RAILTEX INC, 10-K, 1997-03-28

RAILTEX INC
10-K, 1997-03-28
RAILROADS, LINE-HAUL OPERATING

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UNITED STATES SECURITIES AND
EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the fiscal year ended December 31, 1996

[_] Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from
_____________________ to _____________________

Commission File Number 34-022552

RAILTEX, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

TEXAS 74-1948121
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

4040 Broadway, Suite 200
SAN ANTONIO, TEXAS 78209
(Address of principal executive offices) (Zip Code)

Registrant's telephone number,
including area code: (210) 841-7600

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

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

Common Stock, $0.10 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.

[X] YES [ ] 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. [ ]

The aggregate market value (based on the closing sales price on March 25, 1997
as reported by the Nasdaq National Market) of the voting stock of the Registrant
held by non-affiliates of the Registrant was approximately $142.9 million. For
the sole purpose of making this calculation, the term "non-affiliate" has been
interpreted to exclude directors and executive officers of the Registrant. Such
interpretation is not intended to be, and should not be construed to be, an
admission by the Registrant or such directors or executive officers that such
directors and executive officers are "affiliates" of the Registrant, as that
term is defined under the Securities Exchange Act of 1934.

Indicate the number of shares outstanding of the Registrant's Common Stock as of
March 25, 1997: 9,152,260

DOCUMENTS INCORPORATED BY REFERENCE

Certain portions of the Company's Proxy Statement for its annual meeting of
shareholders are incorporated by reference into Items 10, 11, 12 and 13 of Part
III. The registrant intends to file such Proxy Statement no later than 120 days
after the end of the fiscal year covered by this Form 10-K.
<PAGE>
TABLE OF CONTENTS

PART I

ITEM PAGE

1. Business......................................................... 4
2. Properties....................................................... 16
3. Legal Proceedings................................................ 22
4. Submission of Matters to a Vote of Security Holders.............. 23

PART II

5. Market for the Registrant's Common Equity and Related Stockholder
Matters...................................................... 25
6. Selected Consolidated Financial and Operating Data............... 26
7. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................ 27
8. Financial Statements............................................. 39
9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure......................................... 63

PART III

10. Executive Officers of the Registrant............................. 64
11. Executive Compensation........................................... 64
12. Security Ownership of Certain Beneficial Owners and Management... 64
13. Certain Relationships and Related Transactions .................. 64

PART IV

14. Exhibits and Reports on Form 8-K................................. 65

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This Form 10-K contains certain "forward-looking" statements as such term is
defined in The Private Securities Litigation Reform Act of 1995 and information
relating to the Company and its subsidiaries that are based on the beliefs of
the Company's management. When used in this report, the words "anticipate,"
"believe," "estimate," "expect" and "intend" and words or phrases of similar
import, as they relate to the Company or its subsidiaries or Company management,
are intended to identify forward-looking statements. Such statements reflect the
current risks, uncertainties and assumptions related to certain factors
including, without limitation, competitive factors, general economic conditions,
customer relations, relationships with vendors, the interest rate environment,
governmental regulation and supervision, seasonality, distribution networks,
product introductions and acceptance, technological change, changes in industry
practices, one-time events and other factors described herein and in other
filings made by the Company with the Securities and Exchange Commission. Based
upon changing conditions, should any one or more of these risks or uncertainties
materialize, or should any underlying assumptions prove incorrect, actual
results may vary materially from those described herein as anticipated,
believed, estimated, expected, or intended. The Company does not intend to
update these forward-looking statements.

The remainder of this page is intentionally left blank

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PART I

ITEM 1. BUSINESS

RailTex, Inc. ("RailTex" or the "Company") is the leading operator of short
line freight railroads in North America, based on total track miles and the
number of railroads operated. The Company, through its subsidiaries, operates
over approximately 3,800 miles of track in 22 states, Canada and Mexico. The
Company also owns an approximate 11.0% equity interest in the Ferrovia Centro
Atlantica, S.A. ("FCA") which operates an approximately 4,400 mile railroad in
central and eastern Brazil and owns an approximate 6.0% interest in the Ferrovia
Sul Atlantica, S.A. ("FSA") which operates a 4,200 mile railroad in southern
Brazil. In 1996, RailTex railroads transported almost 360,000 carloads of
freight for over 940 customers. Traffic which originated or terminated on
RailTex's lines generated more than 96.0% of the Company's total freight
revenues in 1996.

The Company built its portfolio of railroads through purchase, lease or
contract to operate. Of the 30 railroads RailTex has acquired to date, 19 are
owned, four are leased, four are partially owned and partially leased, two are
operated under long-term contracts and one ceased operations in 1996. RailTex
began operating its first railroad in 1984.

In the fourth quarter of 1996, the Company, through a newly formed wholly
owned subsidiary, acquired 42 miles of track located in the Pittsburgh
metropolitan area from Conrail for $3.0 million ("Pittsburgh Acquisition"). The
Company, through a newly formed wholly owned subsidiary, also acquired, 26 miles
of track in eastern Ontario, Canada from Canadian National ("CN") for CDN $1.1
million (approximately U.S. $800,000) in the fourth quarter ("Ontario
Acquisition"). In September 1996, the Company, through a newly formed wholly
owned subsidiary, purchased 23 miles of track located in Connecticut and six
locomotives from Conrail. In addition, the Company was granted rights to operate
over an additional 49 miles of track from just north of New Haven, Connecticut
to Springfield, Massachusetts under a freight operating agreement with Amtrak.
The total purchase price was $3.5 million ("Connecticut Southern Acquisition").
In June 1996, the Company, through a newly formed wholly owned subsidiary,
acquired 100.0% of the outstanding stock of the Indiana & Ohio Rail Corp.
("INOH") for $12.4 million including an $8.9 million cash payment and the
assumption of $3.5 million of long-term debt, of which $2.1 million was paid
down after completion of the acquisition. Through its subsidiaries the INOH
operates ten line segments totaling 230 miles of track in southwestern Ohio and
southeastern Indiana ("INOH Acquisition"). In February 1997, a wholly owned
subsidiary of the INOH, purchased 146 miles and was granted trackage rights to
operate over an additional 109 miles of track between Flat Rock, Michigan and
Cincinnati, Ohio for $22.0 million from Grand Trunk Western Railroad ("GTWR"), a
subsidiary of CN, ("DTI Acquisition").

In September 1996, the Company, through a newly formed wholly owned
subsidiary, completed an investment, totaling approximately Brazilian Reals ("R
$") $16.0 million (approximately U.S. $16.1 million), in FCA which was awarded a
30 year concession to operate the 4,400 mile Center Eastern Network of the
Brazilian federal railroad. In December 1996, the Company, through a newly
formed wholly owned subsidiary, initiated an investment, totaling approximately
R $8.6 million (approximately U.S. $8.3 million), in FSA which was awarded the
concession to operate the 4,200 mile southern network of the Brazilian federal
railroad. In February 1997, 2.8 million shares of preferred stock in FCA were
sold for approximately R $2.9 million (U.S. $2.8 million) to fund a portion of
the investment in FSA. As of February 1997, the Company currently owns
approximately 11.0% and 6.0% interest in FCA and FSA, respectively.

The Company's strategy is to grow through (i) additions to its portfolio of
short line railroad properties, seeking overall diversification with respect to
geography, customers, commodities and connecting railroads, and (ii) improvement
in the operating performance of newly added and currently operated properties.
RailTex believes its emphasis on diversification, its expertise in adding
railroad properties to its portfolio and its focus on customer service, employee
productivity and operating efficiency position it to effectively implement its
strategy.

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RailTex intends to capitalize on the opportunities created by the major rail
carriers' ongoing commitment to downsizing. Since deregulation of the U.S. and
Canadian railroad industries in the 1980's, major North American railroads have
taken steps to improve profitability and increase market share by streamlining
their operations. These major railroads have generally concentrated their
management and marketing attention on core, long-haul routes, while divesting
(through sale or lease) many of their low-density branch lines to smaller and
more cost-efficient freight railroad operators such as RailTex. These short line
"feeder" railroads typically serve multiple industries located along branch
lines and "feed" freight to the connecting main line carriers. More than 260
short line and regional railroads, operating approximately 30,000 miles of
track, have been created in North America since 1980. In addition, the Company
believes that it will benefit from acquisition opportunities created by mergers
among long haul railroads. These acquisition opportunities are expected to arise
as routes are sold in response to regulatory requirements or in order to
eliminate duplicate routes. Almost all of the rail lines operated by the Company
were previously operated by five of North America's largest railroads. RailTex
believes it has significant opportunities to expand its portfolio by acquiring
branch line railroad properties operated by major railroads and existing short
line railroads in both the United States and Canada. In addition, the Company
believes that international rail privatization will offer additional long term
opportunities as certain governments privatize their country's rail systems.

The Company has increased the traffic volume and operating efficiency of its
portfolio of railroad properties. RailTex credits its operating record in large
part to its performance-based management approach and decentralized management
structure, which places primary operating responsibility for each railroad with
local management, and its incentive-based compensation programs, which reward
employees for improving customer service and operating results. Unlike major
rail carriers, the Company also benefits from its flexible work environment in
which the Company's railroads can assign their operating employees to tasks on
an as-needed basis without regard for traditional railroad industry craft
distinctions (pursuant to which railroad operating employees are assigned to
tasks based upon narrowly defined job descriptions).

RailTex believes its established reputation as an acquirer and operator of
short line rail properties, in combination with its managerial and financial
resources, has positioned the Company to take advantage of future growth
opportunities.

The Company was incorporated in Texas in December 1977, and until 1984 its
principal business was the short-term, full-service leasing and management of
open top aggregate hopper railcars. In October 1984, RailTex entered the short
line freight railroad business by contracting to operate the San Diego &
Imperial Valley Railroad. By year end 1988, the Company's short line railroad
portfolio had grown to six rail lines and generated 85.0% of the Company's
operating revenues. In mid-1989, RailTex sold its railcar leasing assets,
utilizing the sale proceeds to purchase additional short line railroad
properties. Since the sale of its railcar leasing assets, the Company's sole
business activity has been the operation of short line railroads. The Company
added three short line railroad properties to its portfolio in 1989, six
properties in 1990, one property in 1991, four properties in 1992, three
properties in 1993, one property in 1994, one property in 1995 and four
properties in 1996. The Company also invested in two separate companies each of
which has begun operating newly privatized railroads in Brazil.

INDUSTRY OVERVIEW

The U.S. railroad industry is dominated by major Class I railroads, which
operated approximately 125,000 miles of track at year end 1995 (the most recent
year available) and represented approximately $31.4 billion, or approximately
91.5%, of total rail industry operating revenues of $34.3 billion in 1995. In
addition to large railroad operators, at year end 1995 there were more than 500
short line and regional railroads, such as the Company, which generated
approximately $3.0 billion of operating revenues in 1995 and operated
approximately 45,000 miles of track at year end 1995. Reflecting downsizing by
major rail carriers, the proportion of total track

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miles operated by short line and regional railroads in the United States
increased to 27.0% of total railroad industry track miles in 1995 from
approximately 17.0% in 1986.

Since deregulation of the U.S. and Canadian railroad industries in the
1980's, major North American railroads have taken steps to improve profitability
and increase market share by streamlining their operations. The Staggers Rail
Act of 1980 ("Staggers Act") enabled many of the structural changes in the U.S.
rail industry which have favorably affected the Company's profitability and
ability to add short line railroads. Canada's National Transportation Act of
1987 liberalized the process for branch line divestiture, much as the Staggers
Act facilitated the process for U.S. railroads. A 1993 study prepared for the
National Transportation Agency, Canada's primary federal regulator of railroads
("NTA"), recommended that legislation be enacted to accelerate and further
facilitate the branch line divestiture process in Canada. In September 1995, the
Canadian Transportation Act ("C-101") was introduced in the House of Commons and
became law in July 1996. Under C-101, the sale of a rail line in Canada is not
subject to federal approval, although a process of advertising and negotiations
is required. In addition, a Certificate of Fitness, which is issued to a company
which proposes to construct or operate a railway in Canada, is now required.
Pursuant to C-101, the NTA was replaced by the Canada Transportation Agency
("CTA").

As a result of deregulation, major railroads have been able to concentrate
their management and marketing attention on core, long-haul routes, while
divesting (through sale or lease) many of their branch lines to smaller and more
cost-efficient freight railroad operators such as RailTex. The major railroads
have derived significant benefits from the divesting of branch lines to short
line operators. Divesting these branch lines allows major railroads to minimize
incremental capital expenditures, increase traffic density and improve railcar
utilization. Because of the focus of short line railroads on increasing traffic
volume through increased customer service and more efficient operations, traffic
volume on short line railroads frequently increases after divestiture.
Consequently, these transactions often result in net increases in divesting
carriers' freight traffic because much of the business originating or
terminating on branch lines feeds into divesting carriers' core routes.

The timing and pace of RailTex's acquisition activity is primarily dependent
upon a timetable established by the Class I railroads. The Company is
continually reviewing potential acquisitions for rail lines offered by the Class
I railroads; however, the number of lines available for acquisition may be
affected by Class I merger activity or other commitments of the Class I
railroads' resources. The timing and pace of the acquisition of existing short
line railroads is primarily a function of identifying a willing seller and
agreeing to financial considerations.

AVAILABILITY OF SHORT LINE PROPERTIES

Since 1980, more than 260 short line and regional railroads, operating
approximately 30,000 miles of track, have been created in the United States
primarily as a result of divestiture by major rail carriers. The Company
believes this trend is likely to provide a continuing source of expansion
opportunities for the next several years. In addition, there are approximately
300 other small railroads, most of which are owned by other railroads,
non-railroad companies, investment partnerships, and individuals. The Company
has purchased three of the railroad properties it operates from sellers other
than major railroads, and believes other independent railroad operators
represent additional sources of desirable properties. The Company has also
successfully commenced operations on three Canadian short lines, and anticipates
it will have the opportunity to add more Canadian short line railroad properties
to its portfolio. In addition, the Company believes that international rail
privatization will offer additional long-term opportunities as certain
governments privatize their country's rail system.

BUSINESS STRATEGY

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its emphasis on diversification, its expertise in adding railroad properties to
its portfolio and its focus on customer service, employee productivity and
operating efficiency position it to implement effectively its strategy.

EXPANSION STRATEGY

RailTex's expansion strategy is to maintain its diversified revenue base
while growing portfolio of short line railroad properties and to maintain its
position as a competitive bidder for new railroad properties. The key components
of RailTex's expansion strategy are:

DIVERSIFICATION: RailTex believes that its portfolio diversification limits
its exposure to geographic, economic and customer related risks, while it
positions the Company to take advantage of a broad range of business
opportunities. This diversification, and the increasing stability it provides to
the Company's operations, differentiates RailTex from regional and other short
line carriers. Diversification also enables the Company to develop and maintain
close working relationships with essentially all major rail carriers in North
America.

INTERNATIONAL: RailTex believes that its international acquisition strategy
is a natural extension of its North American acquisition strategy and that
international rail privatization will offer significant long term opportunities.
The Company's strategy regarding international acquisitions includes analyzing
the country's political and economic environment, identifying potential country
risks and attracting strong local investment partners. Additionally, the Company
has developed certain guidelines regarding the percentage of assets and equity
invested in international acquisitions in relation to total assets and equity.
RailTex believes its current international investment experience gives it an
additional advantage over other U.S. short line carriers.

EXPERIENCE: RailTex believes it has positioned itself as a reliable,
experienced acquirer and operator of short line railroad properties. The Company
believes its record, evidenced by its acquisition, integration and operation of
30 rail properties since 1984, gives the Company a significant competitive
advantage over other bidders for short line railroad properties. RailTex also
believes its ability to finance and close transactions and commence operations
in a timely manner is well recognized by the major rail carriers. In addition,
the Company believes it has developed good relationships with the major rail
carriers and that these relationships provide an advantage in competing for
additional properties.

