEx, Inc.,
                  BankOne, Texas, N.A., as Administrative Agent, and the lenders
                  party thereto.
        10.14     Form of Employment and Noncompetition Agreement for Messrs.
                  Cruz and Freeman #
        21.1      List of subsidiaries of PalEx, Inc.
        23.1      Consent of Arthur Andersen LLP
        27.1      Financial Data Schedule

(1)  Incorporated by reference from the exhibits to the Company's Registration
     Statement on Form S-1 (Registration No. 333-18683).

(2)  Incorporated by reference from the exhibits to the Company's Current Report
     on Form 8-K (Commission File No. 000-22237) as filed with the Commission on
     February 27, 1998.

(3)  Incorporated by reference from the exhibits to the Company's Current Report
     on Form 8-K (Commission File No. 000-22237) as filed with the Commission on
     September 23, 1998.

(4)  Incorporated by reference from the exhibits to the Company's Annual Report
     on Form 10-K (Commission File No. 000-22237) as filed with the Commission
     on March 30, 1998.

(5)  Incorporated by reference from the exhibits to the Company's Quarterly
     Report on Form 10-Q (Commission File No. 000-22237) as filed with the
     Commission on November 12, 1998.

#    Management Contract

(b)  Reports on Form 8-K:

                                       43

<PAGE>
 
(i)   The Company's Current Report on Form 8-K dated February 12, 1998 and filed
      with the Commission on February 27, 1998 with respect to the acquisition
      of Consolidated Drum Reconditioning Co., Inc. and Acme Barrel Company,
      Inc. and related companies, as amended by Current Report on Form 8-K/A
      filed with the Commission on April 28, 1998.

(ii)  The Company's Current Report on Form 8-K dated September 11, 1998, and
      filed with the Commission on September 23, 1998, with respect to the
      acquisition of SMG Corporation, as amended by Current Report on Form 8-K/A
      filed with the Commission on November 25, 1998.financial information
      related to the acquisition of SGM Corporation as required by Regulation 
      S-X.

(iii) The Company's Current Report on Form 8-K dated October 23, 1998, and filed
      with the Commission on December 11, 1998, with respect to the acquisitions
      of American Pallet Recyclers, Inc., Capital Pallet, Incorporated, Pallet
      Outlet Company, Inc., Southern Pallets, Inc., Shipshewana Pallet Co.,
      Inc., Gilbert Lumber Inc., Valley Pallets, Inc., Duckert Pallet Co., Inc.,
      Continental Associated Investments, Isaacson Lumber Company, McCook Drum &
      Barrel Co., Inc. and Charlotte Steel Drum Company.

                                       44

<PAGE>
 
SIGNATURES

     Pursuant to the requirements of the 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, in the City of
Houston, State of Texas, on March 29, 1999.

                            PALEX, INC.

                            By: /s/ Vance K. Maultsby, Jr.
                                --------------------------
                                Vance K. Maultsby, Jr.
                                Chief Executive Officer

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

<TABLE> 
<CAPTION> 
<S>                                  <C>                                                      <C>

/s/ VANCE K. MAULTSBY, JR.           Chief Executive                                          March 29, 1999
--------------------------           Officer (Principal Executive Officer) 
Vance K. Maultsby, Jr.               
 
/s/ CASEY A. FLETCHER                Chief Accounting Officer                                 March 29, 1999
--------------------------           (Principal Financial and Accounting Officer) 
Casey A. Fletcher                    
 
/s/ TUCKER S. BRIDWELL               Director                                                 March 29, 1999
--------------------------
Tucker S. Bridwell
 
/s/ A. JOSEPH CRUZ                   Director                                                 March 29, 1999
--------------------------
A. Joseph Cruz
 
/s/ JOHN E. DRURY                    Director                                                 March 29, 1999
--------------------------
John E. Drury
 
/s/ TROY L. FRASER                   Director                                                 March 29, 1999
--------------------------
Troy L. Fraser
 
/s/ A.E. HOLLAND, JR.                Director                                                 March 29, 1999
--------------------------
A.E. Holland, Jr.
 
/s/ SAM W. HUMPHREYS                 Director                                                 March 29, 1999
--------------------------
Sam W. Humphreys
 
/s/ ELLIOT S. PEARLMAN               Director                                                 March 29, 1999
--------------------------
Elliot S. Pearlman
 
/s/ STEPHEN C. SYKES                 Director                                                 March 29, 1999
--------------------------
Stephen C. Sykes
</TABLE>

                                       45

<PAGE>
 
                         INDEX TO FINANCIAL STATEMENTS

                                                                     PAGE
                                                                     ----
PALEX, INC. AND SUBSIDIARIES
   Report of Independent Public Accountants.........................  F-2
   Consolidated Balance Sheets......................................  F-3
   Consolidated Statement of Operations.............................  F-4
   Consolidated Statements of Comprehensive Income..................  F-5
   Consolidated Statements of Changes in Stockholders' Equity.......  F-6
   Consolidated Statements of Cash Flows............................  F-7
   Notes to Consolidated Financial Statements.......................  F-8

                                      F-1
<PAGE>
 
              REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Board of Directors of PalEx, Inc.:

We have audited the accompanying consolidated balance sheets of PalEx, Inc. (a
Delaware corporation) and subsidiaries as of December 28, 1997, and December 27,
1998, and the related consolidated statements of operations, comprehensive
income, changes in stockholders' equity and cash flows for the years ended
November 30, 1996, December 28, 1997, and December 27, 1998, and the one-month
period ended December 31, 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the  financial position of PalEx, Inc. and subsidiaries
as of December 28, 1997, and December 27, 1998, and the results of their
operations and their cash flows for the years ended November 30, 1996, 
December 28, 1997, and December 27, 1998, and the one month period ended 
December 31, 1996, in conformity with generally accepted accounting principles.


ARTHUR ANDERSEN LLP

Tampa, Florida
February 26, 1999 

                                      F-2
<PAGE>
 
<TABLE>
<CAPTION>
                                       PALEX, INC. AND SUBSIDIARIES
                                        CONSOLIDATED BALANCE SHEETS
                                     (In thousands, except share data)
 
                      ASSETS                                     December 28, 1997    December 27, 1998
                      ------                                     -----------------    -----------------
<S>                                                              <C>                 <C>
CURRENT ASSETS:                                                                     
   Cash and cash equivalents                                          $  7,448              $  4,157
   Accounts receivable, net of allowances of $617 and $1,616            21,592                44,543
   Inventories                                                          20,383                29,986
   Deferred income taxes                                                   945                 2,105
   Prepaid expenses and other current assets                             3,387                 4,427
                                                                      --------              --------
      Total current assets                                              53,755                85,218
                                                                                    
PROPERTY, PLANT AND EQUIPMENT, net                                      37,850                75,724
GOODWILL, net of accumulated amortization of $593 and $3,570            26,262               127,234
OTHER ASSETS                                                             2,138                 4,262
                                                                      --------              --------
      Total assets                                                    $120,005              $292,438
                                                                      ========              ========
                                                                                    
          LIABILITIES AND STOCKHOLDERS' EQUITY                                                
          ------------------------------------                                                                          
CURRENT LIABILITIES:                                                                
   Line of credit                                                     $  1,150              $      -
   Current maturities of long-term debt                                  1,057                 1,960
   Bank overdraft                                                            -                 8,407
   Accounts payable                                                      9,342                 9,004
   Accrued expenses                                                      5,094                10,646
   Income taxes payable                                                  1,407                   529
                                                                      --------              --------
      Total current liabilities                                         18,050                30,546
                                                                                    
LONG-TERM DEBT, net of current maturities                               30,673               143,902
CONVERTIBLE NOTES PAYABLE TO RELATED PARTIES                                 -                 9,910
DEFERRED INCOME TAXES                                                    3,167                 5,350
FOREIGN DEFERRED INCOME TAXES                                                -                 3,957
OTHER LONG-TERM LIABILITIES                                                678                 3,493
COMMITMENTS AND CONTINGENCIES                                                       
STOCKHOLDERS' EQUITY:                                                               
   Common stock, $.01 par value; 30,000,000 shares authorized;                         
     17,644,520 and 20,289,091 shares outstanding                          176                   203
   Capital in excess of par value                                       54,107                79,030
   Unearned compensation                                                (1,770)               (1,770)
   Accumulated other comprehensive income (loss):                                      
     Foreign currency translation adjustment                                 -                  (623)
   Retained earnings                                                    14,924                18,440
                                                                      --------              --------
      Total stockholders' equity                                        67,437                95,280
                                                                      --------              --------
      Total liabilities and stockholders' equity                      $120,005              $292,438
                                                                      ========              ========
</TABLE>

                The accompanying notes are an integral part of 
                   these consolidated financial statements.

                                      F-3
<PAGE>
 
                          PALEX, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                (In thousands, except share and per share data)


<TABLE> 
<CAPTION> 
                                                            One Month                                      
                                          Year Ended       Period Ended    Year Ended     Year Ended       
                                          November 30,     December 31,    December 28,   December 27,     
                                             1996              1996           1997           1998          
                                          ------------     ------------    ------------   ------------     
<S>                                             <C>              <C>              <C>           <C>                
REVENUES                                   $145,030           $3,828         $222,993       $319,691       
COST OF GOODS SOLD                          121,865            3,121          188,084        259,562       
INVENTORY VALUATION                                                                                        
 ADJUSTMENT                                       -                -                -          1,235       
                                           --------           ------         --------       --------
Gross Profit                                 23,165              707           34,909         58,894       
SELLING, GENERAL AND                                                                                       
 ADMINISTRATIVE EXPENSES                     14,063              749           20,135         33,042       
GOODWILL AMORTIZATION                             -                -              593          2,977       
POOLING EXPENSES                                  -                -                -          1,841       
COMPENSATION DIFFERENTIAL                         -                -            1,020          1,062       
RESTRUCTURING CHARGE                              -                -                -            949       
PLANT CLOSURE COSTS AND ASSET                                                                              
 ABANDONMENT LOSS                                 -                -                -          1,369       
                                           --------           ------         --------       --------
Income (loss) from operations                 9,102              (42)          13,161         17,654       
INTEREST EXPENSE                             (1,576)             (25)          (1,722)        (8,468)      
OTHER INCOME (EXPENSE), NET                     346                1              (95)           (95)      
                                           --------           ------         --------       --------
INCOME (LOSS) BEFORE PROVISION   
 FOR INCOME TAXES                             7,872              (66)          11,344          9,091
PROVISION FOR INCOME TAXES                    1,833                -            4,704          5,105
                                           --------           ------         --------       --------
NET INCOME (LOSS)                          $  6,039           $  (66)        $  6,640       $  3,986
                                           ========           ======         ========       ========
Net income (loss) per share-basic          $    .64           $ (.01)        $    .43       $    .21
                                           ========           ======         ========       ========
Net income (loss) per share-diluted        $    .64           $ (.01)        $    .42       $    .21
                                           ========           ======         ========       ========
Shares used in computing net income
 (loss) per share-basic                   9,433,414        9,433,414       15,561,489     18,937,354
                                          =========        =========       ==========     ==========
Shares used in computing net
 income (loss) per share-diluted          9,433,414        9,433,414       15,914,157     19,310,295
                                          =========        =========       ==========     ==========
</TABLE> 
The accompanying notes are an integral part of these consolidated financial
statements.