OPERATING STRATEGY

RailTex's operating strategy is to improve the performance of its railroad
properties by focusing on improved customer service and operating efficiency.
The key components of RailTex's operating strategy are:

CUSTOMER SERVICE: The Company seeks to build its business by providing its
customers with convenient and cost-effective service to meet their
transportation needs. To this end, the Company works with its customers to
assess their requirements and then tailors its operations to increase the
frequency and reliability of service. The Company believes these efforts to
enhance customer service have resulted in increased traffic and good
relationships with customers along the Company's lines.

OPERATING EFFICIENCY: RailTex focuses on promoting cost-efficient operations
at all levels of its organization. Unlike major rail carriers, the Company
benefits from its flexible work environment in which the Company's railroads can
assign their operating employees to tasks on an as-needed basis without regard
for railroad industry craft distinctions.

MANAGEMENT PHILOSOPHY: RailTex, through its performance-based process
management approach and decentralized management structure, believes it has
developed a culture that encourages employees to take initiative and
responsibility. Further, the Company rewards productivity through its
performance-based, incentive compensation programs. During the last three years,
the Company's employees received an average of at least 10.0% of their base pay
in incentive payments.

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PORTFOLIO EXPANSION

Since 1984, the Company has built a portfolio of railroads, almost all of
which were added as a result of a competitive bidding process. RailTex has
developed a disciplined approach for identifying, analyzing, negotiating and
structuring additions to RailTex's portfolio of short line railroads. The
Company believes this approach, together with its ability to finance
acquisitions quickly with borrowings under the Company's $75.0 million revolving
U.S. acquisition facility ("U.S. Acquisition Facility") and its CDN $25.0
million revolving Canadian acquisition facility ("Canadian Acquisition
Facility"), has provided it with a competitive advantage.

The Company has developed an acquisition team with broad experience in the
transportation sector which is responsible for implementing the Company's
expansion program. Expansion opportunities are presented to the Company by
divesting carriers or are identified by the Company through dialogues maintained
by this acquisition team with major rail carriers and other railroad operators.

Opportunities are evaluated according to Company guidelines with respect to,
among other matters, size, effect on geographic, commodity, connecting carrier
and customer diversification and financial returns. Members of the Company's
acquisition team, assisted by senior management, complete a thorough evaluation
of each opportunity. This evaluation includes in-depth, on-site investigations,
reviews of historical traffic volumes, interviews with operating personnel and
current and potential customers and conversations with local officials and
members of the business community.

RailTex adds short line railroad properties to its portfolio through
purchase, lease or contract to operate. Typically, the Company bids against
other short line operators for available properties. The timing and structure of
each transaction is determined by the divesting railroad based upon strategic
and economic considerations. In addition to factors such as the price they will
receive for the sale of a railroad property and the price per carload they will
pay a new operator for interchanging traffic, divesting carriers consider a
prospective operator's experience and its ability to close a transaction and
commence operations in a timely manner.

The Company intends to use its U.S. Acquisition Facility and its Canadian
Acquisition Facility to finance purchases of additional railroad properties in
North America. At February 28, 1997, the Company had $15.2 million and CDN $23.9
million available under the U.S. Acquisition Facility and Canadian Acquisition
Facility, respectively. Upon utilization of the entire amount of the Company's
U.S. Acquisition Facility, the Company believes it has a number of viable
financing alternatives available that will result in additional acquisition
capacity. The financing alternatives include, but are not limited to, an
expansion of the current U.S. Acquisition Facility, a private placement of
medium to long term notes, or an additional equity offering.

Following the closing of a transaction, railroad properties acquired by
RailTex are integrated into the Company by "Go Teams" of RailTex professionals.
These transition teams, headed by the Company's regional general managers, are
composed of experienced Company employees assembled from throughout the RailTex
organization. These teams establish RailTex's policies and procedures at the
newly added railroad properties and conduct interim operations until the new
general managers of these railroads are able to hire and train a full-time work
force. The Company believes its approach to commencing operations on its
properties benefits its customers by helping to eliminate the service delays and
interruptions which often accompany transitions to new operators.

SHORT LINE OPERATIONS

MARKETING

Following commencement of operations by RailTex, the Company's railroads
generally have attracted increased rail shipments from existing customers and
obtained traffic from new customers which had not previously shipped by rail or
had ceased rail shipments. The Company believes its ability to generate
additional

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traffic is enhanced by its marketing efforts which are aimed at identifying and
responding quickly to the individual business needs of customers along its rail
lines. As part of these marketing efforts, the Company often schedules more
frequent rail service, helps customers negotiate price and service levels with
connecting carriers and assists customers in obtaining the quantity and type of
rail equipment required for their operations. The Company also often runs
non-scheduled trains on short notice to accommodate customers' special or
emergency needs.

The Company assigns primary responsibility for price and service decisions
affecting a railroad's customers to the general manager of each railroad. These
railroad managers encourage their entire staff to participate in marketing
efforts. General managers and marketing personnel at each railroad are supported
by senior marketing management at RailTex's headquarters, who assist with sales
calls, provide industrial development expertise, conduct formal marketing
training and make coordinated sales calls on national accounts which have
facilities on more than one Company railroad.

In 1996, the Company served more than 940 customers which shipped and
received a wide variety of products. RailTex's ten largest customers accounted
for 24.0% of the Company's operating revenues in 1996. The Company's largest
customer in 1996 was Indianapolis Power & Light Company ("Indianapolis P&L")
representing 4.6% of operating revenues. Assuming continuation of RailTex's
expansion strategy, management expects its reliance on any one customer,
including Indianapolis P&L, to diminish over time. Shipments for Indianapolis
P&L are made pursuant to a contract between it and the Company which expires in
1998, and while the loss of this business would have a material adverse effect
on the Company, management believes that there is not a significant risk of such
loss. RailTex believes its relationships with its customers are excellent.

MANAGEMENT

The Company's decentralized management structure is an important element in
its operating strategy. Significant operational autonomy and responsibility for
financial results is given to local railroad management, while corporate
headquarters is responsible for setting overall policies and for strategic and
financial planning, as well as accounting and other shared services. The Company
has implemented a performance-based process management approach which relies
upon key performance indicators or critical success factors ("CSFs") to manage
performance against previously defined targets. On a monthly basis, each manager
conducts a formal review of performance against target for each CSF; focusing on
items that are not on target; identifying the root cause of the variance and
formulating action plans for getting back on target. The Company believes its
decentralized management structure, in conjunction with performance-based
process management, enables each railroad to tailor its operations to its
customers' needs and optimize performance.

Each RailTex railroad is managed by a general manager who has broad
authority and responsibility for pricing, staffing, purchasing, marketing and
operations. General managers operate their railroads pursuant to business plans
developed annually and updated quarterly. Progress against plan is reviewed
monthly by the executive officers of the Company. Most of the Company's general
managers have been recruited from operating or marketing management at the major
railroads and typically have several years of railroad industry experience. Each
new general manager is provided with an extensive orientation to the Company's
operating policies and procedures. In addition, all general managers attend
semi-annual meetings to exchange information with respect to operating,
marketing and regulatory issues. General managers also remain current on
industry developments by, among other means, attending national and regional
railroad conferences.

In addition to the general manager, each railroad typically employs an
operations manager, a marketing manager, a clerk and several transportation
specialists. Transportation specialists perform a wide variety of operating
tasks such as switching, locomotive operations and minor track and railcar
repair. Major track and railcar repair and derailment work is often contracted
to outside specialists.

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WORK FORCE

Flexibility with respect to work assignments is a key element of the
Company's operating strategy and contributes significantly to operational
productivity of the Company's railroads. All of the Company's personnel are
trained in a wide range of skills necessary for short line operations. Railroad
operating employees can be assigned to tasks on an as-needed basis because the
Company's railroads are not bound by traditional railroad industry craft and
work distinctions (pursuant to which railroad operating employees are assigned
to tasks based upon narrowly defined job descriptions). Trains are typically
operated by two-person crews, consisting of transportation specialists who
operate the locomotive and couple and uncouple railcars. The Company believes
the organization of its railroads into relatively small work groups encourages
greater team effort and permits more clearly defined responsibility and
accountability than is obtainable by larger, more centrally managed railroads.

All but one of the Company's short line railroads maintains a
performance-based, incentive compensation program through which a portion of a
railroad's operating profits is distributed quarterly to its employees.
Incentive compensation programs are administered by the general managers and
distributions are made principally on the basis of individual performance.

Certain employees of three of the Company's U.S. railroads elected to be
represented by a union pursuant to governing National Mediation Board ("NMB")
procedures. A total of 37 employees representing three of the Company's U.S.
railroads are represented by the United Transportation Union ("UTU"). Each of
these railroads is involved in mediation with the UTU over the terms of a
collective bargaining agreement; however, the NMB has previously determined in
all cases the employees will fall under a general craft of "transportation
specialists."

On October 18, 1994, 14 employees of one of the Company's Canadian railroads
elected to be represented by the Brotherhood of Locomotive Engineers ("BLE")
pursuant to the Ontario Labor Relations Act. These employees did not seek to
impose craft distinctions on this railroad, but sought certain compensation
levels before an arbitration panel. On December 22, 1995, the arbitration panel
ruled that the railroad's wage rates should be similar to wage rates paid to
skilled unionized employees within the railroad's local economy. The arbitration
panel also ruled that these employees may no longer participate in the Company's
incentive compensation program.

Because of the small number of employees involved, the Company's continued
freedom from craft line distinctions, and the small percentage of the Company's
revenues and operating income generated by the affected railroads, the Company
believes that union representation of these employees (4.3% of the Company's
total workforce as of March 1, 1997) will not have a material adverse effect on
its operations or financial condition.

On October 21, 1993, a union representing certain CN employees filed an
application with the Canada Labor Relations Board ("CLRB"), seeking to bind the
Cape Breton & Central Nova Scotia ("CBNS") to the collective agreement formerly
in effect between such union and CN. On August 5, 1994 the CLRB ruled in favor
of the Company and determined that CBNS was not bound by the CN's pre-existing
collective agreement. This decision was appealed by the union to the Supreme
Court of Canada, the ultimate Court of Appeal in that jurisdiction. On January
11, 1996, the Supreme Court dismissed the union's appeal, confirming that CBNS
is not bound by the collective agreement formerly in effect between the union
and CN. The Company believes that the effect of this decision, in most cases, is
that the acquisition of short lines which operate solely within the boundaries
of a particular province will not be subject to federal labor laws.

At February 28, 1997, the Company had 850 full-time employees. The Company
believes that its relations with its employees are good.

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SAFETY

An important component of the Company's operating strategy is its emphasis
on conducting safe railroad operations for the benefit and protection of
employees, customers and the communities served by the Company's railroads. All
general managers undergo a week-long training course at the Hazardous Materials
Training Center operated by the Association of American Railroads. Operations
managers of railroads which transport hazardous materials also attend this
course. New transportation specialists attend intensive one week training
courses conducted by the Company which cover all aspects of safe and appropriate
locomotive and railcar handling. In addition, transportation specialists, prior
to receiving locomotive engineer certification, attend a special one week
training course conducted by the Company. This basic training is supplemented at
each railroad with field and classroom training and annual safety and rules
tests, conducted by operating and safety training specialists who visit each
railroad on a quarterly basis. The Company also conducts safety inspections on
each of its railroads. Each employee involved in train operations is subject to
pre-employment and random drug testing, whether or not required by federal
regulation. In addition, personnel from each railroad conduct railroad-crossing
safety education programs at schools, driver education courses and service clubs
in the communities they serve.

TRAFFIC

Rail traffic may be categorized as interline, local or bridge traffic.
Interline traffic either originates or terminates with customers located along a
rail line and is interchanged with other rail carriers. Local traffic both
originates and terminates on the same rail line and does not involve other rail
carriers. Bridge traffic neither originates nor terminates on a rail carrier's
line, but rather passes over the line from one connecting rail carrier to
another.

Traffic which originated or terminated on RailTex's lines generated 96.0%
and 97.0% of the Company's total freight revenues in 1996 and 1995,
respectively. The Company believes that higher levels of interline and local
traffic provide it with greater stability of revenues because such traffic
represents shipments to or from customers located along its lines which, unlike
bridge traffic, cannot easily be diverted to other rail carriers.

The following table summarizes freight revenues by type of traffic carried
by the Company's railroads in 1995 and 1996.

FREIGHT REVENUES
YEARS ENDED DECEMBER 31, 1995 AND 1996
(DOLLARS IN THOUSANDS)

1995 1996
---------------- -----------------
% OF % OF
DOLLARS TOTAL DOLLARS TOTAL
------- ----- -------- -----
Freight revenues:
Interline .................. $78,091 85.0% $ 87,331 84.8%
Local ...................... 11,341 12.3 11,341 11.0
Bridge ..................... 2,477 2.7 4,345 4.2
------- ----- -------- -----
Total freight revenues . $91,909 100.0% $103,017 100.0%
======= ===== ======== =====

CONNECTING CARRIERS

Most of RailTex's short line properties interchange traffic with multiple
carriers. At February 28, 1997, the Company's railroads connected with 35
railroads operated by other carriers. Of the Company's rail lines, 72.4% connect
with two or more carriers.

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<PAGE>
The following table summarizes the Company's significant connecting carriers
in 1995 and 1996 by freight revenues and carloads as a percentage of total
interchanged (interline and bridge) traffic.

INTERCHANGED TRAFFIC
YEAR ENDED DECEMBER 31, 1995 AND 1996
<TABLE>
<CAPTION>
1995 1996
--------------- ---------------
FREIGHT FREIGHT
CONNECTING CARRIER REVENUES CARLOADS REVENUES CARLOADS
----- ----- ----- -----
<S> <C> <C> <C> <C>
Union Pacific Southern Pacific Railway Company . 39.2% 40.8% 37.3% 38.2%
Canadian National Railways .................... 21.8 14.2 20.5 13.9
CSX Transportation, Inc. ...................... 15.5 18.7 16.2 19.1
Consolidated Rail Corporation ................. 5.7 4.3 8.4 6.8
Norfolk Southern Railway Company .............. 5.3 7.8 6.2 9.8
Burlington Northern Santa Fe Railway Company .. 7.8 7.5 4.7 3.3
All other railroads ........................... 4.7 6.7 6.7 8.9
----- ----- ----- -----
Total interchanged traffic ............... 100.0% 100.0% 100.0% 100.0%
===== ===== ===== =====
</TABLE>
Charges for interchanged traffic are generally billed to the customer by the
connecting carrier and cover the entire transportation of a shipment from origin
to destination, including the portion that travels over the Company's lines. The
Company's revenues from such traffic are generally collected through fees paid
directly to the Company by the connecting carriers rather than by customers on
its lines, and are payable regardless of whether the connecting carriers are
able to collect from the customers. The fees payable by connecting carriers are
set forth in contracts entered into by each of the Company's railroads with
their respective connecting carriers and are subject to periodic adjustments.

COMMODITIES

RailTex's railroads transport a wide variety of commodities for their
customers. Some of the Company's railroads have a well-diversified commodity
base, while other Company railroads transport one or two dominant commodities.
By favoring portfolio additions whose commodity mix would further diversify the
Company's railroad portfolio, RailTex seeks over the long term to limit its
exposure to any single commodity to no more than 20.0% of freight revenues. In
1996, lumber and forest products and coal, which contributed 21.2% and 15.8%,
respectively, of freight revenues, were the two largest commodity groups
transported by the Company's railroads.

The following table summarizes the Company's freight revenues and traffic
volume in 1995 and 1996 by commodity group.

FREIGHT REVENUES AND CARLOADS COMPARISON BY COMMODITY GROUP
YEARS ENDED DECEMBER 31, 1995 AND 1996
<TABLE>
<CAPTION>
FREIGHT REVENUES CARLOADS
----------------------------------- ----------------------------------
1995 1996 1995 1996
--------------- ---------------- --------------- ---------------
% OF % OF % OF % OF
COMMODITY GROUP DOLLARS TOTAL DOLLARS TOTAL NUMBER TOTAL NUMBER TOTAL
------- ----- -------- ----- ------- ----- ------- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Lumber and forest products $18,875 20.5% $ 21,811 21.2% 46,748 14.7% 57,456 16.0%
Coal ..................... 15,307 16.7 16,240 15.8 72,864 22.9 84,957 23.6
Chemicals ................ 9,652 10.5 11,484 11.1 29,361 9.2 33,221 9.2
Scrap paper & paper
products ................. 9,452 10.3 9,758 9.5 22,724 7.1 24,075 6.7
Scrap metal & metal
products ................. 7,808 8.5 7,419 7.2 24,347 7.7 23,231 6.5
Farm products ............ 7,476 8.1 8,986 8.7 31,754 10.0 34,767 9.7
Non-metallic ores ........ 5,980 6.5 6,898 6.7 32,246 10.1 36,365 10.1
Food products ............ 4,954 5.4 5,944 5.8 19,837 6.2 22,049 6.1
Petroleum products ....... 4,592 5.0 4,767 4.6 10,476 3.3 11,623 3.2
Minerals and stone 3,983 4.3 5,008 4.9 13,659 4.3 14,306 4.0
Other .................... 3,830 4.2 4,702 4.5 14,171 4.5 17,619 4.9
------- ----- -------- ----- ------- ----- ------- -----
Total ............... $91,909 100.0% $103,017 100.0% 318,187 100.0% 359,669 100.0%
======= ===== ======== ===== ======= ===== ======= =====
</TABLE>
12
<PAGE>
The following is a description of the commodities transported by the
Company:

LUMBER AND FOREST PRODUCTS represented 21.2% of 1996 freight revenues and
16.0% of 1996 traffic volume. The Company transports finished lumber used in
construction, as well as woodchips and pulpwood used in particle board and paper
manufacturing. The Company serves paper mills and lumber producers in Oregon and
Georgia, as well as lumber distribution facilities in New England.

COAL for electric power generating plants represented 15.8% of 1996 freight
revenues and 23.6% of 1996 traffic volume. The Company serves four large
electric utilities located in Indiana, Missouri, Arkansas and Nova Scotia,
Canada. In Indiana and Nova Scotia, the Company transports unit coal trains from
local coal mines to the utility's power plants. The Company also transports unit
trains of Powder River Basin coal to power plants in Missouri and Arkansas and
unit trains of West Virginia coal to a co-generation plant in Virginia.

CHEMICALS represented 11.1% of 1996 freight revenues and 9.2% of 1996
traffic volume, and consists primarily of chemicals used in the manufacturing of
polyester fiber in South Carolina. Chemicals also include liquid and bulk
agricultural fertilizers and plastic pellets.

SCRAP PAPER AND PAPER PRODUCTS represented 9.5% of 1996 freight revenues and
6.7% of 1996 traffic volume. The Company serves paper mills that produce paper
products in Oregon and newsprint and paper in Nova Scotia. The Company also
serves warehouses for paper and paper products in New England and a South
Carolina manufacturing facility that produces paper plates, cups and bowls.

SCRAP METAL AND METAL PRODUCTS represented 7.2% of 1996 freight revenues and
6.5% of 1996 traffic volume. The Company serves a steel works in Nova Scotia
that utilizes scrap metal to manufacture railroad rail and steel blooms. The
Company also serves a steel mini-mill in South Carolina that utilizes scrap
steel and a steel works in Missouri that utilizes coiled steel for the
manufacture of steel springs. In Connecticut, the Company serves a plant that
manufactures rolled copper coil wire from copper bundles.

FARM PRODUCTS represented 8.7% of 1996 freight revenues and 9.7% of 1996
traffic volume. Farm products consist primarily of corn, wheat and soybeans.
Field crops produced in Georgia, North Carolina, Kansas, Missouri, Michigan and
Texas account for the majority of this traffic; however, the Company also
transports unit trains of soybeans and grain to Louisiana for export.

NON-METALLIC ORES represented 6.7% of 1996 freight revenues and 10.1% of
1996 traffic volume. Non-metallic ores consist primarily of limestone used in
road construction in Texas, Virginia and Georgia. Non-metallic ores also include
salt transported by the Company from a large mine in Ontario, Canada and sand
which is used in glass manufacturing and in foundries supporting the automotive
industry.

FOOD PRODUCTS represented 5.8% of 1996 freight revenues and 6.1% of 1996
traffic volume. Food products consist primarily of vegetable oils, with peanut
meal, canned goods, lard and other products accounting for the balance of the
group.

PETROLEUM PRODUCTS represented 4.6% of 1996 freight revenues and 3.2% of
1996 traffic volume. The majority of this traffic is liquefied petroleum gas
produced in New Mexico and Texas which is destined for southern California and,
ultimately, Tijuana, Mexico. The Company also serves a large petrochemical plant
in Louisiana which manufactures fuel additives.

MINERALS AND STONE represented 4.9% of 1996 freight revenues and 4.0% of
1996 traffic volume. The Company transports chemical lime used in the
manufacturing of manganese, calcium carbonate, finished brick and cement.

13
<PAGE>
OTHER traffic volume represented 4.5% of 1996 freight revenues and 4.9% of
1996 traffic volume. Other traffic is primarily composed of machinery and fuel
blending agents.

COMPETITION

PORTFOLIO ADDITIONS

In the process of building its portfolio of short line railroads, RailTex
typically competes with other short line railroad operators. Competition for
short line railroad properties is based primarily upon price, operating history
and financing capability. The Company believes its established reputation as an
acquirer and operator of short line rail properties, in combination with its
managerial and financial resources, effectively positions it to take advantage
of future growth opportunities. To the extent RailTex pursues larger railroad
properties, it expects to encounter increased competition from larger
competitors, such as regional railroads.

RAILROAD OPERATIONS

Each of the Company's railroads is typically the only rail carrier directly
serving its customers; however, the Company's railroads compete directly with
other modes of transportation, principally motor carriers and, to a much lesser
extent, barge operators. The extent of this competition varies significantly
among RailTex's railroads. Competition is based primarily upon the rate charged
and the transit time required, as well as the quality and reliability of the
service provided, for an origin-to-destination transportation package. Cost
reductions achieved by major rail carriers over the past several years have
generally improved their ability to compete with truckload carriers. Since
traffic on most of the Company's railroads is interchanged with long-haul rail
lines, the Company believes it benefits from the improving competitiveness of
its connecting carriers.

INSURANCE

RailTex maintains insurance to cover costs associated with personal injury,
including death, and property damage, including derailments. The Company's
liability policies are currently subject to a self-insured retention of $500,000
per occurrence. With respect to its transportation of hazardous commodities, the
Company's liability policies cover sudden releases of hazardous materials,
including expenses related to evacuation. Personal injuries associated with
grade crossing accidents are also covered under the Company's liability
policies. The Company also maintains all-risk property damage coverage,
including damage to property of shippers, subject to applicable retentions.

The Company's railroad employees are covered by the Federal Employers'
Liability Act ("FELA"), a fault-based system under which injuries and deaths of
railroad employees are settled by negotiation or litigation based on the
comparative negligence of the employee and the employer. FELA-related claims are
covered under the Company's liability insurance policies.

The Company believes its insurance coverage is adequate in light of its
experience and the experience of the rail industry. However, the Company can
give no assurance as to the adequacy, availability or cost of insurance in the
future.

REGULATION

UNITED STATES

OVERVIEW. In addition to the environmental, safety, and other regulation
generally applicable to all businesses, the Company's railroad subsidiaries are
subject to regulation by the Surface Transportation Board ("STB"), the successor
to the Interstate Commerce Commission ("ICC"), and the Federal Railroad
Administration ("FRA") and by regulatory agencies in the various states in which
they do business. The Company believes its operations are in material compliance
with these regulations. Additionally, the Company is subject to STB regulation
in its acquisition of new railroad properties by purchase, lease or contract to
operate. Since 1980, there has been a

14
<PAGE>
significant relaxation in regulations governing such transactions, and this
change has favorably affected the Company's ability to add railroad properties
to its portfolio. Various interests in the United States have sought and
continue to seek reimposition of government controls on the railroad industry in
areas deregulated in whole or in part since 1980, including stricter rate
regulation and more onerous labor protection conditions for rail line transfers.

STB. The ICC Termination Act, which was enacted on December 29, 1995,
eliminated the ICC as an independent agency and created the STB, a new agency
within the Department of Transportation which began functioning on January 1,
1996. The ICC Termination Act made a number of changes which have altered the
procedure and timing for federal approval of rail projects, including
abandonments, line sales, mergers, rates and tariffs. The ICC Termination Act
made significant changes in line sale procedures, particularly with respect to
labor protection on Class II and III acquisitions. Specifically, a Class II
carrier that acquires a line must provide one year of severance pay to employees
who lose their jobs as a result of the acquisition, less any railroad earnings
the employee may receive from the acquiring carrier. Class III carriers and non
carriers are exempt from paying labor protection as a consequence of acquiring a
line. With respect to mergers, the STB is required to approve mergers of two or
more Class II or Class III carriers. Employees adversely affected by a merger,
involving at least one Class II and one or more Class III carriers, must receive
one year of severance pay reduced by any railroad earnings the employee may
receive from the acquiring carrier. If the merger involves only Class III
carriers, no labor protection may be imposed. The Company believes that the line
sale and merger provisions of the ICC Termination Act will not have a negative
effect and may have a favorable effect on the Company's ability to continue to
acquire short line railroads. The ICC Termination Act also simplified and
streamlined the abandonment process. With respect to rates and tariffs,
railroads no longer have an obligation to file tariffs with the federal
government. However, in some instances, primarily for agricultural products,
railroads must make those rates available to persons requesting them in writing.

FRA. The FRA regulates railroad safety and equipment standards, including
track maintenance and train speed standards, special procedures for handling
hazardous shipments, locomotive and railcar inspection and repair requirements,
operating practices and crew qualifications.

STATE REGULATORY AGENCIES. State regulatory agencies no longer have
authority to engage in economic regulation of railroads that are part of the
intrastate network. State and local governments generally retain jurisdiction
over local rail safety matters, such as the installation of grade crossings and
grade crossing warning devices.

CANADA

OVERVIEW. The Company's Canadian railroad subsidiaries are subject to
regulation by the various governmental departments or regulatory agencies in the
provinces in which they do business. The Company believes its operations are in
material compliance with provincial regulations, except for those which are
obsolete and, therefore, not regularly enforced. Additionally, the Company is
subject to CTA regulation with regard to the transfer of federally regulated
railroad properties.

A National Transportation Act Review Commission made recommendations in
January 1993 to reduce the regulatory burden at the federal level on the
conveyance of portions of lines subject to federal regulations to short line
operators and make some potential short lines in Canada more attractive to short
line operators. In September 1995, the C-101 was introduced in the House of
Commons and became law in July 1996. As a result, the sale of a federal rail
line no longer requires federal approval. However, the legislation requires a
process of public advertising and a period for negotiation. No railway may be
operated without a Certificate of Fitness from the CTA, which is issued on proof
of adequate insurance.

FEDERAL. A Canadian railroad generally will fall under federal regulation if
its operations cross any borders between provinces, if it operates
internationally or if Parliament has declared it a federal work or undertaking.
The two major railroads of Canada, CN and the Canadian Pacific Railway Company,
are subject to CTA

15
<PAGE>
regulation because they operate nationwide. Consequently, additions to the
Company's portfolio in Canada will be subject to federal regulatory approval
(mainly Certificates of Fitness) through the CTA as well as Investment Canada
pursuant to the Investment Canada Act, the federal act in Canada governing
purchases of Canadian businesses by non-Canadians.

PROVINCIAL. Short lines which reside wholly within the boundaries of a
particular province are governed almost exclusively by the laws of that
province. Each of the ten provinces in Canada has different laws with respect to
regulation of railroads. Most of the provinces have drafted new legislation
which is more favorable to the operation of short lines than previous provincial
laws.

The recent Supreme Court of Canada decision dismissing an attempt by a labor
union to subject CBNS to federal labor laws has now made it clear that in most
cases short lines that reside wholly within the boundaries of a particular
province will not be subject to federal labor laws.

ENVIRONMENTAL MATTERS

The Company's operations are subject to various U.S. and Canadian federal,
state, provincial and local laws and regulations relating to the protection of
the environment, which have become increasingly stringent. These environmental
laws and regulations, which are implemented principally in the U.S. by the
Environmental Protection Agency and comparable state agencies and principally in
Canada by provincial agencies, govern the management of hazardous wastes, the
discharge of pollutants into the air and into surface and underground waters,
and the manufacture and disposal of certain substances.

One of these environmental laws is the Resource Conservation and Recovery
Act ("RCRA"), which authorizes individuals to bring citizen claims under RCRA.
In March 1996, one of the Company's railroads received notice from an individual
of his intent to file a citizen's suit under RCRA, primarily as a result of an
oil spill caused by a train derailment that occurred five years prior to the
Company's acquisition of the railroad property. The Company is unable to predict
whether a claim will be filed, the probable outcome of any such claim or the
amount or range of potential loss arising therefrom. In April 1996, one of the
Company's railroads received notice of three environmental site evaluations
being conducted by a state environmental agency. The evaluations are the result
of an alleged fuel spill caused by a train derailment and alleged on-site burial
of railroad ties and unreported leaking underground storage tanks and an alleged
release of diesel fuel during locomotive refueling. The Company believes these
evaluations relate to events that occurred prior to the Company's acquisition of
the railroad property. The Company is cooperating with the state environmental
agency to complete these evaluations. However, the Company may be held liable
for some or all expenses associated with these evaluations and the expenses
associated with any necessary remedial actions. To the extent the Company incurs
expenses in connection with these evaluations, or remedial actions, it may seek
to recover such expenses from the prior owners of the property or other
responsible parties. The Company is unable to predict the probable outcome of
these site evaluations or the amount or range of potential loss arising
therefrom. Other than the potential RCRA claim and the three environmental site
evaluations, there are no material environmental claims pending or, to the
Company's knowledge at this time, threatened against the Company.

The Company also believes that its operations are in material compliance
with current laws and regulations. The Company estimates that any expenses
incurred in maintaining compliance with current laws and regulations will not
have any material effect on the Company's earnings or capital expenditures.
However, the Company can provide no assurance that the current regulatory
requirements will not change or that currently unforeseen environmental
incidents will not occur or that past non-compliance with environmental laws
will not be discovered on the Company's properties.

ITEM 2. PROPERTIES

The Company, through its subsidiaries, operates over approximately 3,800
miles of track in 22 states, Canada and Mexico. The Company has added railroad
properties to its portfolio through purchase of track and roadbed,

16
<PAGE>
lease of such assets and contracts to operate properties under management
agreements, depending upon the economic and strategic considerations of the
divesting carriers. Of the 30 properties the Company has acquired to date, 19
are owned, four are leased, four are partially owned and partially leased, two
are operated under long-term management agreements and one ceased operations in
1996. After acquiring the right to operate a railroad property, the Company must
arrange for the purchase or lease of operating equipment and hire the work force
necessary to operate the property.

For properties which the Company owns, the continuity of operations of
purchased railroad properties has been limited to the physical transfer of these
assets. The Company typically does not contractually assume any of the
operations or liabilities of the divesting carriers. Quality of the Company's
title to its owned rights-of-way varies. The Company's properties were acquired
by its predecessors over extended periods of time and by different companies.
Accordingly, the original conveyancing documents were not standardized and are
subject to judicial interpretation as to the interest conveyed to the original
acquiring railroad. In cases involving other railroads, deeds have sometimes
been construed to create either an easement for railroad purposes or an
ownership interest that terminated upon the cessation of use for railroad
purposes. If the Company ceases to operate its railroad over a parcel, the
Company's interest in the parcel could revert to adjacent landowners or to
others holding a reversionary interest. In addition, under certain limited
circumstances, three of the railroad properties may be repurchased by the
original selling carriers for their original purchase prices.

For properties it leases, the Company ordinarily assumes upon the
commencement date all operating and financial responsibilities including
maintenance, payment of property taxes and regulatory compliance. Lease payments
on three railroads leased from one major railroad are structured to ensure that
the Company interchanges an agreed upon percentage of outbound carloads with the
lessor railroad. Under these leases, the Company makes no payments as long as it
interchanges a minimum percentage of its traffic with the lessor; therefore, the
Company controls the amount that may be payable under these leases. These leases
have an initial 20 year term with one or more renewal terms at the Company's
option. In addition, lease payments on five properties leased from two other
major railroads are subject to reduction from the base rate, down to zero,
depending upon the level of traffic interchanged with the lessors. The maximum
aggregate annual lease payments under these leases is approximately $1.7
million. These leases have initial lease terms of five years to 20 years and
include purchase options which may be exercised by the Company after one to
three years of operation. No payments have been required under any of the
Company's railroad property leases, and the Company anticipates that its traffic
interchange for the foreseeable future will not result in any payments being
incurred under any railroad property leases. Generally, upon the termination of
a lease, the Company does not have a right to the return of any capital
investment made in its property leased.