                                      F-4
<PAGE>
 
                          PALEX, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
                                 (In thousands)
<TABLE>
<CAPTION>
 
                                                                    One Month
                                               Year Ended         Period Ended        Year Ended          Year Ended
                                            November 30, 1996  December 31, 1996   December 28, 1997  December 27, 1998
                                            -----------------  -----------------   -----------------  -----------------
<S>                                         <C>                <C>                 <C>                <C>
Net income (loss)                               $6,039               $(66)             $6,640             $3,986
Other comprehensive income (loss):            
 Foreign currency translation adjustment             -                  -                   -               (623)
                                                ------               ----              ------             ------
Comprehensive income (loss)                     $6,039               $(66)             $6,640             $3,363
                                                ======               ====              ======             ====== 
</TABLE>
    The accompanying notes are integral part of these consolidated financial
                                  statements.

                                      F-5
<PAGE>
 
                          PALEX, INC. AND SUBSIDIARIES
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
                                 (In thousands)

<TABLE> 
<CAPTION> 
                                                                                                        Accumulated  
                                  Common Stock      Capital in                                             Other          Total     

                                ----------------    Excess of       Unearned     Retained   Treasury   Comprehensive  Stockholders' 

                                Shares    Amount    Par Value     Compensation   Earnings    Stock     Income (loss)     Equity    
                                ------    ------    ----------    ------------   --------   --------   -------------  ------------- 

<S>                             <C>        <C>          <C>             <C>      <C>        <C>        <C>            <C> 
BALANCE, November 30, 1995       9,433     $  94       $ 5,232        $ (2,260)  $ 16,834    $  (876)          $   -      $  19,024
Distributions to stockholders, 
 net                                 -         -             -               -     (2,229)         -               -         (2,229)

Capital contributions equal to 
 the current income taxes of 
 S corporations                      -         -         1,329               -          -          -               -          1,329
Shares released under leveraged 
 ESOP plan                           -         -             -             280          -          -               -            280
Net income                           -         -             -               -      6,039          -               -          6,039
                                ------     -----       -------          -------   --------     -----           -----       --------
BALANCE, November 30, 1996       9,433        94         6,561          (1,980)    20,644       (876)              -         24,443
Issuance of common stock:
 Shares issued to profit 
  sharing plans                    143         1           800               -          -          -               -            801
 Public offering, net of 
  offering costs                 3,450        35        23,529               -          -          -               -         23,564
 Acquisition of founding 
  companies                      4,087        41        17,228               -          -          -               -         17,269
 Acquisition of purchased 
  company                          286         3         4,457               -          -          -               -          4,460
 Acquisition of pooled company
  at inception                     245         2            92               -        497          -               -            591
Retire treasury shares               -         -             -               -       (876)       876               -              -
Capital contributions                -         -           231               -          -          -               -            231
Capital contributions equal to 
 the current income taxes of 
 S corporations                      -         -         1,209               -          -          -               -          1,209
Distributions to stockholders, 
 net                                 -         -             -               -    (12,382)         -               -        (12,382)

Net loss for the one-month 
 period ended December 31, 1996      -         -             -               -        (66)         -               -            (66)

Adjustment to conform year-end 
 of pooled companies                 -         -             -               -        467          -               -            467
Shares released under leveraged 
 ESOP plan                           -         -             -             210          -          -               -            210
Net income, year ended
 December 28, 1997                   -         -             -               -       6,640         -               -          6,640
                                ------     -----       -------          -------   --------     -----           -----       --------
BALANCE, December 28, 1997      17,644       176        54,107           (1,770)    14,924         -                         67,437
Issuance of common stock: 
 Acquisition of purchased 
  companies                      2,639        27        25,502                -          -         -               -         25,529
 Exercise of stock options           6         -            49                -          -         -               -             49
Purchase of minority
 interest in pooled company          -         -          (751)               -          -         -               -           (751)

Capital contribution                 -         -           123                -          -         -               -            123
Foreign currency translation 
 adjustment                          -         -             -                -          -         -            (623)          (623)

Adjustment to conform year end 
 of pooled companies                 -         -             -                -       (470)        -               -           (470)

Net income                           -         -             -                -      3,986         -               -          3,986
                                ------     -----       -------          -------   --------     -----           -----       --------
BALANCE, December 27, 1998      20,289     $ 203       $79,030          $(1,770)  $ 18,440     $   -           $(623)      $ 95,280
                                ======     =====       =======          =======   ========     =====           =====       ========
</TABLE> 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-6
<PAGE>
 
                          PALEX, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)
<TABLE>
<CAPTION>
                                                   Year Ended           One Month           Year Ended       Year Ended  
                                                   November 30,        Period Ended        December 28,      December 27, 
                                                      1996           December 31, 1996        1997              1998     
                                                   ------------      -----------------     ------------      -----------  
<S>                                                <C>               <C>                   <C>              <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)                                     $ 6,039              $ (66)           $  6,640         $   3,986
Net loss for Fraser for the one month
 transition period                                          -                  -                 (66)                -
Adjustment to conform year-end of pooled
 companies                                                  -                  -                 467              (470)
Unearned compensation                                     280                  -                 210                 -
Cash acquired from pooled company at inception              -                  -                  51                 -
Adjustments to reconcile net income (loss) to
 net cash provided  by (used in) operating
 activities:
 Depreciation and amortization                          3,432                 99               5,558            11,308
 Loss on sale of property, plant and equipment             29                  -                 400             1,135
 Foreign currency translation adjustment                    -                  -                   -              (623)
 Capital contributions equal to the current
  income taxes of S corporations                        1,329                  -               1,209                 -
 Deferred tax provision (benefit)                         134                  -                 (86)            1,207
Changes in operating assets and liabilities
 net of  purchased companies:
 Accounts receivable                                   (1,045)              (387)             (1,632)           (7,302)
 Inventories                                              282               (486)             (5,458)              509
 Prepaids and other current assets                       (404)                80              (1,478)              (23)
 Other assets                                          (1,173)                 1               1,370               242
 Accounts payable                                       1,599                434                  51             1,703
 Accrued expenses                                       1,626               (402)             (2,155)             (869)
 Income taxes payable                                      66                  -               1,135              (878)
 Deferred revenue                                         (78)                (2)                147               285
 Other liabilities                                          -                  -                   -             2,747
                                                      -------              -----            --------         ---------
Net cash provided by (used in) operating
 activities                                            12,116               (729)              6,363            12,957
                                                      -------              -----            --------         ---------
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 Purchase of property, plant and equipment             (7,355)               (92)             (9,149)          (13,951)
 Purchase of minority interest in pooled
  company                                                   -                  -                   -              (751)
 Cash paid for purchased companies, net of
  cash acquired                                             -                  -              (4,607)          (85,512)
                                                      -------              -----            --------         ---------
Net cash used in investing activities                  (7,355)               (92)            (13,756)         (100,214)
                                                      -------              -----            --------         ---------
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 Net payments on lines of credit                       (3,535)                 -                (365)           (1,150)
 Net proceeds (payments) on notes payable to
  related parties                                         555                  -              (2,980)                -
 Proceeds from debt                                     6,801                821              32,787           170,675
 Payments on debt                                      (6,642)                 -             (28,648)          (59,064)
 Payment of acquired indebtedness of purchased
  companies                                                 -                  -                   -           (26,667)
 Net proceeds from exercise of stock options                -                  -                   -                49
 Net proceeds from issuance of common stock                 -                  -              23,564                 -
 Other capital contributions                                -                  -                   -               123
 Distributions to stockholders                         (2,230)                 -             (12,382)                -
                                                      -------              -----            --------         ---------
Net cash provided by (used in) financing
 activities                                            (5,051)               821              11,976            83,966
                                                      -------              -----            --------         ---------
 
NET INCREASE (DECREASE) IN CASH AND CASH
 EQUIVALENTS                                             (290)                 -               4,583            (3,291)
CASH AND CASH EQUIVALENTS, beginning of period          3,155                  -               2,865             7,448
                                                      -------              -----            --------         ---------
CASH AND CASH EQUIVALENTS, end of period              $ 2,865              $   -            $  7,448         $   4,157
                                                      =======              =====            ========         =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
 INFORMATION:
 
  Cash paid for interest                              $ 1,703              $  25            $  1,710         $   7,474
                                                      =======              =====            ========         =========
  Cash paid for income taxes                          $ 1,008              $   -            $  1,835         $   4,776
                                                      =======              =====            ========         =========
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING
 AND FINANCING ACTIVITIES:
  Convertible notes payable issued in business
   acquisitions                                       $     -              $   -            $      -         $   9,910
                                                      =======              =====            ========         =========
</TABLE> 
  The accompanying notes are an integral part of these consolidated financial
                                   statements

                                      F-7
<PAGE>
 
                          PALEX, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  BUSINESS AND ORGANIZATION:

     PalEx, Inc. ("PalEx" or the "Company") was founded in January 1996 to
create a nationwide provider of pallet products and related services. On March
25, 1997, concurrently with the closing of PalEx's initial public offering (the
"Offering") of its common stock, par value $.01 per share (the "Common Stock"),
PalEx and separate wholly owned subsidiaries of PalEx acquired, in separate
transactions (the "Acquisitions"), the following three businesses: Fraser
Industries, Inc. ("Fraser"), Ridge Pallets, Inc. ("Ridge"), and Interstate
Pallet Co., Inc. ("Interstate"), collectively referred to as the "Founding
Companies." The consideration for the acquisitions of the Founding Companies
consisted of a combination of cash and Common Stock.