Rail properties operated by the Company under management agreements
typically have initial ten year terms followed by either a purchase option or
one or more renewal terms at the Company's option. These operating contracts
typically require that the Company assume all operating and financial
responsibilities for freight operations on the property including maintenance,
payment of property taxes and regulatory compliance. Payments by RailTex for the
right to conduct rail operations on these properties are typically calculated as
percentages of its revenues from the respective properties. Generally, as in the
case of leases, upon termination of these agreements the Company does not have a
right to the return of any capital investment made in the property managed.

The Company is currently seeking regulatory approval to abandon or
discontinue service on certain segments of track on three railroads to achieve
certain operating efficiencies. If approved, abandonment or discontinuance of
service on these segments would not have a material effect on the Company's
results of operations.

Railroad properties owned, leased or operated under contract by the
Company's subsidiaries typically consist of the track, ties and underlying land.
Real estate adjacent to the railroad rights-of-way is generally retained by the
seller, and the Company's holdings of such property are not material. Similarly,
the seller typically retains mineral rights and fiber optics easements in the
properties acquired by the Company. Revenues derived by the Company from various
rentals and easements totaled approximately $2.4 million in 1996.

17
<PAGE>
The following list describes each of the railroads operated by the Company
as of March 15, 1996:

The Austin & Northwestern ("AUNW") began operations on August 15, 1986 under
a ten year contract with Capital Metro, an Austin, Texas area transit authority
and the city of Austin. The AUNW experienced a significant decline in traffic in
1994 and 1995 and the Company did not expect significant improvement in the
foreseeable future. Given this situation, the AUNW decided not to pursue further
its rights unilaterally to renew the existing contract for an additional ten
year period and ceased operations in May 1996. As a result, the Company recorded
a Special Charge, in the second quarter of 1995, in the amount of $2,140,000
before tax and $1,389,000 after tax, or $0.15 per share, representing the write
down of the unamortized value of leasehold improvements of the AUNW.

The assets of the Cape Breton & Central Nova Scotia ("CBNS") were purchased
from Canadian National Railways ("CN") on October 1, 1993. The line is
approximately 245 miles long, and runs from Truro to Sydney, Nova Scotia.
Traffic includes coal, which both originates and terminates on the line. Inbound
traffic consists of scrap iron, chemicals, and salt. Outbound traffic consists
of newsprint, woodpulp, steel railroad rail, and railroad cars.

The assets of the Carolina Piedmont ("CPDR") were purchased from CSX
Transportation, Inc. ("CSX") on November 2, 1990. The line is approximately 37
miles long and runs from Greenville to Laurens, South Carolina. Inbound traffic
consists of plastics, resins, vegetable oils, cement, lumber, potash, glass
sand, brick, newsprint and various chemicals. Outbound traffic consists of
pulpwood, scrap paper and industrial engines.

The assets of the Central Oregon & Pacific Railroad ("CORP") were partially
purchased and partially leased from Southern Pacific Transportation Company
("SP") on December 31, 1994. The purchased segment is approximately 336 miles
long and runs from Belleview to Eugene, Oregon and from Eugene to Cordes,
Oregon. Another 103 miles is leased for five years and runs from Cordes to
Coquille, Oregon and from Belleview, Oregon to Black Butte, California. Outbound
traffic consists of lumber and wood products, and pulp and paper products.
Traffic also includes lumber and wood products which both originate and
terminate on the line.

The Chesapeake & Albemarle ("C&A") was leased from Norfolk Southern Railway
Company ("NS") on April 2, 1990 for a term of 20 years, with an option in favor
of C&A to purchase the line during the term of the lease. The railroad is
approximately 82 miles long and runs from Chesapeake, Virginia to Edenton, North
Carolina. Inbound traffic consists of limestone. Outbound traffic consists of
grain, lumber and scrap metal.

The assets of the Connecticut Southern ("CSOR") were purchased from Conrail
on September 21, 1996. The purchased segment is approximately 23 miles long and
located in Hartford, Connecticut. The CSOR operates an additional 49 miles of
track from just north of New Haven, Connecticut to Springfield, Massachusetts
under trackage rights. Inbound traffic consists of lumber and wood products,
pulp and paper products and metal products. Outbound traffic consists of scrap
paper.

The assets of the Dallas, Garland and Northeastern ("DGNO") were partially
purchased and partially leased from Union Pacific Railroad Company ("UP") on
February 9, 1992. The lease agreement provides for a 20 year term and grants
RailTex three options to renew for additional 20 year terms. The line is
approximately 92 miles long and extends from Trenton to Garland, Texas. Inbound
traffic consists of limestone, food, farm products and plastics. Outbound
traffic consists of food, farm products and plastics.

Substantially all of the assets of the Georgia Southwestern ("GSWR") were
purchased from CSX on June 5, 1989. The GSWR currently operates over 261 miles.
One segment extends from Preston, Georgia east to Rochelle, Georgia, and another
segment extends from Cuthbert, Georgia, south to Bainbridge, Georgia. The GSWR
also operates from Columbus to Cusseta, Georgia and from Columbus, east to
Americus then south to Albany, Georgia under a combination of track lease and
operating rights with Norfolk Southern. The GSWR also operates over two miles of
track in Dawson, Georgia which was acquired from CSX on December 14, 1990. This

18
<PAGE>
track was formerly operated by another RailTex railroad, the Georgia Great
Southern ("GGS"). The Georgia & Alabama ("GAAB") was leased from NS on June 1,
1989 for a term of 20 years with an option in favor of RailTex to purchase the
line during the term of the lease. The railroad is approximately 75 miles long
and runs from Smithville, Georgia to White Oak, Alabama. In 1995, the operations
of the GGS and GAAB were consolidated into the GSWR. Inbound traffic consists of
cement, fertilizer, sugar, forest products and chemicals. Outbound traffic
consists of forest products, grain, food products, lumber, auto parts, paper and
scrap metal.

The assets of the Goderich-Exeter ("GEXR") were purchased from CN on April
3, 1992. The line is approximately 70 miles long and runs from Goderich to
Centralia, Ontario. Inbound traffic consists of fertilizer and grain. Outbound
traffic consists of salt, grain and road machinery.

The assets of the Grand Rapids Eastern ("GRE") were purchased from Central
Michigan Railway Company ("CMGN") on July 10, 1993. The line is approximately 38
miles long and extends from Grand Rapids to Ionia, Michigan. Inbound traffic
consists of chemicals. Outbound traffic consists of auto parts.

The stock of the Indiana & Ohio Rail Corp. ("INOH") was purchased on June 4,
1996. Through its subsidiaries the INOH operates ten line segments totaling 230
miles of track in southwestern Ohio and southeastern Indiana. Inbound traffic
consists of farm products, non-metallic ores, chemicals and scrap metal.
Outbound traffic consists of farm products, food, chemicals, clay, concrete,
stone and scrap metal. On February 15, 1997, a subsidiary of the INOH, Indiana &
Ohio Railway Company ("IORY"), purchased from GTWR the assets of the former
Detroit, Toledo and Ironton ("DTI"). The DTI line is 146 miles long and is
located between Flat Rock, Michigan to Cincinnati, Ohio and with trackage rights
operates over 255 miles of track. Traffic consists primarily of automobiles and
automobile parts which both originate and terminate on the line.

The assets of the Indiana Southern ("ISRR") were purchased from Consolidated
Rail Corporation ("Conrail") on April 11, 1992. The line extends 170 miles from
Indianapolis to Evansville, Indiana. In addition, ISRR operates six miles of
trackage rights over Canadian Pacific ("CP") rail between Elnora and Bee Hunter,
Indiana. Traffic consists primarily of coal, which both originates and
terminates on the line.

The assets of the Michigan Shore ("MS") were purchased from CMGN on December
14, 1990. The line runs approximately 7 miles and is located in Muskegon,
Michigan. Outbound traffic consists of sand and chemicals.

The assets of the Mid-Michigan ("MMRR") were purchased from CSX on December
19, 1987. The MMRR consists of two separate line segments. One segment is
approximately 30 miles long and runs from Elmdale to Greenville, Michigan. The
other segment is approximately 37 miles long and runs from Paines to Alma,
Michigan. Inbound traffic consists of fertilizer, plastic and lumber. Outbound
traffic consists of refrigerators, unit grain trains, liquified petroleum gas,
scrap metal, auto parts and farm and food products.

The assets of the Missouri & Northern Arkansas ("M&NA") were partially
purchased and partially leased from UP on December 13, 1992. The lease has a 20
year term with three 20 year renewal options. The line is approximately 527
miles long and runs from Kansas City, Missouri to Newport, Arkansas; from Fort
Scott, Kansas to Clinton, Missouri, and from Carthage to Joplin, Missouri. The
M&NA operates over trackage rights on the UP from Pleasant Hill to Kansas City,
Missouri and from Diaz Junction to Newport, Arkansas. Inbound traffic consists
of coal and food products. Outbound traffic consists of grain products, frozen
food, minerals, chemicals, forest products and steel. The Branson Scenic
Railroad, Inc. ("BSR"), a passenger railroad operator which is not affiliated
with the Company, operates passenger excursion trains over a 44-mile segment of
the M&NA. The M&NA provides the crews to the BSR and, in turn, receives a flat
fee plus a specified percentage of the BSR's revenues over a base amount.

The assets of the New England Central ("NECR") were purchased from Grand
Trunk Corporation ("GTC"), an affiliate of CN, on February 4, 1995. The NECR
operates over approximately 319 miles of track, extending from East Alburgh,
Vermont to New London, Connecticut, plus an additional approximately six miles
over which it operates under trackage rights agreements. Inbound traffic
consists primarily of paper, lumber, copper and wood products. A significant
portion of the inbound lumber and paper products is received by transload
facilities

19
<PAGE>
located on the NECR. These facilities transload the commodities to truck for
further distribution throughout the New England area and beyond. The majority of
these transload operations are affiliated with the CN. Outbound traffic consists
primarily of corrugated paper and coal fly ash.

The assets of the New Orleans Lower Coast ("NOLR") were purchased from UP on
March 17, 1991. The line is approximately 24 miles long and runs from Gouldsboro
to Myrtle Grove, Louisiana. Inbound traffic consists of unit grain trains.
Outbound traffic consists of petroleum products.

The assets of the North Carolina & Virginia ("NCVA") were purchased from CSX
on November 1, 1987. The line is approximately 54 miles long and runs from
Boykins, Virginia, south to Kelford, North Carolina, then northeast to Tunis,
North Carolina. Inbound traffic consists of grain and chemicals. Outbound
traffic consists of woodchips, lumber, particle board, peanuts and peanut hulls.

The assets of the Northeast Kansas & Missouri ("NEKM") were purchased from
UP on February 26, 1990. The railroad is approximately 114 miles long and
extends west from St. Joseph, Missouri to Upland, Kansas. Inbound traffic
consists of fertilizers. Outbound traffic consists of grain and food products.

The assets of the Ontario L'Orignal ("OLOR") were purchased from CN
effective November 2, 1996. The line is approximately 26 miles long and is
located in eastern Ontario, Canada. Traffic consists primarily of scrap iron and
steel products, which both originate and terminate on the line.

The assets of the Pittsburgh Industrial ("PIRR") were purchased from Conrail
on December 7, 1996. The line is approximately 42 miles long and is located in
the Pittsburgh metropolitan area. Inbound traffic consists of scrap metal,
plastics, lubricating oils, chemicals and food products. Outbound traffic
consists of scrap metal, plastics and chemicals.

The Salt Lake City Southern ("SLCS") began operating over property owned by
the Utah Transit Authority ("UTA") on April 19, 1993. The SLCS operates the
property under a freight easement granted by UP, the former owner of the line.
The easement may be repurchased by UP for a nominal amount at any time after
October 30, 1997. The line is approximately 25 miles long and extends from Salt
Lake City to Mount, Utah. Inbound traffic consists of cement, grain, lumber and
coal.

The San Diego & Imperial Valley ("SDIV") began operations on October 15,
1984 under a ten year contract with the San Diego Metropolitan Transit
Development Board ("MTDB") in the San Diego, California area. Under the terms of
this contract, the SDIV provides freight service over trackage owned by a
subsidiary of MTDB and over which MTDB provides passenger service. In 1994, the
SDIV exercised an option to renew the contract until 2004. Additionally, this
contract has three remaining ten year renewal options. SDIV also has a trackage
rights agreement with Ferrocarriles Nacionales de Mexico Region Pacifico
("Ferrocarriles"). This agreement has a ten year term, but may be terminated by
Ferrocarriles with one year's notice in the event of a change in Mexican law or
presidential decree. The SDIV is approximately 163 miles long and extends from
San Diego, California through Tijuana and Tecate, Mexico, to Plaster City,
California. Inbound traffic consists of liquefied petroleum gas, lumber,
beverages, paper, plastics, lard and grain. Outbound traffic consists of scrap
metal and scrap paper.

The assets of the South Carolina Central ("SCC") were purchased from CSX on
December 1, 1987. The railroad is composed of two line segments. One is
approximately 46 miles long and runs from Florence to Bishopville, South
Carolina. The other is approximately 12 miles long and runs from Cheraw to
Society Hill, South Carolina. Inbound traffic consists of scrap metal,
chemicals, coal, scrap paper and corn sweeteners. Outbound traffic consists of
finished steel and paper.

The assets of the Texas-New Mexico ("TNMR") were purchased from UP on
September 18, 1989. The line is approximately 107 miles long and runs from
Monahans, Texas north to Lovington, New Mexico. Outbound traffic consists of
liquefied petroleum gas, chemicals, farm products, scrap metal and minerals.

20
<PAGE>
The Texas Northeastern ("TNER") was leased from UP effective October 22,
1990 under a 20 year lease with three 20 year options to renew. The line is
approximately 107 miles long and runs from Texarkana to New Boston, Texas, from
Paris, Texas to Sherman, Texas, from Sherman, Texas north to Denison, Texas and
from Bells, Texas south to Trenton, Texas. Inbound traffic consists of food,
paper products and edible oils. Outbound traffic consists of grain.

The Virginia Southern ("VSRR") was leased from NS on November 28, 1988 under
a 20 year lease agreement. The lease grants VSRR a right to purchase
substantially all of the line during the term of the lease for its net
liquidation value. The line is approximately 75 miles long and extends from
Burkeville, Virginia to Oxford, North Carolina. Inbound traffic consists of
coal, wool, fructose and chemicals. Outbound traffic consists of pulpwood and
woodchips.

In August 1995, the Company entered into a management agreement with
Tengizchevroil ("TCO"), a limited partnership of Chevron Overseas Company and
Tengizmunaygaz, to provide on-site technical and operating management of the TCO
railroad. The railroad runs from Kulsary, Kazakhstan to the TCO plant complex at
Tengiz, Kazakhstan, a distance of approximately 104 kilometers or 62 miles. The
initial term of the agreement is for two years with year-to-year extensions
after the initial term. Currently, the Company is in the process of
renegotiating the contract.

TRACK

RailTex conducted its freight operations on 3,793 miles of track as of
February 28, 1997. Railroads owned by the Company represented 2,394 miles of
track. Railroads operated by the Company pursuant to lease arrangements from
other railroads comprised 901 miles of track. Railroads operated by the Company
under long-term operating contracts with the owners accounted for an additional
139 miles of track. In addition, the Company operated on 359 miles of track
owned by other railroads pursuant to trackage rights agreements.