     Subsequent to the acquisition of the Founding Companies and the Offering,
and during fiscal 1997, PalEx acquired 5 additional companies. Sheffield Lumber
& Pallet Company, Inc. ("Sheffield"), Sonoma Pacific Company ("Sonoma"), Bay
Area Pallet ("Bay Area") and New London Pallet ("New London") were accounted for
as poolings-of-interests (the "Pooled Companies"). The fifth acquisition,
Summers Pallet Manufacturing, Inc. ("Summers"), was accounted for as a purchase.

     During fiscal 1998, the Company acquired 19 additional companies, 4 of
which, Acme Barrel Company, Inc. ("Acme"), Drum Service Co. of Florida ("DSF"),
Consolidated Container Corporation ("CCC") and Western Container, Limited
Liability Company ("Western"), were accounted for as poolings-of-interests (the
"1998 Pooled Companies"). The other 15 companies, Consolidated Drum
Reconditioning, Inc. ("CDR"), American Pallet Recyclers, Inc. ("APR"), Capital
Pallet, Incorporated ("Capital"), Pallet Outlet Company, Inc. ("POC"), Southern
Pallets, Inc. ("Southern"), Shipshewana Pallet Co., Inc. ("Shipshewana"),
Gilbert Lumber Inc. ("Gilbert"), Valley Pallets, Inc. ("Valley"), Duckert Pallet
Co., Inc. ("Duckert"), Continental Associated Investments ("Continental"),
Isaacson Lumber Company ("Isaacson"), McCook Drum & Barrel Co., Inc. ("McCook"),
Charlotte Steel Drum ("CSD"), Atlas Drum ("Atlas") and SMG Corporation ("SMG")
were accounted for as purchases (the "1998 Purchased Companies" and, together
with Summers, the "Purchased Companies"). Eight of the 19 companies acquired in
fiscal 1998 are engaged in the reconditioning and rebuilding of industrial steel
containers. SMG is engaged in the rental of pallets in Canada.

     The Company's headquarters are in Houston, Texas, with significant
manufacturing operations located in Arkansas, California, Florida, Georgia,
Illinois, North Carolina, Ohio, Pennsylvania, Texas and Wisconsin and pallet
leasing operations in 7 Canadian provinces. Sales are made throughout the United
States and Canada with significant concentrations in the southeastern,
midwestern and western regions of the United States serving primarily
agricultural and industrial customers. The Company's pallet leasing operations
serve six Canadian provinces. Revenues related to the agricultural customers are
highly seasonal, occurring primarily during the harvesting season.

     Unless the context otherwise requires, all references herein to the Company
include PalEx, the Founding Companies, the Pooled Companies, the 1998 Pooled
Companies and the Purchased Companies.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Basis of Presentation

     Fraser has been identified as the accounting acquiror for financial
statement presentation purposes. The acquisitions of Ridge, Interstate and the
Purchased Companies were accounted for using the purchase method of accounting.
The allocations of the purchase price to the assets acquired and liabilities
assumed have been assigned and recorded based on estimates of fair value and
will be adjusted to reflect changes in the estimates of fair value, although the
Company does not believe those changes will be material. The accompanying
consolidated financial statements present Fraser combined with the Pooled
Companies and the 1998 Pooled Companies for all periods, and include Ridge,
Interstate and the Purchased Companies from their respective dates of
acquisition. All significant 

                                      F-8
<PAGE>
 
intercompany transactions and balances have been eliminated in consolidation.
Certain reclassifications have been made to prior year consolidated financial
statements to conform with the current-year presentation.

     The Pooled Companies previously reported on a calendar year-end. As such,
the accounts of these companies for their 1996 calendar year have been
consolidated with the accounts of PalEx as of and for the year ended November
30, 1996. Acme, DSF and CCC previously reported on year-ends of April 30,
October 31 and November 30, respectively. The results of operations for Acme
have been conformed to the fiscal-year end of PalEx for 1997. Revenues and net
loss for the four month period ended April 30, 1997 were approximately
$8,445,000 and $467,000, respectively. Acme's net loss for the four-month
transition period is included as an adjustment to the consolidated statements of
stockholders' equity and cash flows for the year ended December 28, 1997. Acme's
results of operations for its year ended April 30, 1997 has been included in the
Company's consolidated statement of operations for the year ended November 30,
1996. The results of operations included herein for the years ended November 30,
1996 and December 28, 1997 include DSF and CCC for their respective twelve-month
periods ended October 31, 1996 and 1997 and November 30, 1996 and 1997. An
adjustment has been made to the accompanying consolidated statements of
stockholders' equity and cash flows for the year ended December 27, 1998, to
reflect the net loss for the transition periods of DSF and CCC. Revenues and
net loss for DSF and CCC for the transition period were approximately
$3,075,000 and $470,000, respectively.

Fiscal Year

     During 1997, PalEx changed its year-end to the last Sunday in the calendar
year from November 30. Accordingly, it maintains its accounting records using a
52/53-week year ending on the last Sunday in December. Each quarter contains 13
weeks, unless otherwise noted. The accompanying consolidated financial
statements include the statement of operations and cash flows for the one-month
period ended December 31, 1996, representing the income and cash flows of
Fraser, the accounting acquiror, for this one-month transition period.

Cash and Cash Equivalents

     The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents.

Inventories

     Inventories are valued at the lower of cost or market, with cost determined
on a first-in, first-out basis or by specific identification. The cost of
finished goods inventory includes direct materials, direct labor and overhead.

Property, Plant and Equipment

     Property, plant and equipment acquired in purchase business combinations is
recorded at fair value. Property, plant, and equipment acquired subsequently is
carried at cost. Depreciation and amortization are provided for in amounts
sufficient to relate the cost of depreciable assets to operations over their
estimated service lives. The Company's capital leases are insignificant. The
straight-line method of depreciation is utilized for substantially all assets
for financial reporting purposes, but accelerated methods are used for tax
purposes.

     The Company's rental pool consists of a pallet rental pool at its Canadian
operations and industrial bulk containers at one of the drum operations. Where
the Company repairs its own pallets or reuses industrial containers, cost
includes materials plus direct labor and applicable overhead. The rental pool is
being depreciated to estimated salvage value using the straight line method over
lives ranging from 3 to 10 years.

     Expenditures for maintenance and repairs are charged to expense as
incurred. Additions and major replacements or betterments that increase capacity
or extend useful lives are added to the cost of the asset. Upon sales or
retirement of property, plant and equipment, the cost and related accumulated
depreciation are eliminated from the respective accounts and the resulting gain
or loss is included in other income (expense), net, in the accompanying
consolidated statements of operations.

                                      F-9
<PAGE>
 
     In 1996, the Company adopted Statement of Financial Accounting Standards
("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of" ("SFAS No. 121").  SFAS No. 121 establishes
the recognition and measurement standards related to the impairment of long-
lived assets. The Company periodically assesses the realizability of its long-
lived assets pursuant to the provisions of SFAS No. 121 and has determined that
no impairments would have been recognized under SFAS No. 121, other than those
related to the termination of the Company's relationship with CHEP USA ("CHEP"),
as discussed in Note 11.

Goodwill

     Goodwill, which represents the excess of acquisition cost over the fair
market value of identified net assets acquired in business combinations
accounted for as purchases, is amortized using the straight-line method over 30
years. The Company evaluates on a regular basis whether events and circumstances
have occurred that indicate that the carrying amount of goodwill may warrant
revision. Management believes that there has been no impairment of the goodwill
as reflected in the Company's consolidated financial statements as of December
27, 1998.

Income Taxes

     The Company uses the liability method of accounting for income taxes,
wherein deferred tax assets and liabilities are recognized for future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using tax
rates expected to apply to taxable income in the years in which those temporary
differences are expected to reverse. The effect of a change in tax rates on
deferred tax assets and liabilities is recognized in income in the period that
includes the enactment date.

     Deferred income taxes were not provided on the undistributed foreign
earnings of SMG because such earnings are expected to be reinvested
indefinitely.

     The stockholders of Fraser and three of the four Pooled Companies elected
to be taxed under the provisions of Subchapter S of the Internal Revenue Code
prior to their acquisition by the Company. Under these provisions, these
companies did not pay federal and certain state income taxes. Instead, these
companies' respective stockholders paid income taxes on their proportionate
shares of the companies' net earnings. The S Corporation status of Fraser and
the applicable Pooled Companies was terminated effective with the combination
with PalEx, and the Company is now subject to federal and state income taxes.
The Company recorded a charge to income tax expense of approximately $488,000 on
March 25, 1997, representing income taxes at that date which were not previously
recorded because of Fraser's status under Subchapter S.

     For purposes of these consolidated financial statements, federal and state
income taxes have been provided for the net income of the applicable Pooled
Companies as if these companies had filed C Corporation tax returns for the
preacquisition periods. The current income tax expense of the applicable Pooled
Companies is reflected in the consolidated financial statements in the provision
for income taxes and as an increase to capital in excess of par value.

Revenue Recognition

     The Company recognizes revenue upon delivery of the product to the
customer.

Fair Value of Financial Instruments

     SFAS No. 107, "Disclosures About Fair Values of Financial Instruments", and
SFAS No. 119, "Disclosures About Derivative Financial Instruments and Fair Value
of Financial Instruments", require the disclosure of the fair value of financial
instruments, both assets and liabilities recognized and not recognized on the
balance sheet, for which it is practicable to estimate fair value. The carrying
value of the Company's financial instruments approximates fair value.

                                      F-10
<PAGE>
 
Foreign Currency Translation

     The financial statements of the Company's Canadian subsidiary are
translated to U.S. dollars using the exchange rate as of the balance sheet date
for assets and liabilities and a weighted average exchange rate for the reported
amount of revenues, expenses, gains and losses during the reporting period. The
cumulative translation adjustment is recorded as a separate component of
stockholders' equity.

Use of Estimates

     The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires the use of estimates and
assumptions by management in determining the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the consolidated financial statements and the reported amount of revenues and
expenses during the reporting period. Although the Company reviews all
significant estimates affecting its consolidated financial statements on a
recurring basis and records the estimated effect of any necessary adjustments
prior to their publication, actual results could differ from these estimates.

Earnings Per Share

     In February 1997, the Financial Accounting Standards Board issued SFAS No.
128, "Earnings Per Share" ("SFAS No. 128"). The Company adopted SFAS No. 128 for
the year ended December 28, 1997. Under SFAS No. 128, net income per share -
basic excludes dilution and is determined by dividing income available to common
stockholders by the weighted average number of common shares outstanding during
the period. Net income per share - diluted reflects the potential dilution that
could occur if securities and other contracts to issue common stock were
exercised or converted into common stock. Net income per share - diluted is
computed similarly to fully diluted net income per share under previous
accounting rules.

     Net income per share - basic and diluted was computed using 9,433,414
shares (the aggregate number of shares attributable to Fraser and the shares
issued in acquisitions accounted for under the pooling-of-interests method) for
the year ended November 30, 1996 and the one-month transition period ended
December 31, 1996. Net income per share - basic for the year ended December 28,
1997 was computed using, in addition to the aforementioned shares, 6,128,075
weighted average shares issued in consideration for the acquisition of Ridge,
Interstate and Summers, the shares issued pursuant to the Offering and
overallotment option, the shares issued to Main Street Capital Partners, L.P.
and to PalEx management, the shares issued to the profit sharing plans of the
Founding Companies and the shares issued in the acquisition of one of the 1998
Pooled Companies, deemed to have been acquired at its date of inception in 1997.

     Net income per share - basic for the year ended December 27, 1998 was
computed using 17,644,521 shares issued in consideration for the acquisition of
the Founding Companies, the Pooled Companies, the 1998 Pooled Companies and
Summers, the shares issued pursuant to the Offering and overallotment option,
shares issued to Main Street Capital Partners, L.P. and to PalEx management, the
shares issued to the profit sharing plans of the Founding Companies and
1,292,833 weighted average shares issued for the acquisition of the 1998
Purchased Companies and exercise of stock options.

     Net income per share - diluted for the years ended December 28, 1997 and
December 27, 1998 includes 352,668 and 372,941 shares, respectively, for
unexercised stock options computed under the treasury method. The weighted
average shares for 1998 includes as common stock equivalents those shares of the
Company's Canadian subsidiary which are convertible on a share for share basis
into the common stock of the Company. The effect of the conversion of the
Company's outstanding convertible notes payable was anti-dilutive for the year
ended December 27, 1998, and therefore not included in the calculation of net
income per share - diluted.

                                      F-11
<PAGE>
 
     The following stock options were outstanding as of the end of the fiscal
years but were not included in the computation of net income per share - diluted
because the options' exercise prices were greater than the average market price
of the common shares:
<TABLE> 
<CAPTION> 
                                                              Year ended:
                                        --------------------------------------------------------
                                        December 28, 1997                      December 27, 1998
                                        -----------------                      ----------------- 
<S>                                     <C>                                    <C>       
Number of options                           292,000                                1,056,000
Exercise price (range)                  $11.38-$14.75                           $10.25-$14.88
Expiration date (range)        August 1, 2007-December 10, 2007            June 6, 2007-May 21, 2008
 
</TABLE>

Concentrations of Risk

      Materials

      Pallet prices are closely related to the changing costs and availability
of lumber, the principal raw material used in the manufacture and repair of
wooden pallets. Lumber supplies and costs are affected by many factors including
weather, governmental regulation of logging on public lands, lumber agreements
between Canada and the United States and competition from other industries that
use similar grades and types of lumber.

     Drum demand in certain regions of the United States has required more drums
to be shipped outside of the region than are shipped into the region.
Consequently, the acquisition costs of used drums, the primary raw materials for
reconditioned drums, in these regions are significantly higher since the used
drum deficit must be replaced by collecting and shipping used drums over
significant distances. The West Coast and Southeast are regions that tend to be
net exporters of open top drums because of their emphasis on agriculture. The
Midwest tends to be a significant accumulator of drums because of its greater
industrial content and usage of petroleum products, coatings and chemicals.

     Markets

     Markets for pallet manufacturing and pallet recycling are highly fragmented
and competitive. These markets are not capital-intensive and barriers to entry
in such businesses are minimal.

     Markets for steel drum reconditioning are highly fragmented and
competitive. There are three significant barriers to entry in the steel drum
reconditioning industry: (i) regulatory permits for facilities and ongoing
compliance requirements, (ii) significant distribution barriers as a result of
high transportation costs for containers and (iii) capital-intensive nature of
the business.

     Vendors

     During the year ended December 27, 1998, the Company purchased
approximately 13% of its lumber from two vendors.

     Customers

     The Company seeks to efficiently serve large numbers of customers across
diverse markets and industries to provide a stable and diversified base for
ongoing sales of products and services in all of its operations.

     Customers of the Company include companies in the automotive, chemical,
consumer products, grocery, produce and food production, petroleum, paper and
forest products, retail, and steel and metals industries and are both regional
and national in scale. Because a significant part of the Company's products and
services are sold to customers engaged in the produce and citrus industries, the
Company's sales volumes in certain regions tend to be seasonal.

                                      F-12
<PAGE>
 
     On April 29, 1998 the Company notified its largest customer, CHEP, that
PalEx was terminating all its existing agreements with CHEP (also see Note 11).
CHEP operates a national pallet leasing program that provides 48" x 40" pallets
primarily to grocery and consumer products customers throughout the U.S. for a
daily fee. The Company manufactured and repaired pallets for CHEP and provided a
variety of logistical services with respect to CHEP's pallet leasing program,
including the storage and just-in-time delivery of pallets. Sales to CHEP were
approximately 21 percent, 26 percent and 8 percent of the Company's
consolidated revenues in 1996, 1997, and 1998, respectively.

     The Company sold approximately $490,000 and $481,000 of lumber to a 
corporation owned by a board director and two other employees during the fiscal 
years 1997 and 1998, respectively. Management believes the sales prices 
approximate those charged to unaffiliated third parties. 

Recent Accounting Pronouncements

     Comprehensive Income

     In 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income"
("SFAS No. 130").  This statement establishes rules for the reporting of
comprehensive income and its components.  The Company's comprehensive income
consists of net income and foreign currency translation adjustments and is
presented in the accompanying consolidated statements of comprehensive income.
The adoption of SFAS No. 130 had no impact on total stockholders' equity.  The
Company had no other comprehensive income prior to 1998.

     Segment Information

     The Company operates in two business segments; pallet manufacturing and
recycling and steel drum reconditioning, and follows the reporting requirements
of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information" (see Note 12).

3.  BUSINESS COMBINATIONS:

1997 Purchase Acquisitions

     The acquisitions of Ridge, Interstate and Summers in 1997 were accounted
for as purchases and have been reflected in the Company's consolidated financial
statements from March 31, 1997 for Ridge and Interstate and from November 20,
1997 for Summers. The aggregate consideration paid in these transactions was
approximately $4.6 million in cash and 3,301,971 shares of commons stock with an
estimated fair value of approximately $21.7 million. The accompanying
consolidated balance sheet as of December 28, 1997 includes allocations of the
respective purchase prices of Ridge, Interstate and Summers. The allocations
resulted in approximately $25.2 million of goodwill, which represents the excess
of purchase price over the fair value of net assets acquired, as follows (in
thousands):

      Goodwill                           $ 25,241
      Fair value of assets acquired        20,503
      Liabilities assumed                 (19,408)
      Fair value of common stock          (21,729)
                                         --------
      Cash paid, net of cash acquired    $  4,607
                                         ========

                                      F-13
<PAGE>
 
1998 Purchase Acquisitions

     The acquisitions of the 1998 Purchased Companies were accounted for as
purchases and have been reflected in the Company's financial statements from the
date of each respective acquisition. The aggregate consideration paid in these
transactions was approximately $85.5 million in cash, 2,638,571 shares of common
stock with an estimated fair value of approximately $25.5 million and issuance
of convertible notes payable to former shareholders of approximately $9.9
million. The accompanying consolidated balance sheet as of December 27, 1998
includes allocations of the respective purchase prices of the 1998 Purchased
Companies. The allocations resulted in approximately $103.9 million in goodwill,
which represents the excess of purchase price over the fair value of net assets
acquired, as follows (in thousands):
 
 
      Goodwill                            $103,949
      Fair value of assets acquired         62,602 
      Convertible notes payable issued      (9,910)
      Liabilities assumed                  (45,597)
      Fair value of common stock           (25,532)
                                          --------
      Cash paid, net of cash acquired     $ 85,512  
                                          --------

Pro Forma Presentation

     The following table sets forth unaudited pro forma statements of operations
data of the Company which reflects adjustments to the consolidated financial
statements to present the effect of the acquisitions of Ridge, Interstate and
the Purchased Companies as if the acquisitions were effective January 1, 1997
(amounts in thousands, except per share data):
 
                                                Year Ended
                                                ----------
                                  December 28, 1997      December 27, 1998
                                  -----------------      -----------------
                                                (unaudited)
Revenues                              $379,534                $379,854
                                  =================      =================
Net Income                            $ 10,574                $  6,512
                                  =================      =================
Net Income per share - diluted        $    .52                $    .32
                                  =================      =================

     Pro forma adjustments included in the amounts above primarily relate to
adjustments to selling, general and administrative expenses for changes in the
compensation level of the owners of the acquired businesses, adjustments to
interest expense attributable to incremental borrowing levels and incremental
interest rate levels, amortization of goodwill and adjustment to the income tax
provisions based on pro forma operating results.  Net income per share - diluted
assumes all shares had been outstanding for the periods presented, except for
shares issued pursuant to the over-allotment option and those shares issued to
the profit-sharing plans of the Founding Companies, which are included only from
their date of issuance.