Because of the relatively short length of the typical RailTex railroad and
the stop-and-start nature of its switching activity, most of the Company's
freight operations are conducted at speeds of 25 miles per hour or less. Of the
3,793 miles of track operated by the Company on February 28, 1997, 7.0% was in
FRA Class IV condition, permitting speeds up to 60 miles per hour, 28.0% was in
FRA Class III condition, permitting speeds up to 40 miles per hour for freight
trains. An additional 36.0% was in FRA Class II condition, permitting speeds up
to 25 miles per hour. Another 19.0% was in FRA Class I or FRA Excepted Class I
condition, which permits maximum speeds of ten miles per hour. The remaining
10.0% was located in Mexico or Canada and not subject to FRA inspection and
regulation. Of the U.S. track owned by RailTex, 79.0% was rated FRA Class II or
higher and 21.0% was rated FRA Class I or lower at February 28, 1997.

TRACK CONDITION
<TABLE>
<CAPTION>
FRA CLASS
----------------------------------------
IV III II I EXCEPTED OTHER TOTAL %
--- ----- ----- --- --- --- ----- ---
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Owned .......................... 146 568 892 296 151 341 2,394 63%
Leased ......................... -- 371 402 89 39 -- 901 24
Contract ....................... -- 49 7 74 9 -- 139 4
Trackage Rights(1) ............. 109 93 45 63 -- 49 359 9
--- ----- ----- --- --- --- ----- ---
Total Miles ............... 255 1,081 1,346 522 199 390 3,793 100%
=== ===== ===== === === === ===== ===
FRA Track Class as Percentage of
Miles .......................... 7% 28% 36% 14% 5% 10% 100%
</TABLE>
- --------------
(1) Includes trackage rights associated with owned or leased railroad
properties.

The Company's track maintenance strategy is to maintain its track, ties,
roadbed and structures consistent with safe operations and with the volume of
traffic transported over its lines. RailTex believes its capital expenditure
requirements for track maintenance are lower than those incurred by the major
rail carriers which previously operated most of the Company's railroad
properties because such major rail carriers generally operated

21
<PAGE>
at higher speeds over this track and, therefore, required greater levels of
track maintenance. Also, the labor costs incurred by major railroads for track
maintenance are typically higher than RailTex's labor costs.

Safety-related maintenance needs receive the Company's highest maintenance
priority, followed by high density track segments on which the highest volume of
traffic is transported. Low-density segments, sidings, and lines for which
higher transit speeds are not essential to providing timely and effective
customer service are maintained at lower FRA class conditions. Track maintenance
is performed by each railroad's operating personnel with local track contractors
supplementing this effort on an as-needed basis. In connection with the lease of
one of its railroad properties, the Company has committed to upgrade
approximately 107 miles, net of abandonments, of track to Class II standards by
October 1998; however, the Company is negotiating with the lessor to extend this
period. The Company now estimates the cost of this upgrade to be approximately
$4.0 million to $5.0 million.

EQUIPMENT

At February 28, 1997, the Company's rolling stock consisted of 234
locomotives and 3,805 freight cars, some of which it owned and some of which
were leased from others. All of the leased locomotives and freight cars were
provided under short-term operating lease agreements or per diem sharing
agreements. The following table summarizes the composition of the Company's
equipment fleet at February 28, 1997:

LOCOMOTIVES

HORSEPOWER/UNIT OWNED LEASED TOTAL
----- ------ -----
1500 to 3000 ........................ 220 8 228
1500 and under ...................... 6 - 6
----- ------ -----
Total .......................... 226 8 234
===== ====== =====

The average age of the Company's locomotive fleet is 32 years. Of the 226
locomotives owned by RailTex, most have been rebuilt, updated or overhauled.
Calculating locomotive age from the date of rebuild, the Company's locomotives
have an average age of 26 years. The Company's availability rate with respect to
its locomotive fleet was 90.0% in 1996.

FREIGHT CARS
PER DIEM
SHARING
TYPE OWNED LEASED ARRANGEMENTS TOTAL
--- ----- ----- -----
Hopper cars ...................... 94 793 254 1,141
Flat cars ........................ 105 43 455 603
Gondola cars ..................... -- 55 725 780
Box cars ......................... 24 110 1,137 1,271
Refrigerated box cars ............ -- 10 -- 10
--- ----- ----- -----
Total ....................... 223 1,011 2,571 3,805
=== ===== ===== =====

The Company has entered into per diem sharing arrangements covering 2,571
cars as of February 28, 1997. Under these arrangements, the Company agrees to
place the freight cars on its railroads for prospective loading by customers
and, in exchange, the Company does not incur rent on these cars when these cars
are on one of its railroads. In addition, car owners pay the Company a portion
of the rents earned when the freight cars are on railroads other than the
Company's.

ITEM 3. LEGAL PROCEEDINGS

The Company is currently subject to a number of claims and legal actions
that arose in the ordinary course of business, including FELA claims by its
employees and personal injury claims (including wrongful death claims) by third
parties. The Company believes these claims, taking into account reserves and
applicable insurance, will

22
<PAGE>
not have a material adverse effect on the Company. Adverse judgments in these
claims, individually or in the aggregate, in excess of related reserves and
applicable insurance, could have a materially adverse effect on the Company's
financial condition and results of its operations.

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

None.

EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth information regarding the executive officers
of the Company.

NAME AGE POSITION
- ---- --- --------
Bruce M. Flohr............... 57 Chairman of the Board, Chief Executive
Officer, and Director

Henry M. Chidgey............. 47 President, Chief Operating Officer, and
Director

Laura D. Davies.............. 38 Vice President-Finance and Administration,
Chief Financial Officer and Director

Michael T. Brigham........... 50 Vice President-Sales and Marketing

David P. Valentine........... 70 Vice President-Line Analysis

Michael A. Nosil............. 49 Vice President-Human Resources

Mr. Flohr founded RailTex in 1977 and has served as Chairman of the Board of
Directors, and Chief Executive Officer since that date. From 1977 to October
1995, Mr. Flohr also served as President of RailTex. From 1975 through 1977, Mr.
Flohr held the positions of Deputy Administrator and Acting Administrator of the
Federal Railroad Administration in Washington, DC. In those positions he had
primary responsibility for rail safety, operation of the Alaska Railroad, and
operation of the Transportation Test Center at Pueblo, Colorado. Mr. Flohr was
employed by the Southern Pacific Transportation Company from 1965 through 1975
and served as Division Superintendent of its San Antonio Division from 1971
through 1975. He is a founder and current Chairman of the Regional Railroads of
America and is a Director of the Association of American Railroads. Mr.
Flohr is also a director of Harmon Industries, Inc.

Mr. Chidgey joined RailTex as Chief Operating Officer in April, 1995. He was
elected to be a Director of RailTex in June 1995. In October, 1995, Mr. Chidgey
was appointed as President of RailTex. From 1993 through 1995, Mr. Chidgey was
employed by the Southern Pacific Transportation Company as Vice President and
Chief Mechanical Officer. From 1989 to 1993, Mr. Chidgey was Vice President and
Chief Mechanical Officer of the Illinois Central Railroad Company. Prior to
joining the Illinois Central Railroad Company, Mr. Chidgey was employed, for 19
years, by the Southern Pacific Transportation Company where he held various
operating positions.

Mrs. Davies has served as Vice President-Finance and Administration and
Chief Financial Officer since July 1995. Mrs. Davies was Vice President-Finance
of RailTex Service Co., Inc. ("RSC"), a subsidiary of RailTex from February 1995
to June 1995 and as Controller of RSC since 1986. She was elected to be a
Director of RailTex in June 1996. Mrs. Davies is a Certified Public Accountant
and from 1981 to 1986 was employed by Arthur Andersen LLP.

Mr. Brigham has served as Vice President-Sales and Marketing since October,
1995. Mr. Brigham was Regional General Manager of RSC from 1993 to October,
1995. From 1991 to 1993, Mr. Brigham was General Manager of the ISRR. From 1989
to 1991, Mr. Brigham was General Manager of the GAAB, the NEKM and the TNER. Mr.
Brigham joined RailTex in 1987 as Marketing Manager on the AUNW. Prior to

23
<PAGE>
joining RailTex, Mr. Brigham was employed by the Missouri-Kansas-Texas Railroad
in the marketing department from 1973 to 1987.

Mr. Valentine has served as Vice President-Line Acquisitions of RSC since
September 1995. From 1987 to September 1995 Mr. Valentine was Vice
President-Rail of RSC. From 1970 through 1986, Mr. Valentine was employed by The
Atchison, Topeka & Santa Fe Railway Company, most recently as General
Superintendent of Transportation and General Manager-Western Lines.

Mr. Nosil has served as Vice President-Human Resources since June 1996.
Prior to joining RailTex, Mr. Nosil was managing consultant for Hewitt
Associates, LLC, a major international human resource consulting firm, from 1993
to 1996. From 1975 to 1992, Mr. Nosil was employed by La Quinta Motor Inns,
Inc., most recently as Vice President of Human Resources. Mr. Nosil was plant
personnel manager in Arlington, Texas for NCR Corporation from 1972 to 1975.

The executive officers of the Company serve at the discretion of the
Company's Board of Directors.

The remainder of this page is intentionally left blank.

24
<PAGE>
PART II

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

The Company's Common Stock is traded on the Nasdaq National Market under the
symbol "RTEX". The following table sets forth, for the periods indicated, the
high and low sales price per share of the Company's Common Stock as quoted on
the Nasdaq National Market.

PRICE PER SHARE
---------------------------
HIGH LOW
------- -------
1995
First Quarter ........... $26 3/4 $21 1/4
Second Quarter .......... 28 1/4 23 1/2
Third Quarter ........... 29 1/2 19 1/2
Fourth Quarter .......... 21 1/4 17 1/4
1996
First Quarter ........... 25 5/8 20 1/4
Second Quarter .......... 25 3/4 23 1/4
Third Quarter ........... 26 1/2 21 1/2
Fourth Quarter .......... 27 3/8 19 3/4

Since its inception, the Company has not paid, and it has no current plans
to pay, cash dividends on the Common Stock. The Company currently intends to
retain all earnings to support the Company's operations and future growth. The
payment of any future dividends will be determined by the Board of Directors
based upon the Company's earnings, financial condition and cash requirements,
restrictions in financing agreements, business conditions and other factors that
the Board of Directors may deem relevant. The Company's financing agreements
prohibit the payment of dividends. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and Capital
Resources."

As of March 25, 1997, the Company had 9,152,260 shares of Common Stock
outstanding and there were 429 shareholders of record.

25
<PAGE>
ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AND OPERATING DATA)
<S> <C> <C> <C> <C> <C>
SUMMARY OF INCOME STATEMENT DATA:
Operating revenues ................................. $ 39,343 $ 59,849 $ 74,528 $ 107,841 $ 121,106
Operating expenses ................................. (32,222) (49,534) (61,351) (90,046) (99,065)
--------- --------- --------- --------- ---------
Operating income before Special Charge ............. 7,121 10,315 13,177 17,795 22,041
Special Charge for AUNW discontinuance ............. -- -- -- (2,140) --
--------- --------- --------- --------- ---------
Operating income ................................... 7,121 10,315 13,177 15,655 22,041
Interest expense ................................... (2,829) (4,719) (2,965) (5,696) (6,893)
Other income ....................................... 178 504 1,287 1,715 1,521
--------- --------- --------- --------- ---------
Income before taxes ................................ 4,470 6,100 11,499 11,674 16,669
Income taxes ....................................... (1,767) (2,467) (4,618) (4,776) (6,708)
--------- --------- --------- --------- ---------
Net income ......................................... $ 2,703 $ 3,633 $ 6,881 $ 6,898 $ 9,961
========= ========= ========= ========= =========
PER SHARE DATA:
Net income per share ............................... $ 0.52 $ 0.65 $ 0.88 $ 0.78 $ 1.08
========= ========= ========= ========= =========
Weighted average number of shares
of Common Stock and Common Stock
equivalents (in thousands) ......................... 5,243 5,621 7,820 8,897 9,231

OPERATING DATA:
Total track mileage (1) ............................ 1,818 2,496 2,713 3,390 3,431
Total carloads ..................................... 152,508 222,909 253,163 318,187 359,669
Total employees (1) ................................ 277 402 505 681 720
Operating revenues per mile (1) .................... $ 21,641 $ 23,978 $ 27,471 $ 31,812 $ 35,298
Operating revenues per carload ..................... $ 258 $ 268 $ 294 $ 339 $ 337
Operating revenues per employee (1) ................ $ 142,032 $ 148,878 $ 147,580 $ 158,357 $ 168,203
Carloads per mile (1) .............................. 84 89 93 94 105
Carloads per employee (1) .......................... 551 555 501 467 500
Operating ratio before Special Charge (2) .......... 81.9% 82.8% 82.3% 83.5% 81.8%
Operating ratio after Special Charge (2) .......... 81.9% 82.8% 82.3% 85.5% 81.8%
Labor ratio (3) .................................... 30.8% 30.6% 29.1% 30.3% 28.9%

BALANCE SHEET DATA AS OF PERIOD END:
Total assets ....................................... $ 80,694 $ 113,303 $ 139,656 $ 204,982 $ 269,470
Long-term debt ..................................... 42,360 29,310 43,389 58,911 98,704
Shareholders' equity ............................... 25,003 65,671 72,382 112,602 122,703
</TABLE>
- -----------------
(1) Total track mileage and total employees are calculated based on weighted
monthly averages over the respective periods.

(2) Operating ratio equals operating expenses divided by operating revenues. See
"Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations--General."

(3) Labor ratio equals labor expenses divided by operating revenues. See "Item
7. Management's Discussion and Analysis of Financial Condition and Results
of Operations--General."

26
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

THE FOLLOWING DISCUSSION SHOULD BE READ IN CONNECTION WITH THE COMPANY'S
CONSOLIDATED FINANCIAL STATEMENTS, RELATED NOTES AND OTHER FINANCIAL INFORMATION
INCLUDED ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K.

GENERAL

The Company's growth to date has resulted primarily from implementation of
its expansion strategy. The number of miles of track operated by RailTex has
grown to more than 3,500 at December 31, 1996.

The Company has added railroad properties to its portfolio primarily through
purchase of track and roadbed, lease of such assets, and contracts to operate
such assets under management agreements. These arrangements typically relate
only to the physical assets of the railroad property; and except for the
purchase of the Indiana & Ohio Rail Corp. ("INOH"), which was structured as an
acquisition of stock, the Company typically does not contractually assume any of
the operations or liabilities of the divesting carriers. After acquiring the
right to operate each of its railroad properties, the Company must arrange for
the purchase or lease of operating equipment and hire the work force necessary
to operate the railroad. Accordingly, for any railroad property, the historical
results of operations of the railroad property as previously operated are not
necessarily indicative of the results of operations for the property following
commencement of operations by the Company.

Because of variations in the structure, timing and size of portfolio
additions and differences in economics among the Company's portfolio railroads
resulting from the unique terms, rates and other provisions for each railroad's
operation established through negotiation between RailTex and each divesting
carrier, the Company's results of operations in any reporting period may not be
directly comparable to (i) its results of operations in other reporting periods
or (ii) the results of operations of other railroad companies. Therefore, care
should be taken when using traditional measurements of railroad operating
performance, such as freight revenues per carload, operating ratio and labor
ratio, in assessing or comparing the Company's operating results.

"Comparable Railroad Properties" for each period are railroad properties
which the Company operated throughout both the full current year and the full
prior year. "New Railroad Properties" for each period are railroad properties
which the Company began operating after the start of the prior year.

For 1996, New Railroad Properties include the New England Central Railroad
("NECR"), which operated for a full twelve months in 1996 versus eleven months
in 1995 and 1996 acquired properties, the INOH, the Connecticut Southern
Railroad ("CSOR"), the Ontario L'Orignal Railway, Inc. ("OLOR") and the
Pittsburgh Industrial Railroad, Inc. ("PIRR").

RESULTS OF OPERATIONS

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

The Company's net income increased by $1.7 million, or 20.1%, to $10.0
million in 1996 excluding the impact of a Special Charge ("Special Charge")
recorded in 1995, representing the write down in the amount of $2,140,000 before
taxes ($1,389,000 or $0.15 per share after taxes) to reflect the unamortized
value of leasehold improvements of the Austin and Northwestern Railroad
("AUNW"), which ceased operations in May 1996. Net income per share increased by
16.1% to $1.08 from $0.93 in the prior year, excluding the Special Charge.
Including the Special Charge recorded in 1995, the Company's net income
increased by $3.0 million, or 44.0%, to $10.0 million from $6.9 million in the
prior year and net income per share increased 38.5% to $1.08 from $0.78 in the
prior year.