     The unaudited pro forma data presented above is not necessarily indicative
of actual results that might have occurred had the operations and management
teams of PalEx, the Founding Companies, the Pooled Companies, the 1998 Pooled
Companies and the Purchased Companies been combined at the beginning of each
period presented.

                                      F-14
<PAGE>
 
4.  PROPERTY, PLANT AND EQUIPMENT:

     Property, plant and equipment consist of the following (in thousands):

<TABLE> 
<CAPTION> 
                                    Estimated Useful 
                                     Lives In Years      December 28, 1997     December 27, 1998
                                    ----------------     -----------------     -----------------
     <S>                            <C>                  <C>                   <C>
     Land                                                   $  3,273               $  5,485
     Machinery and equipment               5-10               48,089                 60,753
     Rental assets                         3-10                    -                 15,537
     Buildings                            15-40               12,977                 19,890
     Furniture and fixtures                 5-8                1,706                  3,890
     Tractors and trailers                  5-6               10,636                 18,122
                                                            --------               --------
                                                              76,681                123,677
     Less: accumulated depreciation                          (38,831)               (47,953)
                                                            --------               --------
                                                            $ 37,850               $ 75,724
                                                            ========               ======== 
</TABLE>

5.  DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS:

     Activity in the Company's allowance for doubtful accounts consists of the
following (in thousands):
<TABLE>
<CAPTION>
 
                                                                                 December 28,    December 27, 
                                                                                    1997            1998
                                                                                 ------------    ------------
<S>                                                                               <C>                 <C>
 Balance at beginning of year                                                       $253              $  617
 Additional charges to costs and expenses                                            227                 394
 Additional allowances from Purchased Companies
                                                                                     165                 843
 Deductions for uncollectible accounts written off                                   (28)               (238)
                                                                                    ----              ------
 Balance at end of year                                                             $617              $1,616
                                                                                    ====              ====== 
</TABLE> 
 The major components of inventories are as follows (in thousands):
<TABLE> 
<CAPTION>  
                                                                                 December 28,    December 27,
                                                                                    1997            1998
                                                                                 ------------    ------------
<S>                                                                                <C>               <C> 
 Raw materials                                                                      $16,555          $23,174
 Work-in-process                                                                        102               43
 Finished goods                                                                       3,726            6,769
                                                                                    -------          -------
                                                                                    $20,383          $29,986
                                                                                    =======          ======= 
</TABLE> 
 Accrued expenses consist of the following (in thousands):
<TABLE> 
<CAPTION> 
 
                                                                                 December 28,    December 27,   
                                                                                    1997            1998
                                                                                 ------------    ------------
 <S>                                                                              <C>              <C> 
 Accrued compensation and benefits                                                  $2,132          $ 2,762
 Accrued taxes                                                                         756            1,503
 Other accrued expenses                                                              2,206            6,381
                                                                                    ------          -------
                                                                                    $5,094          $10,646
                                                                                    ======          =======

</TABLE> 

                                      F-15
<PAGE>
 
6.  DEBT:

     Credit Facility

     On March 25, 1997, the Company entered into a credit agreement with Bank
One, Texas, N.A. ("Bank One"), which was amended on January 29, 1998, September
3, 1998 and November 10, 1998 (the "Credit Facility"). The Credit Facility
provided the Company with a revolving line of credit of up to $150.0 million
which could be used for general corporate purposes, including the repayment or
refinancing of indebtedness of the Founding Companies, the Pooled Companies, the
1998 Pooled Companies and the Purchased Companies, future acquisitions, capital
expenditures, letters of credit and working capital.

     Advances under the Credit Facility bore interest at designated variable
rates plus margins ranging from 0 to 25 basis points, depending on the ratio of
the Company's interest bearing debt to its pro forma trailing earnings before
interest, taxes, depreciation and amortization for the previous four quarters.
At the Company's option, the loans could bear interest based on a designated
London interbank offered rate ("LIBOR") plus a margin ranging from 75 to 200
basis points, depending on the ratio noted above. Commitment fees of 17.5 to 30
basis points are payable on the unused portion of the line of credit. The Credit
Facility contained a limit for standby letters of credit up to $10.0 million.
There were letter of credit commitments of approximately $3.0 million
outstanding under the Credit Facility as of December 27, 1998. The Credit
Facility prohibited the payment of dividends by the Company, restricted the
Company's incurrence or assumption of other indebtedness and required the
Company to comply with financial covenants, including fixed charge coverage,
certain funded debt to earnings before taxes, depreciation, interest,
amortization and tangible assets to liabilities ratios. The Company was in
compliance with, or had obtained waivers for, the covenants on December 27,
1998. The approximate level of borrowings available under the Credit Facility as
of December 27, 1998 was approximately $5.5 million. The Company's U.S.
subsidiaries guaranteed and the outstanding stock of each of the Company's U.S.
subsidiaries and 65% of the outstanding stock of the Company's Canadian
subsidiary was pledged to secure the repayment of all amounts due under the
Credit Facility.

     The Credit Facility was amended on December 28, 1998 (the "Amended Credit
Facility").  The Amended Credit Facility provides the Company with a revolving
line of credit of up to $150.0 million, which may be used for general corporate
purposes, including acquisitions, the repayment or refinancing of indebtedness
of all acquisitions including future acquisitions, capital expenditures, letters
of credit and working capital.  The Amended Credit Facility will terminate and
all amounts outstanding thereunder, if any, will be due and payable on April 1,
2000.

     Advances under the Amended Credit Facility bear interest at Bank One's base
interest rate, as defined, plus a margin of 50 basis points through March 31,
1999 and increasing by 50 basis points on that date and each quarter until
maturity.  At the Company's option, such advances may bear interest based on a
designated LIBOR plus a margin of 275 basis points through March 31, 1999 and
increasing by 50 basis points on that date and each quarter until maturity.
Commitment fees of 50 basis points are payable on the unused portion of the line
of credit through March 31, 1999 and increase by 50 basis points on that date
and each quarter until maturity.  The Amended Credit Facility contains a limit
for standby letters of credit of up to $10.0 million.  The Amended Credit
Facility prohibits the payment of dividends by the Company, restricts the
Company's incurrence or assumption of other indebtedness and requires the
Company to comply with certain financial covenants including consolidated net
worth, fixed charge coverage, and funded debt and senior debt to earnings before
interest, taxes, depreciation and amortization ratios.  The Amended Credit
Facility is secured by a lien on the real and tangible personal property of the
Company, as defined, a pledge of the outstanding stock of each of the Company's
U.S. subsidiaries and 65% of the outstanding stock of the Company's Canadian
subsidiary.  The amounts due under the Amended Credit Facility are also
guaranteed by the Company's U.S. subsidiaries.

Convertible Notes Payable to Related Parties

     The Company issued approximately $9.9 million in subordinated convertible
notes payable (the "Convertible Notes") to certain former owners of the 1998
Purchased Companies. The Convertible Notes, which bear interest at rates ranging
from six to eight percent, include provisions that allow conversion into shares
of the 

                                      F-16
<PAGE>
 
Company's Common Stock beginning on the first anniversary date of the
Convertible Notes (the "Conversion Date") at conversion prices ranging from
$10.78 to $15.86 per share. If the Convertible Notes are not converted they
become due and payable on their second anniversary. At the Company's option, the
Convertible Notes may be prepaid at any time following the Conversion Date.

Long-term debt consists of the following (in thousands):
<TABLE> 
<CAPTION> 

                                                                 December 28, 1997  December 27, 1998
                                                                 -----------------  -----------------
<S>                                                              <C>                <C>
 Advances under the Credit Facility, bearing interest at rates
 ranging from 7.04% to 8.04 % as of December 27, 1998                 $ 24,000           $141,500

 Industrial development revenue bonds, bearing interest at a 
 variable rate (6.20% at December 27, 1998), payable in annual 
 installments of $50 through maturity in 2008, secured by a 
 certificate of deposit and bank letter of credit                          550                500

 Various notes payable, bearing interest at rates ranging from 
 5.02% to 8.30% in 1997 and 7.00% to 7.50% at December 27, 
 1998, with monthly installments totaling approximately $31 and 
 maturity dates ranging from 1999 until 2009,  secured by certain 
 Company assets                                                          5,387              2,136

 Variable rate note issued by the Acme ESOP (see Note 10), 
 guaranteed by the Company, interest at 5.81% as of December 27, 
 1998                                                                    1,770              1,700 
 
 Other notes payable                                                        23                 26
                                                                       -------           --------
                                                                        31,730            145,862
 Less-current maturities                                                (1,057)            (1,960)
                                                                       -------           --------
                                                                       $30,673           $143,902
                                                                       =======           ========
</TABLE> 
Future maturities of long-term debt as of December 27, 1998 are as follows (in
thousands):
 
              Fiscal Year Ending                                           
                  December,                                                
              ------------------                                           
                    1999                          $  1,960  
                    2000                           141,865  
                    2001                               329  
                    2002                               316  
                    2003                               308  
                    Thereafter                       1,084  
                                                  --------
                                                  $145,862  
                                                  ========

                                      F-17
<PAGE>
 
7.  INCOME TAXES:

     The provision (benefit) for income taxes consists of the following (in
thousands):
<TABLE>
<CAPTION>
 
                                           Year Ended
                                           ----------
                       November 30,        December 28,       December 27, 
                          1996                1997               1998
                       ------------        ------------       ------------
<S>                     <C>                 <C>                 <C>
Federal
  Current                $1,207              $3,944              $2,831
  Deferred                  143                 (71)                892
                         ------              ------              ------
                          1,350               3,873               3,723
                         ------              ------              ------
                          
Foreign
  Current                     -                   -                 238
  Deferred                    -                   -                 184
                         ------              ------              ------
                              -                   -                 422
                         ------              ------              ------
 
State
  Current                   492                 846                 829
  Deferred                   (9)                (15)                131
                         ------              ------              ------
                            483                 831                 960
                         ------              ------              ------

                         $1,833              $4,704              $5,105
                         ======              ======              ======
</TABLE> 
     The differences in income taxes provided and the amounts determined by
applying the federal statutory tax rate to income before income taxes result
from the following (in thousands):

<TABLE>
<CAPTION>
 
                                                                           Year Ended
                                                                           ----------  
                                                       November 30,        December 28,        December 27, 
                                                          1996                1997                1998
                                                       ------------        ------------        ------------
<S>                                                   <C>                 <C>                 <C>
Tax at federal statutory rate of 35%                     $ 2,755              $3,970              $3,182
Increase (decrease) resulting from:
State income taxes, net of federal benefit                   353                 547                 624
 Income taxed to Fraser stockholders                      (1,381)               (172)                  -
 Additional foreign income tax  provision                      -                   -                  74
 Nondeductible items:
  Goodwill amortization                                        -                 200                 484
  Pooling expenses                                             -                  45                 603
 Other nondeductible items                                    76                  16                  89
Other                                                         30                  98                  49
                                                         -------              ------              ------              
                                                         $ 1,833              $4,704              $5,105
                                                         =======              ======              ====== 
</TABLE>

                                      F-18
<PAGE>
 
     Deferred taxes result from temporary differences in the recognition of
income and expenses for financial reporting purposes and for tax purposes.
Components of the Company's net deferred tax liability are as follows (in
thousands):
 
                                                  December 28,      December 27,
                                                      1997              1998
                                                  ------------      ------------
Deferred income tax liabilities:
 Property and equipment                              $(2,547)          $(8,405)
 Other                                                  (620)            ( 902)
  Total deferred income tax liabilities               (3,167)           (9,307)
Deferred income tax assets:                                     
 Basis difference in inventory                             -               175
 Allowance for doubtful accounts                         111               654
 Accruals and reserves                                   834             1,276
  Total deferred income tax assets                       945             2,105
  Net deferred income tax liabilities                $(2,222)          $(7,202)

8.  COMMITMENTS AND CONTINGENCIES:

Litigation

     The Company is involved in various legal proceedings that have arisen in
the ordinary course of business. While it is not possible to predict the outcome
of such proceedings with certainty, in the opinion of the Company's management,
all such proceedings are adequately covered by insurance or, if not so covered,
should not materially result in any liability which would have a material
adverse effect on the financial position, liquidity or results of operations of
the Company.

Insurance

     The Company carries a broad range of insurance coverage, including general
and business auto liability, commercial property, workers' compensation and a
general umbrella policy.

     The Company is self-insured for certain medical claims up to $50,000 per
person per year. Provisions for expected future payments are accrued based on
the Company's estimate of its aggregate liability for all open and unreported
claims. Management believes the amount currently accrued is adequate to cover
all known and unreported claims as of December 27, 1998.

Operating Lease Agreements

     The Company leases certain facilities and equipment. Minimum future rental
payments under noncancelable operating leases as of December 27, 1998 are as
follows (in thousands):
 
        Fiscal Year Ending
        1999                   $ 2,889
        2000                     2,313
        2001                     2,050
        2002                     1,599
        2003                     1,122
        Thereafter               1,543
                               -------
                               $11,516
                               =======

     Rent expense under operating leases was approximately $463,000, $1,445,000
and $2,995,000 for fiscal years 1996, 1997 and 1998, respectively. Rent expense
paid to related parties and included in the foregoing amounts was approximately
$227,000, $146,000 and $558,000 for fiscal years 1996, 1997 and 1998,
respectively. In June 1998, the company purchased property for $1,400,000 from 
an officer/board director. Management believes that the purchase price 
approximates market value. 

                                      F-19
<PAGE>
 
Potential Environmental Liabilities

     In February 1998, the Company acquired DSF, a steel drum reconditioning
company with a facility in Zellwood, Florida. DSF is a wholly-owned subsidiary
of the Company. In 1982, DSF was notified by the U.S. Environmental Protection
Agency (the "EPA") and the Florida Department of Environmental Regulation (the
"DER") that they believed that DSF might be a potentially responsible party
("PRP") regarding the Zellwood Groundwater Contamination Site in Orange County,
Florida (the "Zellwood Site"). The Zellwood Site was designated a "Superfund"
environmental clean-up site after the DER discovered arsenic contamination in a
shallow monitoring well adjacent to it. The DSF facility is a portion of the 57
acres constituting the Zellwood Site. The Company believes that DSF and its
former shareholders were among approximately 25 entities and individuals
identified as PRPs by the EPA.

     Between March 1990 and July 1996, the EPA issued various unilateral
administrative orders and notices to DSF and various other PRPs. Those orders
and notices demanded reimbursement from PRPs of approximately $2 million of the
EPA's costs regarding the Zellwood Site and requested the PRPs to accept
financial responsibility for additional clean-up efforts. During that time, the
EPA estimated that the cost of the selected remedy for soil at the Zellwood Site
would be approximately $1 million and the cost of the selected remedy for
groundwater at the Zellwood Site would be approximately $5.1 million. DSF and
the other PRPs did not agree to the EPA's demands or agree to fund any
additional clean-up. In April 1997, the EPA issued an order unilaterally
withdrawing its previous orders.

     On June 12, 1998 a suit was filed in the United States District Court for
the Middle District of Florida (Orlando Division) against DSF and certain other
PRPs with respect to the Zellwood Site (United States of America v. Drum Service
Co. of Florida, John Michael Murphy, Douglass Fertilizer & Chemical, Inc., et,
al., Civil No. 98-687-Civ-Orl-22C) (the "Zellwood Suit"). In this lawsuit, the
EPA is seeking reimbursement of costs incurred at the Zellwood Site during the
past 17 years and a declaratory judgment for future response costs.

     DSF has maintained comprehensive general liability insurance coverage for
over 25 years, and a number of the policies providing such coverage did not
contain exclusions for environmental contamination. DSF has notified the
insurers that issued such policies of the EPA's claims regarding the Zellwood
Site and the commencement of the Zellwood Suit. In addition, the former
shareholders of DSF have agreed with DSF and the Company to bear liabilities and
expenses with respect to the Zellwood Site, to the extent such liabilities
exceed the Company's insurance recoveries.

     DSF and several other PRPs are currently negotiating with the EPA to settle
the Zellwood Suit. DSF intends to vigorously defend the Zellwood Suit and pursue
its insurance coverage with respect to losses and expenses incurred in
connection with the Zellwood Site. Although there can be no assurance as to any
ultimate liability of DSF under the Zellwood Suit, the amount of recoveries from
other PRPs or the insurance coverage, or the amount of insurance recoveries, the
Company's management believes that DSF's insurance coverage, recoveries from
other PRPs and the obligations of DSF's former shareholders will be adequate to
cover any liability or expenses of DSF arising from the Zellwood Suit. The 
accompanying consolidated balance sheet as of December 27, 1998 includes a $2.0
million receivable from a former shareholder of DSF and a corresponding amount 
in other long-term liabilities.

     In November 1998, Container Services Company ("CSC"), a subsidiary of PalEx
Container Systems, Inc. which acquired CDR, received notice from the EPA that it
had been identified as a de minimis PRP with respect to the Casmalia Disposal
Site in Santa Barbara County, California ("Casmalia Site").

     The Casmalia Site was a licensed hazardous waste disposal facility from
1974 to 1989. In 1989, the EPA refused to reissue Casmalia's RCRA permit on the
grounds that the operator of the site was in violation of the preexisting permit
and other environmental laws and regulations. As a result of the owner/operator
abandoning efforts to properly close and clean up the site, the EPA took
emergency action. There are approximately 10,000 

                                      F-20
<PAGE>
 
generators who legally sent (according to EPA estimates) approximately 4.5
billion pounds of waste to the Casmalia Site. EPA estimates that the clean up of
this site will cost approximately $500 million and will take over 30 years to
complete.

     The EPA has entered in a partial settlement with 50 major PRPs and is
currently in negotiations with over 50 other major PRPs. In October 1998, the
EPA sent out general notices to 750 de minimis PRPs, including CSC. In addition,
it is expected that the EPA will send out several hundred additional notice
letters to de minimis PRPs. The EPA estimates that the original 750 de minimis
PRPs are responsible for an aggregate of about 10% of the volume of waste
shipped to the Casmalia Site.

     Based on CSC's alleged contribution of waste to the Casmalia Site, the EPA
has offered to settle its claims against CSC for approximately $300,000, which
represents a 100% premium over EPA's estimate of CSC's proportionate share of
the estimated clean up costs. In return for settlement, CSC will be granted
contribution protection against lawsuits by other PRPs who contributed waste to
the Casmalia Site. CSC is currently reviewing EPA's settlement offer and
estimates of CSC's contribution of waste to the site. In addition, CSC has
joined a joint defense group of over 140 other de minimis PRPs for the primary
purpose of negotiating a reduction in, and the terms of, the EPA's settlement
offer. The Company has included such settlement amount as accrued expenses in
the accompanying consolidated balance sheet as of December 27, 1998.

Contingent Purchase Price

     The Company is obligated under the terms of an agreement with the former
owners of one of the 1998 Purchased Companies to pay, in either cash or equal
amounts of cash and the Company's Common Stock, up to $6,000,000 based on the
subsidiary's post-acquisition earnings, as defined. Amounts due under this
contingency, if any, will be accrued as part of the purchase price when the
contingency is resolved in 1999 and 2000.

Employment Agreements

     The Company has entered into employment agreements with certain Company
officers and certain former owners of the companies acquired by PalEx. The
remaining commitment under the terms of these agreements as of December 27, 1998
is approximately $5.6 million, of which approximately $4.6 million is payable in
1999 and approximately $1.0 million is payable in 2000. These employment
agreements expire on various dates through September 2000.

Warrant

     On September 30, 1998, the Company issued a warrant for the purchase of up
to 250,000 shares of its Common Stock for professional advisory services at an
exercise price of $11.375 per share. The warrant may be exercised in whole or in
part upon the consummation of certain defined transactions, none of which had
occurred as of December 27, 1998, and expires in May 2005.