27
<PAGE>
The following table compares operating revenues, operating expenses,
operating income and income before income taxes, excluding the Special Charge,
for the years ended December 31, 1995 and 1996, (in thousands):

FOR THE YEARS
ENDED DECEMBER 31,
----------------------------
1995 1996
--------- ---------
Operating revenues ....................... $ 107,841 $ 121,106
Operating expenses ....................... 90,046 99,065
--------- ---------
Operating income ......................... 17,795 22,041
Other income (expense) ................... (3,981) (5,372)
--------- ---------
Income before income taxes ............... $ 13,814 $ 16,669
========= =========

OPERATING REVENUES. Operating revenues in 1996 increased by $13.3 million,
or 12.3%, to $121.1 million from $107.8 million in the prior year. Operating
revenues attributable to New Railroad Properties accounted for 60.3% of this
increase. Operating revenues for Comparable Railroad Properties increased $5.5
million, or 6.2%. Carloads transported increased by 41,482 carloads, or 13.0%,
to 359,669 carloads from 318,187 carloads in the prior year. Carloads
attributable to New Railroad Properties accounted for 48.9% of this increase
while carloads attributable to Comparable Railroad Properties increased 8.3%
over the prior year.

In January 1997, a wall at a coal mine served by one of the Company's
subsidiaries collapsed which will reduce first quarter 1997 operating revenues
by approximately $1.0 million.

Freight operating revenues in 1996 increased by $11.1 million, or 12.1%, to
$103.0 million from $91.9 million in the prior year. The following table
compares freight revenues, traffic volume (in carloads) and average freight
revenues per carload by commodity group for the years ended December 31, 1995
and 1996.

FREIGHT REVENUES AND CARLOADS COMPARISON BY COMMODITY GROUP
YEARS ENDED DECEMBER 31, 1995 AND 1996
<TABLE>
<CAPTION>
FREIGHT REVENUES CARLOADS
---------------------------------------- --------------------------------------- AVERAGE
1995 1996 1995 1996 FREIGHT
------------------ ------------------- ------------------ ----------------- REVENUES PER
(DOLLARS IN THOUSANDS) CARLOAD(1)
% OF % OF % OF % OF ------------
COMMODITY GROUP DOLLARS TOTAL DOLLARS TOTAL NUMBER TOTAL NUMBER TOTAL 1995 1996
- --------------- ------- ----- -------- ----- ------- ------ ------ ----- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Lumber and forest products .... $18,875 20.5% $ 21,811 21.2% 46,748 14.7% 57,456 16.0% $404 $380
Coal .......................... 15,307 16.7 16,240 15.8 72,864 22.9 84,957 23.6 210 191
Chemicals ..................... 9,652 10.5 11,484 11.1 29,361 9.2 33,221 9.2 329 346
Scrap paper & paper products .. 9,452 10.3 9,758 9.5 22,724 7.1 24,075 6.7 416 405
Scrap metal & metal products .. 7,808 8.5 7,419 7.2 24,347 7.7 23,231 6.5 321 319
Farm-products ................. 7,476 8.1 8,986 8.7 31,754 10.0 34,767 9.7 235 258
Non-metallic ores ............. 5,980 6.5 6,898 6.7 32,246 10.1 36,365 10.1 185 190
Food products ................. 4,954 5.4 5,944 5.8 19,837 6.2 22,049 6.1 250 270
Petroleum products ............ 4,592 5.0 4,767 4.6 10,476 3.3 11,623 3.2 438 410
Minerals and stone ............ 3,983 4.3 5,008 4.9 13,659 4.3 14,306 4.0 292 350
Other ......................... 3,830 4.2 4,702 4.5 14,171 4.5 17,619 4.9 270 267
------- ----- -------- ----- ------- ----- ------- -----
Total .................... $91,909 100.0% $103,017 100.0% 318,187 100.0% 359,669 100.0% $289 $286
======= ===== ======== ===== ======= ===== ======= =====
</TABLE>
- ---------------
(1) Calculated as freight revenues divided by carloads.

Approximately $7.4 million, or 66.7%, of the $11.1 million increase in
freight operating revenues in 1996 is attributable to New Railroad Properties.
These properties added approximately 20,278 carloads consisting primarily of
lumber and forest products (2,318), chemicals (3,389), scrap paper and paper
products (4,294), scrap metal and metal products (2,540), farm products (1,815),
non-metallic ores (1,790), food products (1,777), and minerals and stone
(1,247). Freight revenues for Comparable Railroad Properties in 1996 increased
by $4.4

28
<PAGE>
million, or 5.7%, while carloadings for Comparable Railroad Properties increased
23,869, or 8.0%, consisting primarily of lumber and forest products (8,390),
coal (12,688) and non-metallic ores (2,329).

Non-freight operating revenues in 1996 increased by $2.2 million, or 13.8%,
to $18.1 million from $15.9 million in the prior year. Non-freight operating
revenues include joint facilities, switching, demurrage, car hire, car repair
and track maintenance services performed for third parties and lease income.
These revenues contributed 14.9% and 14.8% of operating revenues in 1996 and
1995, respectively. New Railroad Properties contributed approximately $550,000,
or 25.0%, of the increase, primarily as a result of demurrage, car hire income
and joint facility income. Non-freight revenues for Comparable Railroad
Properties increased approximately $1.1 million, or 9.2%, primarily as a result
of increased carhire, switching, demurrage and other income which were partially
offset by decreases in car repair income.

OPERATING EXPENSES. Operating expenses, excluding the effects of the Special
Charge recorded in 1995, increased $9.0 million, or 10.0%, to $99.1 million from
$90.1 million in the prior year. The Company's operating ratio (operating
expenses divided by operating revenues), decreased for the year, to 81.8%,
compared to 83.5% in the prior year. New Railroad Properties represent 73.5% of
the increase in expenses. The remainder of the increase is attributable to a
2.6% increase in expenses for Comparable Railroad Properties and a 12.7%
increase in corporate expenses including depreciation expense on locomotives
acquired for New Railroad Properties.

The following table sets forth a comparison of the Company's operating
expenses during 1995 and 1996, in dollars and as a percentage of operating
revenues.

OPERATING EXPENSES COMPARISON
YEARS ENDED DECEMBER 31, 1995 AND 1996

1995 1996
------------------ ------------------
%OF % OF
OPERATING OPERATING
DOLLARS REVENUES DOLLARS REVENUES
------- --------- ------- ---------
(DOLLARS IN THOUSANDS)
Labor and benefits ...................... $32,662 30.3% $35,025 28.9%
Equipment rents ......................... 14,170 13.2 13,845 11.5
Depreciation and amortization ........... 8,237 7.6 10,147 8.4
Diesel fuel ............................. 7,666 7.1 9,307 7.7
Purchased services ...................... 6,179 5.7 8,129 6.7
Casualties and insurance ................ 5,607 5.2 5,867 4.8
Materials ............................... 4,880 4.5 4,387 3.6
Other ................................... 10,645 9.9 12,358 10.2
------- ---- ------- ----
Total excluding Special Charge ..... 90,046 83.5 99,065 81.8

Special Charge for AUNW discontinuance .. 2,140 2.0 -- --
------- ---- ------- ----
Total .............................. $92,186 85.5% $99,065 81.8%
======= ==== ======= ====

Labor and benefits in 1996 increased $2.4 million, or 7.4%, to $35.0 million
from $32.6 million in the prior year. Labor and benefits attributable to New
Railroad Properties increased $2.3 million and accounted for 95.8% of the
overall increase. Labor and benefits for Comparable Railroad Properties
increased approximately $200,000, or only 1.0%, despite the 8.0% increase in
carloadings.

Equipment rents in 1996 decreased approximately $325,000, or 2.3%, to $13.8
million from $14.2 million in the prior year. Equipment rents attributable to
New Railroad Properties increased $1.1 million, or 37.2%.

29
<PAGE>
Equipment rents for Comparable Railroad Properties decreased 3.3% due primarily
to decreased car hire expense. The decrease in car hire expense is due to
certain per diem sharing arrangements under which the Company has placed over
2,300 freight cars on its railroads for prospective loading by customers and, in
exchange, the Company does not incur rent on these cars when these cars are on
its railroads. In addition, the car owners pay the Company a portion of the
rents earned when the freight cars are on railroads other than the Company's.
The remainder of the decrease is due primarily to the AUNW which ceased
operations in May 1996.

Depreciation and amortization in 1996 increased $1.9 million, or 23.2%, to
$10.1 million from $8.2 million in the prior year. Depreciation and amortization
attributable to New Railroad Properties accounted for 30.3% of this increase.
The remainder is due to capital projects completed for Comparable Railroad
Properties, increased locomotive depreciation related to fleet expansion and
depreciation of new computer hardware and software.

Diesel fuel expense in 1996 increased $1.7 million, or 22.4%, to $9.3
million from $7.6 million in the prior year. New Railroad Properties accounted
for 49.1% of this increase. Diesel fuel expense for Comparable Railroad
Properties increased by approximately $880,000, or 13.5%, due to a combination
of increased consumption related to increased carloadings and higher fuel prices
during the current year. The Company's average fuel cost per gallon increased
approximately $0.10 per gallon, or 14.5%, in 1996. The Company has taken several
steps to reduce its exposure to fuel price fluctuations, including entering into
a fuel hedging collar in July 1996 for approximately 32.0% of the Company's
estimated annual fuel consumption. Additionally, the Company has retained an
independent contractor to negotiate fuel prices for the Company's railroads on a
centralized basis. This contractor will be compensated on a percentage of cost
savings basis.

Purchased services in 1996 increased $1.9 million, or 30.6%, to $8.1 million
from $6.2 million in the prior year. Purchased services attributable to New
Railroad Properties accounted for 16.2% of this increase. Purchased services for
Comparable Railroad Properties increased by approximately $978,000, or 19.5%,
due primarily to increased contract labor related to maintenance of way,
locomotive repairs and warehousing activities. The remainder is primarily due to
increased headquarters' computer services expense.

Casualties and insurance expense in 1996 increased approximately $260,000,
or 4.6%, to $5.9 million from $5.6 million in the prior year. New Railroad
Properties accounted for 51.9% of the increase. Casualties and insurance expense
for Comparable Railroad Properties increased by approximately $690,000, or
15.7%, related to higher casualty expenses primarily related to derailments and
a personal injury which resulted in a fatality. The increase for Comparable
Railroad Properties was partially offset by adjustments to headquarters' self
insured retention liability.

Materials expense in 1996 decreased approximately $490,000, or 10.0%, to
$4.4 million from $4.9 million in the prior year. Materials cost for New
Railroad Properties increased by approximately $205,000. Materials expense for
Comparable Railroad Properties decreased approximately $910,000, or 23.0%,
primarily as a result of decreased car repair and locomotive repair materials in
the current year. The remainder of the change is due to an increase of
approximately $200,000 in headquarters' expenses attributable to increased
spending on locomotives related to new acquisitions and locomotives leased from
third parties.

Other expenses in 1996, including property and franchise taxes and joint
facilities, increased $1.8 million, or 17.0%, to $12.4 million from $10.6
million in the prior year. Other expenses for New Railroad Properties accounted
for 65.6% of this increase. Other expenses for Comparable Railroad Properties
increased by approximately $20,000, or 0.3%, as increased trackage rights
expense and bad debt expenses were offset by decreased property taxes. Trackage
rights expense increased due to the track lease and operating rights agreement
with a connecting Class I carrier on GSWR (see "Properties"). The remainder of
the increase is due to an approximately $200,000 increase in headquarters'
expenses attributable to the Company's growth.

INTEREST EXPENSE. Interest expense in 1996 increased $1.2 million, or 21.0%,
to $6.9 million from $5.7 million in the prior year due to borrowings totaling
$20.0 million to fund acquisitions and totaling $21.2 million to fund the
Company's equity investments in Brazil.

30
<PAGE>
OTHER INCOME. Other income in 1996 decreased by approximately $194,000, or
11.3%, to $1.5 million from $1.7 million in the prior year due primarily to
fewer sales of non-operating properties.

INCOME TAXES. The Company's effective tax rate in 1996 decreased slightly to
40.2% from 40.9% in the prior year. This decrease is a result of a decrease in
the Company's effective state income tax rate in 1996 and a decrease in the
percentage of total income from foreign sources which typically have a higher
tax rate. Of the $6.7 million of income tax expense in 1996, approximately $3.3
million is payable currently and approximately $3.4 million is deferred.

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

The Company's net income in 1995, excluding the Special Charge, increased by
$1.4 million, or 20.4%, to $8.3 million. Net income per share, excluding the
Special Charge, increased by 5.7% to $0.93 from $0.88 in the prior year. Net
income per share reflects a 13.8% increase in weighted average shares
outstanding, as the Company completed a public offering of 1,150,000 shares of
common stock in March 1995. Including the Special Charge of $2,140,000 before
tax and $1,389,000 after tax, or $0.15 per share, net income was $6.9 million
and net income per share was $0.78.

The following table compares operating revenues, operating expenses,
operating income and income before income taxes, excluding the Special Charge,
for the years ended December 31, 1994 and 1995, in thousands:

FOR THE YEARS
ENDED DECEMBER 31,
---------------------------
1994 1995
-------- ---------
Operating revenues ........................ $ 74,528 $ 107,841
Operating expenses ........................ 61,351 90,046
-------- ---------
Operating income .......................... 13,177 17,795
Other income (expense) .................... (1,678) (3,981)
-------- ---------
Income before income taxes ................ $ 11,499 $ 13,814
======== =========

OPERATING REVENUES. Operating revenues, including non-freight revenues,
increased in 1995 by $33.3 million, or 44.7%, to $107.8 million from $74.5
million in the prior year period. Operating revenues attributable to New
Railroad Properties accounted for essentially all of this increase. Operating
revenues for Comparable Railroad Properties were unchanged from the prior year
period. Carloads transported increased by 65,024 carloads, or 25.7%, to 318,187
carloads from 253,163 carloads in the prior year. Carloads attributable to New
Railroad Properties accounted for 88.5% of this increase while carloads
attributable to Comparable Railroad Properties increased 3.0% over the prior
year.

Substantially all of the year's operating revenue increase is attributable
to the inclusion of the results of the CORP, which commenced operations on
December 31, 1994, and the NECR, which commenced operations on February 4, 1995.
Comparable Railroad Properties operating revenues were unchanged for the year as
compared to historical increases of 4.0%-5.0% primarily due to decreased coal
shipments as several of the utility customers on the Company's lines have been
adjusting their inventories after a warmer than expected winter in 1995 and as
part of their continuing efforts to control costs. The decrease in coal
shipments was partially offset by increased carloadings of petroleum products,
minerals and stone and farm products.

31
<PAGE>
Freight revenues in 1995 increased by $29.7 million, or 47.7%, to $91.9
million from $62.2 million in the prior year. The following table compares
freight revenues, traffic volume (in carloads) and average freight revenues per
carload by commodity group for the years ended December 31, 1994 and 1995.