                                      F-21
<PAGE>
 
9.  STOCK OPTION PLAN:

     On June 1, 1996, the Board of Directors and the stockholders of the Company
approved the 1996 Stock Option Plan, as amended (the "Stock Option Plan"). The
Stock Option Plan provides for the granting of stock options to directors,
executive officers, other employees and certain non-employee consultants of the
Company. The Company accounts for the Stock Option Plan under APB Opinion No.
25, and no compensation expense has been recognized. The Stock Option Plan,
which permits an amount equal to no more than 15% of the outstanding shares of
PalEx common stock to be issued as optioned shares, terminates in June 2006. In
general, the terms of the option awards (including vesting schedules) are
established by the Compensation Committee of the Company's Board of Directors.
The following table summarizes activity under the Stock Option Plan:
 
                                      Shares    Exercise Price
                                      ------    --------------
Outstanding at November 30, 1996            -                -
 Granted                            1,328,500    $7.50-$ 14.75
 Exercised                                  -                -
 Forfeited and canceled                (7,000)   $        7.50
Outstanding at December 28, 1997    1,321,500    $7.50-$ 14.75
 Granted                            1,361,500    $ 5.88-$14.88
 Exercised                             (6,500)   $        7.50
 Forfeited and cancelled              (65,850)   $ 7.50-$13.50
Outstanding at December 27, 1998    2,610,650    $ 5.88-$14.88

Weighted average fair value of         
 options granted during 1997            $5.38
                 
Weighted average fair value of 
 options granted during 1998            $6.79

Weighted average remaining 
 contractual life for options 
 issued in 1997                     8.33 years

Weighted average remaining 
 contractual life for options 
 issued in 1998                     9.36 years

     At December 27, 1998, options for approximately 257,000 shares of common
stock were exercisable. Unexercised options expire ten years from the issue
date.

     The following pro forma summary of the Company's consolidated results of
operations have been prepared as if the fair value based method of accounting
required by SFAS No. 123, "Accounting for Stock-Based Compensation" had been
applied (in thousands, except per share data):

<TABLE> 
<CAPTION> 
                                                                              Year ended
                                                                              ----------
                                                                 December 28, 1997   December 27, 1998
                                                                 -----------------   -----------------
<S>                                                                <C>                 <C>
Net income attributable to common stockholders                         $6,640             $ 3,986
Pro forma adjustment                                                     (775)             (1,434)
                                                                       ------             -------
Pro forma net income attributable to common stockholders               $5,865             $ 2,552
 
Net income per share ("EPS")
Basic EPS as reported                                                  $  .43             $   .21
Basic EPS pro forma                                                    $  .38             $   .13
Diluted EPS as reported                                                $  .42             $   .21
Diluted EPS pro forma                                                  $  .37             $   .13
</TABLE>

                                      F-22
<PAGE>
 
     Fair value of the options was estimated at the date of grant using the
Black-Scholes option-pricing model using the following weighted average
assumptions:
<TABLE>
<CAPTION>
 
                                                                 Fiscal Year      Fiscal Year
                                                                1997 Options     1998 Options
                                                                ------------     ------------
<S>                                                              <C>             <C>  
Risk free interest rate                                              6.66%           5.39%
Dividend yield                                                       0.00%           0.00%
Volatility factor                                                   35.77%          41.99%
Weighted average expected life                                    10 years        10 years
</TABLE> 
                                                   
     A summary of stock options outstanding and exercisable as of December 27,
1998 is as follows: 
<TABLE> 
<CAPTION> 
                                                    Options outstanding                    Options exercisable
                                                    -------------------                    -------------------
   Range of              Number          Weighted average        Weighted average       Number         Weighted average
exercise prices       outstanding     remaining life (years)      exercise price     exercisable        exercise price
---------------       -----------     ----------------------     ----------------    -----------       --------------- 
<S>                     <C>             <C>                       <C>                   <C>             <C> 
$5.88-$8.75             1,361,750              8.72                   $ 7.51           181,750             $ 7.50
$8.88-$13.12              811,000              9.14                   $11.73            29,100             $10.19
$13.13-$14.88             437,900              8.89                   $14.23            46,580             $13.66
 
</TABLE>
10.  EMPLOYEE BENEFIT PLANS:

     The Company approved a defined contribution profit-sharing plan (the
"Plan") in March 1997, which qualifies under Section 401(k) of the Internal
Revenue Code. Eligible employees may contribute up to the lesser of 15% of their
annual compensation or the maximum amount permitted under Internal Revenue
Service regulations to their account. The Company matches the contributions of
participating employees on the basis of the percentages specified in the Plan.
The employee and Company matching contributions are invested at the direction of
the individual employee.

     Certain of the Company's subsidiaries had defined contribution employee
benefit plans at the time of their acquisition by PalEx. Employer contributions
to the Plan and the other defined contribution plans for the Pooled Companies
and the 1998 Pooled Companies for all periods presented and for Ridge,
Interstate and the Purchased Companies from their respective dates of
acquisition were approximately $2,184,000, $1,134,000 and $768,000 for 1996,
1997 and 1998, respectively.

     In May 1985, Acme established an employee stock ownership plan ("ESOP") for
Acme's eligible employees, as defined. The ESOP is a qualified plan exempt from
taxes under Internal Revenue Section 401(a). In May 1994, the ESOP purchased
3,400 shares of Acme common stock at $765 per share from a stockholder for
$2,601,000. The ESOP funded the purchase by issuing a variable rate note to a
commercial bank that was guaranteed by Acme. Upon completion of the acquisition
of Acme by PalEx, the shares of Acme stock in the ESOP were replaced with shares
of PalEx stock of equal value and the guaranty by Acme was replaced by a letter
of credit issued under the Credit Facility.

     The Company accounts for the ESOP in accordance with Statement of Position
93-6, "Employers' Accounting for Employee Stock Ownership Plan" ("SOP 93-6").
Accordingly, the debt of the ESOP is recorded as long-term debt and the shares
pledged as collateral are reported as unearned compensation on the Company's
consolidated balance sheet. As shares are released, the Company reports
compensation expense equal to the current estimated market price of the shares.
In accordance with SOP 93-6, additional paid in capital is adjusted whenever the
market value of the shares released is more or less than the cost of the shares
released.

     Contributions to the ESOP amounted to approximately $727,000 and $153,000
for the years ended December 28, 1997 and December 27, 1998, respectively. These
contributions include interest paid by Acme or the Company of approximately
$122,000 and $83,000 for the years ended December 28, 1997 and December 27,
1998, 

                                      F-23
<PAGE>
 
respectively, on the loan used to purchase the ESOP shares. The balance in
unearned compensation of $1,770,000 at December 28, 1997 and December 27, 1998
results from the leveraged ESOP stock purchase less the deemed release of shares
at cost. At December 27, 1998, the ESOP contained 843,061 allocated shares and
425,923 unallocated shares of the Company's common stock, for a total of
1,268,984 shares.

     The Company received a Private Letter Ruling from the Internal Revenue
Service in 1999 that allows the termination of the ESOP and the non-taxable
disposal of the PalEx shares in the ESOP. It is the Company's intent to use the
proceeds from the sale of the shares to repay the ESOP's indebtedness. Upon
termination of the ESOP and debt retirement, the ESOP will allocate the
remaining unallocated shares to the plan participants, resulting in a charge to
earnings by the Company and a corresponding increase to capital in excess of par
for the difference between the total value of the shares at the time of their
sale and the ESOP indebtedness. In anticipation of the termination of the ESOP,
no additional shares were allocated in 1998.

11.  TERMINATION OF CHEP RELATIONSHIP

     During the fourth quarter of 1997 and first quarter of 1998, Company
management had numerous discussions with representatives of its largest
customer, CHEP, regarding numerous issues affecting the profitability of the
products manufactured for CHEP by the Company and the pricing of new pallets,
the uncertainty of CHEP production requirements, the absence of fees for extra
services provided to CHEP, quality control and the opening of new facilities
that would be primarily dedicated to performing services for CHEP. The Company
manufactured new, high-grade pallets for CHEP, which in turn leased these
pallets to its customers. These pallets were part of a "closed-loop" materials
handling and management system that included recovery of the pallet from the end
user, aggregating them in Company operated depots where they were sorted,
repaired and returned to CHEP's customers.

     In addition, the Company began renegotiating the prices CHEP was being
charged for new pallets to more accurately reflect constantly changing lumber
prices. Subsequent discussion and communications ensued until it became apparent
to Company management that the issues would not be resolved to the mutual
satisfaction of CHEP and the Company. Accordingly, CHEP was notified that
effective April 29, 1998, the Company would cease supplying CHEP with new
pallets and provided advance notice (generally, 10 to 60 days) under contractual
arrangements to discontinue repair and depot services for CHEP.

     The termination of the Company's relationship with CHEP affected the
operations of certain of the Company's facilities in the southeastern and
western United States. As a result, management formally adopted a restructuring
plan, which was approved by the Board of Directors, to close, curtail, or
convert operations to alternative business activities at facilities related to
CHEP production. There were eight CHEP-related manufacturing facilities that
were targeted for either closure, sale, consolidation or conversion to
alternative product lines. As of December 27, 1998, three facilities dedicated
to CHEP production have been closed, one was sold and two more were consolidated
into one facility. The other two facilities were converted to manufacture non-
CHEP products. The Company terminated approximately 400 production-related
employees at CHEP related facilities during 1998.

     Management determined that there were four categories of CHEP restructuring
costs, in accordance with Emerging Issues Task Force 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"):
disputed accounts receivable; severance payments; lease cancellation fees and
penalties; and a valuation allowance to restate CHEP-related inventory at its
net realizable value.

                                      F-24
<PAGE>
 
     The results of operations for the year ended December 27, 1998 include net
charges to continuing operations of approximately $1.2 million for an inventory
valuation adjustment to reduce CHEP-related inventory to net realizable value
and approximately $0.9 million for disputed accounts receivable, lease
cancellation fees and penalties and severance pay associated with the
termination of employees at CHEP related facilities. As of December 27, 1998, 
all CHEP restructuring costs have been paid or incurred. Accordingly, there is 
no remaining balance in accrued liabilities or inventory valuation allowance in 
the accompanying consolidated balance sheet.

     In addition, management determined that the termination of the CHEP
relationship also required the application of SFAS No. 121 and evaluated the
facts and circumstances with regard to the CHEP-related facilities and the
assets employed in the production of CHEP pallets. Accordingly, the results of
operations for the year ended December 27, 1998 include a charge of
approximately $1.4 million for plant closure and asset abandonment costs for the
CHEP facilities noted above. The charge includes approximately $0.9 million for
abandoned leasehold improvements and approximately $0.5 million to value pallet
production machinery and equipment at its net realizable value. The abandoned
and impaired assets had a book value of approximately $1.8 million prior to the
revaluation. The net realizable value of these assets was determined based on
management's estimates of current market value for similar types of
manufacturing equipment used in the pallet production process. There have been
no changes in the estimates used nor corresponding adjustments to the charges
previously taken. The Company is attempting to sell the machinery and equipment
as soon as possible. Depreciation expense on these assets for the period from
their impairment date until December 27, 1998 would have been approximately
$109,000.

     Management reviewed the recoverability and possible impairment of goodwill
related to the subsidiaries which operated the CHEP facilities and determined
that no goodwill adjustments were necessary due to the potential for replacing
CHEP business with other customers.

     Management believes that all CHEP-related restructuring was complete as of
December 27, 1998.

12.  BUSINESS SEGMENTS:

     The Company has two business segments, one operating in the pallet industry
and the other in the steel drum reconditioning industry. The pallet segment
produces, recycles, sells, repairs, leases and retrieves wooden 

                                      F-25
<PAGE>
 
pallets in the United States and Canada primarily for use in agricultural and
industrial markets. The drum segment reconditions steel drums in the United
States, primarily for use in agricultural and industrial markets. There were no
significant intercompany sales between the two segments for the fiscal years
1996, 1997 or 1998.

     The Company's business segments are managed separately because they require
different technology and marketing strategies. The accounting policies for the
segments are the same as those described in Note 2, Summary of Significant
Accounting Policies. The Company evaluates the performance of its reportable
segments based on income before corporate overhead charges, interest expense,
non-recurring expenses, goodwill amortization and income taxes.
<TABLE>
<CAPTION>
 
                                                              Year Ended December 27, 1998
                                                              ----------------------------
                                                    Pallet                  Drum              Consolidated
                                                    ------                  ----              ------------  
<S>                                                   <C>                  <C>                <C>
Revenues                                          $234,120                $85,571                 $319,691
Segment earnings contribution                       15,286                 11,743                   27,029
Depreciation and amortization                        9,085                  2,223                   11,308
Total Assets                                       255,363                 37,075                  292,438
Capital Expenditures                                 9,428                  4,523                   13,951
 
                                                              Year Ended December 28, 1997
                                                              ----------------------------
                                                    Pallet                   Drum             Consolidated
                                                    ------                   ----             ------------
Revenues                                          $162,848                 $60,145                $222,993
Segment earnings contribution                       15,402                    (152)                 15,250
Depreciation and amortization                        4,607                     951                   5,558
Total Assets                                        96,562                  23,443                 120,005
Capital Expenditures                                 7,683                   1,466                   9,149
 
                                                              Year Ended November 30,1996
                                                              ---------------------------
                                                    Pallet                    Drum            Consolidated
                                                    ------                    ----            ------------
Revenues                                          $ 96,047                  $48,983               $145,030
Segment earnings contribution                        8,409                      693                  9,102
Depreciation and amortization                        2,165                    1,267                  3,432
Total Assets                                        37,129                   20,739                 57,868
Capital Expenditures                                 4,063                    3,292                  7,355
</TABLE> 
 
     Segment earnings contribution is reconciled to consolidated income before
provision for income taxes as follows:
<TABLE> 
<CAPTION> 
 
                                                       Year Ended               Year Ended              Year Ended
                                                       November 30,            December 28,            December 27,
                                                          1996                    1997                    1998
                                                       ------------            ------------            ------------  
<S>                                                     <C>                     <C>                     <C>  
Total earnings contribution for reportable segments        $9,102                $15,250                  $27,029
Unallocated amounts:
 Corporate expenses                                             -                  1,496                    4,080
 Interest expense                                           1,576                  1,722                    8,468
 Goodwill amortization                                          -                    593                    2,977
 Restructuring charge                                           -                      -                      949
 Plant closure and asset abandonment loss                       -                      -                    1,369
 Other income (expense)                                       346                    (95)                     (95)
                                                           ------                -------                  -------
Income before provision for income taxes                   $7,872                $11,344                  $ 9,091
 
</TABLE>

                                      F-26
<PAGE>
 
The Company's revenue by country, based on the location of the customer, is as
follows:

<TABLE>
<CAPTION>
                     Year Ended    Year Ended    Year Ended
                    November 30,  December 28,  December 27,
                       1996          1997          1998
                    ------------  ------------  ------------
<S>                <C>           <C>           <C>
United States         $145,030      $222,993      $314,967
Canada                       -             -         4,724
                      --------      --------      --------
Consolidated          $145,030      $222,993      $319,691
                      ========      ========      ======== 
</TABLE>

The Company's long-lived assets by country are as follows:

<TABLE>
<CAPTION>
                     Year Ended    Year Ended
                    December 28,  December 27,
                        1997          1998
                    ------------  ------------
<S>                 <C>           <C>
United States         $66,250       $176,063
Canada                      -         31,157
                      -------       --------
Consolidated          $66,250       $207,220
                      =======       ========
</TABLE>

     Earnings contribution for the Drum segment for the year ended December 27,
1998 includes charges of approximately $1.8 million for pooling expenses and
compensation differential (the difference between previous owners' and officers'
compensation before the acquisitions and the amounts to which they have
contractually agreed) of approximately $1.1 million. There were no pooling
expenses for the year ended December 28, 1997. Compensation differential was
approximately $1.0 million for the year ended December 28, 1997.

     Earnings contribution for the Pallet segment for the year ended December
27, 1998 includes an inventory valuation adjustment of approximately $1.2
million.

13.  QUARTERLY FINANCIAL RESULTS (unaudited):

     Summarized quarterly financial data for 1998 and 1997 is as follows (in
thousands except per share data):
                           
<TABLE>
<CAPTION>
                                              Quarter   
                                              ------- 
Year ended December 27, 1998     First   Second    Third   Fourth
                                -------  -------  -------  -------
<S>                             <C>      <C>      <C>      <C>
Revenues                        $68,970  $83,362  $77,912  $89,447
Gross profit                     12,600   14,086   15,380   16,828
Net income                        1,160      169    1,177    1,480
Net income per share-basic          .06      .01      .06      .08
Net income per share-diluted        .06      .01      .06      .08
 
                                              Quarter
                                              -------
Year ended December 28, 1997     First   Second   Third    Fourth
                                -------  -------  -------  -------
Revenues                        $39,797  $63,866  $57,583  $61,747
Gross profit                      5,960   10,919    8,603    9,427
Net income                        1,342    2,618      785    1,895
Net income per share-basic          .12      .15      .05      .11
Net income per share-diluted        .12      .15      .04      .11
</TABLE>

                                      F-27
<PAGE>
 
The results of operations for the first and second quarters of 1998 include
charges of approximately $1.6 and $0.2 million, respectively, for pooling
expenses.  The results of operations for the second quarter of 1998 includes a
pre-tax charge of approximately $5.0 million related to the termination of the
CHEP relationship (see Note 11).  The results of operations for the third
quarter of 1998 includes a pre-tax charge of approximately $1.4 million for
plant closure and asset abandonment costs, offset by a pre-tax credit to the
CHEP restructuring charge of approximately $0.9 million, for a net third quarter
pre-tax charge of approximately $0.5 million.  The results of operations for the
fourth quarter of 1998 include a pre-tax credit of approximately $1.9 million
related to revisions in management's estimates of the CHEP restructuring charge.


                                      F-28
<PAGE>
 
              Report of Independent Certified Public Accountants

        We have audited in accordance with generally accepted auditing 
standards, the consolidated financial statements of PalEx, Inc. and subsidiaries
included in this Annual Report on Form 10-K and have issued our report thereon 
dated February 26, 1999. Our audit was made for the purpose of forming an
opinion on the basic financial statements taken as a whole. The financial data
included in Schedule II is the responsibility of the Company's management and is
presented for purposes of complying with the Securities and Exchange
Commission's rules and are not part of the basic financial statements. This
schedule has been subjected to the auditing procedures applied in the audit of
the basic 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 financial statements taken as a whole.

ARTHUR ANDERSEN LLP

Tampa, Florida
  February 26, 1999 
<PAGE>
 
        Schedule II - Valuation and Qualifying Accounts

The following table sets forth the activity in the allowances and accruals 
related to the termination of the Company's relationship with CHEP (in 
thousands):

<TABLE>
<CAPTION>

                                   Allowance                  Accrued
                                      for                      Lease                                     Allowance         Total
                                   Disputed                 Cancellation                                    for          Accruals
                                   Accounts     Accrued       Fees and                                   Inventory         and
                                  Receivable   Severance      Penalties          Other      Subtotal     Valuation      Allowances
                                 -----------  -----------  ---------------  ------------  -----------  -------------  -------------
<S>                              <C>           <C>          <C>              <C>           <C>          <C>            <C>
Initial liabilities
  recorded at
  April 29, 1998                    $  289       $  835        $ 1,010          $  700       $ 2,834       $ 2,183        $ 5,017

Exit costs paid or incurred           (285)         (86)          (578)              -          (949)       (1,235)        (2,184)

Reductions in
  liabilities due to changes
  in estimates                          (4)        (749)          (432)           (700)       (1,885)         (948)        (2,833)
                                    ------       ------        -------          ------       -------       -------        -------

Balance in liability
  accounts at
  December 27, 1998                 $    -       $    -        $     -          $    -       $     -       $     -        $     -
                                    ======       ======        =======          ======       =======       =======        =======
                                 ===========  ===========  ===============  ============  ===========  =============  =============
</TABLE>