FREIGHT REVENUES AND CARLOADS COMPARISON BY COMMODITY GROUP
YEARS ENDED DECEMBER 31, 1994 AND 1995
<TABLE>
<CAPTION>
FREIGHT REVENUES CARLOADS
--------------------------------- --------------------------------
1994 1995 1994 1995 AVERAGE FREIGHT
-------------- -------------- -------------- -------------- REVENUES PER
(DOLLARS IN THOUSANDS) CARLOAD (1)
%OF %OF %OF %OF --------------
COMMODITY GROUP DOLLARS TOTAL DOLLARS TOTAL NUMBER TOTAL NUMBER TOTAL 1994 1995
- --------------- ------- ----- ------- ----- ------- ----- ------- ----- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Lumber and forest products ............... $ 3,494 5.6 $18,875 20.5% 16,215 6.4% 46,748 14.7% $215 $404
Coal ..................................... 16,132 25.9 15,307 16.7 78,350 30.9 72,864 22.9 206 210
Chemicals ................................ 7,975 12.8 9,652 10.5 24,851 9.8 29,361 9.2 321 329
Scrap paper & paper products ............. 3,938 6.3 9,452 10.3 12,222 4.8 22,724 7.1 322 416
Scrap metal & metal products ............. 4,428 7.1 7,808 8.5 16,256 6.4 24,347 7.7 272 321
Farm products ............................ 5,948 9.6 7,476 8.1 23,732 9.4 31,754 10.0 251 235
Non-metallic ores ........................ 6,471 10.4 5,980 6.5 31,891 12.6 32,246 10.1 203 185
Food products ............................ 3,857 6.2 4,954 5.4 17,661 7.0 19,837 6.2 218 250
Petroleum products ....................... 2,448 3.9 4,592 5.0 6,226 2.5 10,476 3.3 393 438
Minerals and stone ....................... 2,215 3.6 3,983 4.3 8,301 3.3 13,659 4.3 267 292
Other .................................... 5,317 8.6 3,830 4.2 17,458 6.9 14,171 4.5 305 270
------- ----- ------- ----- ------- ----- ------- ----- ---- ----
Total ............................... $62,223 100.0% $91,909 100.0% 253,163 100.0% 318,187 100.0% $246 $289
======= ===== ======= ===== ======= ===== ======= ===== ==== ====
</TABLE>
- ------------
(1) Calculated as freight revenues divided by carloads.

Approximately $29.3 million of the $29.7 million increase in freight
revenues in 1995 is attributable to New Railroad Properties. These properties
added approximately 57,500 carloads consisting primarily of lumber and forest
products (30,800), scrap paper and paper products (10,400), scrap metal and
metal products (4,800), and minerals and stone (2,200). Freight revenues for
Comparable Railroad Properties in 1995 increased by approximately $400,000, or
0.6%, and carloadings increased 3.0% over the prior year.

Non-freight operating revenues in 1995 increased by $3.6 million, or 29.5%,
to $15.9 million from $12.3 million in the prior year. Non-freight operating
revenues include switching, demurrage, car hire, car repair and track
maintenance services performed for third parties and lease income. These
revenues contributed 14.8% and 16.5% of operating revenues in 1995 and 1994,
respectively. Non-freight revenues from New Railroad Properties represent all of
the increase. Non-freight revenues for Comparable Railroad Properties decreased
by approximately $400,000, or 3.4%, primarily as a result of decreased demurrage
and car repair income.

OPERATING EXPENSES. Operating expenses, excluding the Special Charge,
increased $28.7 million, or 46.8%, to $90.1 million from $61.4 million in the
prior year. The Company's operating ratio (operating expenses divided by
operating revenues), excluding the Special Charge, increased for the year, to
83.5%, compared to 82.3% in the prior year, primarily as a result of increased
labor costs, equipment rents and depreciation and amortization for Comparable
Railroad Properties. Including the Special Charge, operating expenses increased
$30.8 million, or 50.3%, and the operating ratio increased to 85.5%.

32
<PAGE>
The following table sets forth a comparison of the Company's operating
expenses during 1994 and 1995, in dollars and as a percentage of operating
revenues.

OPERATING EXPENSES COMPARISON
YEARS ENDED DECEMBER 31, 1994 AND 1995
<TABLE>
<CAPTION>
1994 1995
----------------------- ---------------------
% OF % OF
OPERATING OPERATING
DOLLARS REVENUES DOLLARS REVENUES
------- -------- ------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Labor and benefits ......................................... $21,737 29.1% $32,662 30.3%
Equipment rents ............................................ 8,281 11.1 14,170 13.2
Depreciation and amortization .............................. 5,231 7.0 8,237 7.6
Diesel fuel ................................................ 5,141 6.9 7,666 7.1
Purchased services ......................................... 4,896 6.6 6,179 5.7
Casualties and insurance ................................... 4,298 5.8 5,607 5.2
Materials .................................................. 4,212 5.7 4,880 4.5
Other ...................................................... 7,555 10.1 10,645 9.9
------- ---- ------- ----
Total excluding Special Charge ........................ 61,351 82.3 90,046 83.5
Special Charge ............................................. -- -- 2,140 2.0
------- ---- ------- ----
Total ................................................. $61,351 82.3% $92,186 85.5%
======= ==== ======= ====
</TABLE>
Labor expense in 1995 increased $10.9 million, or 50.3%, to $32.6 million
from $21.7 million in the prior year. Labor expense attributable to New Railroad
Properties accounted for 82.1% of this increase. Labor expense for Comparable
Railroad Properties increased approximately $520,000, or 3.0%, due primarily to
increased wages and overtime resulting from a change in railroad employees'
compensation structure from a salary to a hourly wage structure. Corporate labor
and benefits costs increased by $1.4 million, or 33.3%, due primarily to
increased staffing levels to support the Company's growth. In June 1990, the
United States Railroad Retirement Board notified the Company that the board's
Deputy General Counsel had made determination that RailTex, Inc., the parent
company, is a "covered employer" under the Railroad Retirement and Railroad
Unemployment Insurance Acts ("Retirement Acts"), effective September 17, 1984.
The Company had accrued a $1.0 million loss contingency in 1990 as a result of
this determination. This determination was appealed and on February 17, 1995 the
Railroad Retirement Board reversed the determination of the board's Deputy
General Counsel and ruled that RailTex, Inc., the parent company, is not a
"covered employer" under the Retirement Acts. Therefore, the $1.0 million loss
contingency was reversed and credited against labor expense and simultaneously,
a $1.0 million charge was recorded to labor expense to accrue, among other
things, termination costs associated with a change in the Company's health
insurance carrier.

Equipment rents in 1995 increased $5.9 million, or 71.1%, to $14.2 million
from $8.3 million in the prior year. Equipment rents attributed to New Railroad
Properties accounted for 92.8% of this increase. Equipment rents for Comparable
Railroad Properties increased by approximately $450,000, or 5.6%, due primarily
to increased rentals on freight cars resulting from decreased utilization rates.
A portion of the increase in freight car rentals was offset by an increase in
freight car hire income, as discussed under non-freight operating revenues
above. In the future, the Company expects equipment rents as a percent of
operating revenues for Comparable Railroad Properties to decline as a result of
improved utilization.

Depreciation and amortization in 1995 increased $3.0 million, or 57.5%, to
$8.2 million from $5.2 million in the prior year. Depreciation and amortization
attributable to New Railroad Properties accounted for 73.6% of this increase.
Depreciation and amortization for Comparable Railroad Properties increased by
approximately $167,000, or 4.7%, due to track and roadbed related capital
projects completed in 1994 and 1995. The remainder is due to depreciation
related to an increase in the size of the Company's locomotive fleet to support
New Railroad Properties.

33
<PAGE>
Diesel fuel expense in 1995 increased $2.5 million, or 49.1%, to $7.6
million from $5.1 million in the prior year. New Railroad Properties accounted
for all of this increase. Diesel fuel expense for Comparable Railroad Properties
decreased by approximately $80,000, or 1.6%, due primarily to milder winter
weather conditions in 1995 as compared to 1994. The average cost of diesel fuel
per gallon for Comparable Railroad Properties was essentially unchanged in 1995
from the prior year.

Purchased services in 1995 increased $1.3 million, or 26.2%, to $6.2 million
from $4.9 million in the prior year. Purchased services attributable to New
Railroad Properties accounted for all of this increase. Purchased services for
Comparable Railroad Properties decreased by approximately $263,000, or 4.7%, due
primarily to reductions in contract labor related to locomotive maintenance,
maintenance of way and railcar repair activities. Partially offsetting the
decrease in contract labor was an increase in legal expenses for Comparable
Railroad Properties resulting primarily from the write-off of previously
capitalized legal fees associated with a planned acquisition of a track
extension which did not occur.

Casualties and insurance expense in 1995 increased $1.3 million, or 30.5%,
to $5.6 million from $4.3 million in the prior year. Substantially all of the
increase in casualties and insurance expense is attributable to New Railroad
Properties. Casualties and insurance expense for Comparable Railroad Properties
decreased by approximately $365,000, or 8.8%, as a result of lower property and
liability insurance premiums and derailment related expenses. In 1995 the
Company modified its property and liability insurance policies by increasing
self-insured retentions to $250,000 from $100,000 per incident, which resulted
in lower property and liability insurance premiums in 1995. The decrease in
derailment related expenses for Comparable Railroad Properties in 1995 is due to
fewer incidents.

Materials expense in 1995 increased by approximately $688,000, or 15.9%, to
$4.9 million from $4.2 million in the prior year. Materials expense for New
Railroad Properties amounted to approximately $876,000 and accounted for all of
the increase. Materials expense for Comparable Railroad Properties decreased by
18.9%, due primarily to decreased railcar repair activity, decreased locomotive
repair costs and decreased expenses for ballast in 1995. The decrease in ballast
expense in 1995 is a result of relatively high expenses in 1994 due to flood
related repairs.

Other expenses in 1995, including property and franchise taxes and joint
facilities, increased $3.1 million, or 40.9%, to $10.6 million from $7.6 million
in the prior year. Other expenses for New Railroad Properties accounted for
62.7% of this increase. Other expenses for Comparable Railroad Properties
increased by approximately $500,000, or 8.5%, due primarily to increased
trackage rights and switching charges, increased bad debt expenses and increased
property taxes resulting from higher tax valuations in 1995. The remainder of
the increase is due to increased corporate headquarters costs associated with
the Company's growth.

INTEREST EXPENSE. Interest expense in 1995 increased $2.7 million, or 92.1%,
to $5.7 million from $3.0 million in the prior year. The increase in interest
expense is due to higher borrowings to finance the acquisition of the CORP and
NECR.

OTHER INCOME. Other income in 1995 increased by approximately $428,000, or
33.3%, to $1.7 million from $1.3 million in the prior year. The increase in
other income is due to increased sales of non-operating properties.

INCOME TAXES. The Company's effective tax rate in 1995 increased slightly to
40.9% from 40.2% in the prior year. This increase is a result of an increase in
the Company's effective state income tax rate in 1995. Of the $4.8 million of
income tax expense in 1995, approximately $3.4 million is payable currently and
approximately $1.4 million is deferred.

34
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES

The Company has historically relied primarily on cash generated from
operations to fund working capital and capital expenditure needs relating to
ongoing operations while relying on contributed capital and borrowed funds to
finance its acquisitions.

During 1996, the Company generated cash from operations of $23.4 million,
which was largely used to fund non-acquisition related capital expenditures.
Non-acquisition capital expenditures in 1996 included $11.5 million for track
improvements, $4.4 million for locomotives, $4.8 million for technology and $1.2
million for vehicles and other equipment.

On June 4, 1996, the Company acquired 100.0% of the outstanding stock of the
INOH for an $8.9 million cash payment and the assumption of approximately $3.5
million of long-term debt. This acquisition was funded by borrowings under the
Company's U.S. Acquisition Facility. Upon closing, the Company used proceeds
from the Company's U.S. Acquisition Facility to retire approximately $2.1
million of the $3.5 million assumed long-term debt.

In 1996, a newly formed wholly owned subsidiary of the Company, RailTex
International Holdings, Inc. ("RIHI"), initiated an investment, totaling
approximately R $16.0 million (approximately U.S. $16.1 million), in Ferrovia
Centro Atlantica, S.A. ("FCA"), which was awarded a 30 year concession to
operate the 4,400 mile Center Eastern Network of the Brazilian federal railroad.
The purchase price of the concession was approximately R $316.9 million
(approximately U.S. $318.0 million). The Brazilian government structured the
transaction as a 30 year concession with a 20.0% down payment and future lease
payments due in quarterly installments after an initial two year grace period.
As of February 28, 1997, RIHI owns 12.5% of the voting stock and 8.9% of the
non-voting stock of FCA and will account for the transaction under the cost
method of accounting.

RIHI's initial investment in FCA in June 1996 was approximately R $8.2
million (approximately U.S. $8.2 million) and in September 1996, RIHI invested
another approximately R $7.8 million (approximately U.S. $7.9 million). Both
investments were funded by borrowings under the Company's U.S. Acquisition
Facility.

On September 21, 1996, a newly formed wholly owned subsidiary of the
Company, CSOR, purchased from Conrail certain assets including 23 miles of rail
segments located in Connecticut and six locomotives. The CSOR was also granted
rights to operate over an additional 49 miles of track, from just north of New
Haven, Connecticut to Springfield, Massachusetts, under a freight operating
agreement with Amtrak. The purchase price, $3.5 million, was funded by
borrowings under the Company's U.S. Acquisition Facility.

On November 2, 1996, a newly formed wholly owned subsidiary of the Company,
OLOR, purchased from Canadian National ("CN") certain assets consisting of 26
miles of track in eastern Ontario Canada. The OLOR was granted rights by CN to
operate the property and commenced operations on November 2, 1996 and the
acquisition closed on December 2, 1996. The purchase price was CDN $1.1 million
(approximately U.S. $800,000) and was funded by borrowings under the Company's
Canadian Acquisition Facility.

On December 7, 1996, a wholly owned subsidiary of the Company, PIRR,
purchased from Conrail certain assets consisting of 42 miles of track located in
the Pittsburgh metropolitan area. The purchase price was $3.0 million and was
funded by borrowings under the Company's U.S. Acquisition Facility.

During December 1996, RIHI purchased a 6.0% interest, for approximately R
$8.6 million (approximately U.S. $8.3 million), in Ferrovia Sul Atlantica, S.A.
("FSA") which was awarded the concession to operate the 4,200 mile Southern
Network of the Brazilian federal railroad. The purchase price for the concession
was approximately R $216.6 million (approximately U.S. $208.0 million). The
Brazilian government structured the transaction as a 30 year concession with a
down payment consisting of a 20.0% installment and a payment consisting of
100.0% of the difference between the Brazilian government's minimum bid price
and the purchase

35
<PAGE>
price. The remainder of the purchase price is structured as lease payments due
in quarterly installments after an initial two year grace period.

RIHI's initial investment in FSA in December 1996 was approximately R $5.4
million (approximately U.S. $5.2 million) and was funded by borrowings under the
Company's U.S. Acquisition Facility. RIHI made additional investments totaling
approximately R $3.2 million (approximately U.S. $3.1 million) in 1997. On
February 28, 1997, RIHI sold 2.8 million shares of preferred stock in FCA for
approximately R $2.9 million (approximately U.S. $2.8 million) to fund the
majority of the additional investments. The sale of the FCA preferred shares
reduced RIHI's equity interest in FCA to approximately 11.0%. RIHI will account
for the FSA investment under the cost method of accounting.

On February 15, 1997, a wholly owned subsidiary of INOH, Indiana & Ohio
Railway Company ("IORY"), purchased substantially all of the assets of the
former Detroit, Toledo and Ironton Railroad ("DTI") from Grand Trunk Western
Railroad, Inc., a subsidiary of CN. IORY acquired 146 miles of track for $22.0
million and, with trackage rights, will operate over approximately 255 miles
between Flat Rock, Michigan and Cincinnati, Ohio. The Company expects to spend
approximately $7.2 million in 1997 for organization costs, start up costs and
locomotives. Additionally, the Company has committed to invest over a three year
period, approximately $9.7 million to return the former DTI track to Federal
Railroad Administration ("FRA") Class IV standards. The DTI acquisition was
funded through borrowings under the Company's U.S. Acquisition Facility.

At December 31, 1996, the Company had long-term senior debt, capital leases
and senior subordinated debt outstanding totaling $98.7 million, which
constituted 44.6% of its total capitalization. Comparable figures at December
31, 1995 were $58.9 million and 34.3%, respectively.

The Company currently anticipates that its maintenance capital expenditure
requirements in 1997 for track, locomotives and equipment on properties it
currently operates will be approximately $15.0 million. Additionally, computer
hardware, software and other capital expenditures are currently expected to be
approximately $5.0 million.

Federal income tax liability shown for financial reporting purposes has been
partially deferred, reflecting temporary differences between depreciation for
financial reporting and income tax reporting purposes. The Company's current
income tax obligation will increase with increased exposure to other tax
jurisdictions, such as Canada. Recently enacted increases in U.S. federal income
tax payable on corporate taxable income has also increased the Company's tax
obligation. The increase, related to the law change in 1996, was approximately
$35,000. The Company expects an effective U.S. tax rate of 35.0% in 1997.

In connection with the lease of one of its railroad properties, the Company
has committed to upgrade approximately 107 miles of track, net of abandonments,
to Class II standards as defined by the FRA by October 1998; however, the
Company is negotiating with the lessor to extend this period. Management now
estimates the total cost of this upgrade to be approximately $4.0 million to
$5.0 million.

On August 4, 1995, the Company entered into a ten year Information
Technology Services Agreement ("ITS Agreement") with Electronic Data Systems
Corporation ("EDS"). Under the ITS Agreement, EDS will create and manage a
management information systems department for the Company, will develop, obtain
licenses for and maintain new software for the Company, will coordinate the
acquisition and maintenance of computers and related equipment and will
coordinate the maintenance of the Company's existing software. The Company paid
a fee to EDS for the initial 13 months of the services and will pay
approximately $1.3 million annually thereafter subject to annual escalation
based on the Consumer Price Index.

36
<PAGE>
eligible accounts receivable under the U.S. Working Capital Facility to provide
working capital and may borrow under the U.S. Acquisition Facility to finance
acquisitions of property and equipment which meet defined criteria. The new
facilities expire on April 30, 1999. Interest is payable monthly under the U.S.
Working Capital Facility until April 30, 1999 when all borrowings become
payable. Interest only is payable monthly on new borrowings under the U.S.
Acquisition Facility until April 30 of each year when all such borrowings are
rolled into a term note. Term notes are amortized over a six year period;
however, all borrowings become payable not later than April 30, 2002. Both the
U.S. Working Capital Facility and U.S. Acquisition Facility bear interest based
on stated borrowing margins over the London Interbank Offered Rate ("LIBOR") or
the U.S. prime rate. The borrowing margins are dependent upon the Company's
leverage ratio and are adjusted quarterly. At December 31, 1996, borrowings
outstanding and availability under the U.S. Acquisition Facility were $38.8
million and $36.2 million, respectively. There were no borrowings under the U.S.
Working Capital Facility at December 31, 1996.

On June 21, 1996, a wholly owned subsidiary of the Company, RailTex Canada,
Inc. ("RCI") entered into a new Canadian credit agreement consisting of a CDN
$5.0 million Canadian working capital facility ("Canadian Working Capital
Facility"), which replaced the prior Canadian revolving credit facility, and a
new CDN $25.0 million revolving acquisition facility ("Canadian Acquisition
Facility"). The Canadian credit agreements contain terms and conditions similar
to the U.S. agreements. The Canadian facilities bear interest based on stated
borrowing margins over the bankers acceptance rate ("BA Rate") or the Canadian
prime rate. The borrowing margins are dependent upon the Company's leverage
ratio and are adjusted quarterly. In addition, RailTex, Inc., the parent
company, is a guarantor of the Canadian credit facilities. At December 31, 1996,
borrowings outstanding under the Canadian Working Capital Facility and Canadian
Acquisition Facility were CDN $1.04 million (U.S. $767,746) and CDN $1.1 million
(U.S. $800,000), respectively.

Covenants contained in the agreements evidencing the Company's senior bank,
senior unsecured and senior subordinated debt prohibit the Company from paying
dividends on its capital stock and limit its ability to incur additional
indebtedness, create liens on its assets, make capital expenditures and
repurchase shares of its capital stock or any outstanding options or other
rights to acquire capital stock of the Company. The Company is also limited in
its ability to make loans, investments or guarantees. Additionally, the Company
is required to maintain a minimum tangible net worth and certain ratios of
leverage and cash flow to debt service. At December 31, 1996, the Company was in
compliance with all covenants.

At December 31, 1996, availability under the U.S. Acquisition Facility, the
U.S. Working Capital Facility, the Canadian Working Capital Facility and
Canadian Acquisition Facility was, in U.S. dollars, approximately $36.2 million,
$10.0 million, approximately $2.9 million and approximately $17.4 million,
respectively. The unused portion of all of the Company's senior bank credit
facilities are subject to a 0.25% commitment fee.

The Company believes its cash flow from operations together with available
amounts under the U.S. Working Capital Facility and Canadian Working Capital
Facility will allow it to meet its liquidity and capital expenditure
requirements for railroads it currently operates through the expiration of these
facilities in April 1999.

INFLATION

In recent years, inflation has not had a significant impact on the Company's
operations. The Company's contracts with connecting carriers typically include
clauses that adjust the Company's per car fees based on the Surface
Transportation Board's ("STB") cost or inflation indices.

SEASONALITY

The Company's operating revenues from existing operations have not
historically been subject to significant seasonal changes.

ACCOUNTING MATTERS

In June 1996, Statement of Financial Accounting Standards No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities," ("FAS 125") was issued. FAS 125 provides

37
<PAGE>
accounting and reporting standards for, among other things, the transfer and
servicing of financial assets, such as factoring receivables with recourse. This
statement is effective for transfers and servicing of financial assets occurring
after December 31, 1996, and is to be applied prospectively. Earlier or
retroactive application is not permitted. In 1996, Statement of Financial
Accounting Standards No. 127, "Deferral of the Effective Date of Certain
Provisions of FASB Statement No. 125" ("FAS 127"), was issued. This statement
moves forward the effective date of some, but not all, of the provisions under
FAS 125 to December 31, 1997. The Company believes the adoption of this
statement will not have an impact on the financial condition or results of
operations of the Company.

In March 1997, Statement of Financial Accounting Standards No. 128,
"Earnings Per Share" ("FAS 128"), was issued. FAS 128 establishes standards for
computing and presenting earnings per share and applies to entities with
publicly held common stock or potential common stock. This statement is
effective for fiscal years ending after December 15, 1997 and when adopted will
require restatement of prior years' earnings per share. Early adoption is not
permitted. The Company believes the adoption of this statement will not have an
impact on the financial condition or results of operations of the Company.

The remainder of this page is intentionally left blank.

38
<PAGE>
ITEM 8. FINANCIAL STATEMENTS

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

PAGE
----
RAILTEX, INC. AND SUBSIDIARIES:
Report of Independent Public Accountants............................... 40
Consolidated Statements of Income for the
years ended December 31, 1994, 1995 and 1996........................ 41
Consolidated Balance Sheets as of December 31, 1995 and 1996........... 42
Consolidated Statements of Shareholders' Equity for the years
ended December 31, 1994, 1995 and 1996............................... 43
Consolidated Statements of Cash Flows for the years ended
December 31, 1994, 1995 and 1996..................................... 44
Notes to Consolidated Financial Statements............................. 45

39
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Shareholders of RailTex, Inc.:

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

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

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

ARTHUR ANDERSEN LLP

San Antonio, Texas
February 28, 1997

40
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

YEARS ENDED DECEMBER 31,
------------------------------------
1994 1995 1996
-------- --------- ---------
OPERATING REVENUES .................... $ 74,528 $ 107,841 $ 121,106
OPERATING EXPENSES:
Transportation .................... 22,029 33,523 39,006
General and administrative ........ 15,447 21,250 20,948
Equipment ......................... 10,468 15,828 15,718
Maintenance of way ................ 8,176 11,208 13,246
Depreciation and amortization ..... 5,231 8,237 10,147
Special Charge .................... -- 2,140 --
-------- --------- ---------
Total operating expenses ....... 61,351 92,186 99,065
-------- --------- ---------
OPERATING INCOME ...................... 13,177 15,655 22,041
INTEREST EXPENSE ...................... (2,965) (5,696) (6,893)
OTHER INCOME .......................... 1,287 1,715 1,521
-------- --------- ---------
INCOME BEFORE INCOME TAXES ............ 11,499 11,674 16,669
INCOME TAXES .......................... (4,618) (4,776) (6,708)
-------- --------- ---------
NET INCOME ............................ $ 6,881 $ 6,898 $ 9,961
======== ========= =========
NET INCOME PER SHARE .................. $ 0.88 $ 0.78 $ 1.08
======== ========= =========
WEIGHTED AVERAGE NUMBER OF SHARES
OF COMMON STOCK AND COMMON STOCK
EQUIVALENTS OUTSTANDING ............... 7,820 8,897 9,231

The accompanying notes are an integral part of these consolidated financial
statements.
41
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

ASSETS DECEMBER 31,
----------------------
1995 1996
--------- ---------
CURRENT ASSETS:
Cash and cash equivalents ....................... $ 2,130 $ 2,108
Accounts receivable, net ........................ 19,522 26,834
Prepaid expenses ................................ 2,244 2,468
Deferred tax assets, net ........................ 2,027 1,141
--------- ---------
Total current assets ......................... 25,923 32,551
PROPERTY AND EQUIPMENT, NET ......................... 174,593 209,420

OTHER ASSETS:
Investments, at cost ............................ -- 21,380
Other, net ...................................... 4,466 6,119
--------- ---------
Total other assets ........................... 4,466 27,499
--------- ---------
Total assets ................................. $ 204,982 $ 269,470
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
Short-term notes payable ........................ $ 1,289 $ 352
Current portion of long-term debt ............... 1,718 6,361
Accounts payable ................................ 10,572 14,624
Accrued liabilities ............................. 7,302 11,445
--------- ---------
Total current liabilities .................... 20,881 32,782
--------- ---------
DEFERRED INCOME TAXES, NET .......................... 11,129 17,703
--------- ---------
LONG-TERM DEBT ...................................... 1,208 36,391
--------- ---------
SENIOR NOTES PAYABLE ................................ 50,985 50,952
--------- ---------
SENIOR SUBORDINATED NOTES PAYABLE ................... 5,000 5,000
--------- ---------
OTHER LIABILITIES ................................... 3,177 3,939
--------- ---------
COMMITMENTS AND CONTINGENCIES (Notes 5, 14 and 15)

SHAREHOLDERS' EQUITY:
Preferred Stock; $1.00 par value;
ten million shares authorized;
no shares issued or outstanding ............... -- --
Common Stock; $.10 par value;
30 million shares authorized;
issued and outstanding 1995
- 9,110,606; 1996 - 9,124,290 ................. 911 912
Additional paid-in capital ...................... 83,439 83,629
Retained earnings ............................... 28,316 38,277
Cumulative translation adjustment ............... (64) (115)
--------- ---------
Total shareholders' equity .................. 112,602 122,703
--------- ---------
Total liabilities and shareholders' equity .. $ 204,982 $ 269,470
========= =========

The accompanying notes are an integral part of these consolidated financial
statements.
42
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
COMMON STOCK
----------------------
SHARES $.10 ADDITIONAL CUMULATIVE TOTAL
ISSUED AND PAR PAID-IN RETAINED TRANSLATION SHAREHOLDERS'
OUTSTANDING VALUE CAPITAL EARNINGS ADJUSTMENT EQUITY
----------- ----- ------- ------- ----- -------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE, December 31, 1993 .............. 7,157 $ 716 $50,457 $14,537 $ (39) $ 65,671
Net income ............................ -- -- -- 6,881 -- 6,881
Issuance of Common Stock .............. -- -- 5 -- -- 5
Cumulative effect of
translation adjustment .............. -- -- -- -- (175) (175)
----- ----- ------- ------- ----- ---------
BALANCE, December 31, 1994 .............. 7,157 716 50,462 21,418 (214) 72,382
Net income ............................ -- -- -- 6,898 -- 6,898
Exercise of stock options ............. 306 30 2,784 -- -- 2,814
Shares tendered and
canceled in payment
of exercised options ................ (23) (2) -- -- -- (2)
Conversion of senior
subordinated
notes payable ....................... 521 52 4,948 -- -- 5,000
Issuance of Common Stock .............. 1,150 115 25,245 -- -- 25,360
Cumulative effect of
translation adjustment .............. -- -- -- -- 150 150
----- ----- ------- ------- ----- ---------
BALANCE, December 31, 1995 .............. 9,111 911 83,439 28,316 (64) 112,602
Net income ............................ -- -- -- 9,961 -- 9,961
Exercise of stock options ............. 13 1 190 -- -- 191
Cumulative effect of
translation adjustment .............. -- -- -- -- (51) (51)
----- ----- ------- ------- ----- ---------
BALANCE, December 31, 1996 .............. 9,124 $ 912 $83,629 $38,277 $(115) $ 122,703
===== ===== ======= ======= ===== =========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
43
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------
1994 1995 1996
-------- -------- --------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income .............................................................. $ 6,881 $ 6,898 $ 9,961
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization ........................................ 5,231 8,237 10,147
Special Charge ....................................................... -- 2,140 --
Deferred income taxes ................................................ 2,058 1,371 3,424
Provision for losses on accounts receivable .......................... 359 544 783
Amortization of deferred financing costs ............................. 352 345 348
Gain on sale of assets ............................................... (1,086) (1,599) (1,280)
Other non-cash operating income ...................................... (593) -- --
Changes in current assets and liabilities--
Accounts receivable ................................................ (2,778) (7,817) (6,950)
Prepaid expenses ................................................... (851) (177) 51
Accounts payable and accrued liabilities ........................... 2,286 7,824 6,952
-------- -------- --------
Net cash provided by operating activities ............................ 11,859 17,766 23,436
-------- -------- --------
INVESTING ACTIVITIES:
Purchase of investments in Brazilian railroad companies ................. -- -- (21,380)
Purchase of Indiana & Ohio Rail Corp., net of cash acquired ............. -- -- (8,989)
Purchase of property and equipment ...................................... (31,476) (63,612) (27,986)
Proceeds from sale of property and equipment ............................ 1,126 2,320 2,354
Organization and acquisition costs ...................................... (1,153) (1,047) (1,583)
(Increase) decrease in other assets ..................................... -- 25 (917)
-------- -------- --------
Net cash used in investing activities ............................... (31,503) (62,314) (58,501)
-------- -------- --------
FINANCING ACTIVITIES:
Short-term notes payable, net ........................................... 1,263 27 (937)
Proceeds from long-term debt ............................................ 17,975 49,150 41,569
Proceeds from senior notes payable ...................................... -- 51,193 --
Deferred financing costs ................................................ (312) (521) (465)
Principal payments on long-term debt .................................... (3,886) (81,144) (5,197)
Issuance of Common Stock ................................................ 5 25,749 108
-------- -------- --------
Net cash provided by financing activities ................................. 15,045 44,454 35,078
-------- -------- --------
EFFECT OF EXCHANGE RATE CHANGES ON CASH ................................... (96) 57 (35)
-------- -------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS ................................... (4,695) (37) (22)

CASH AND CASH EQUIVALENTS, beginning of year .............................. 6,862 2,167 2,130
-------- -------- --------
CASH AND CASH EQUIVALENTS, end of year .................................... $ 2,167 $ 2,130 $ 2,108
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
44
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 1994, 1995 AND 1996

1. NATURE OF THE COMPANY'S BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

RailTex, Inc., through its subsidiaries, ("Company") operates short line
freight railroads over more than 3,500 miles of track in 22 states, Canada and
Mexico as of December 31, 1996. The Company also owns an approximate 11.0%
equity interest in the Ferrovia Centro Atlantica, S.A. ("FCA") which operates an
approximately 4,400 mile railroad in central and eastern Brazil and owns an
approximate 6.0% interest in the Ferrovia Sul Atlantica, S.A.
("FSA") which operates a 4,200 mile railroad in southern Brazil.

The Company built its portfolio of railroads through purchase, lease or
contract to operate. Of the 30 railroads RailTex has acquired to date, 19 are
owned, four are leased, four are partially leased, two are operated under
long-term contracts and one ceased operations. RailTex began operating its first
railroad in 1984.

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany transactions and
accounts have been eliminated in consolidation.

ESTIMATES IN FINANCIAL STATEMENTS

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

CASH AND CASH EQUIVALENTS AND CONSOLIDATED STATEMENTS OF CASH FLOWS

All short-term investments which mature in less than 90 days when purchased
are considered cash equivalents for purposes of disclosure in the consolidated
balance sheets and consolidated statements of cash flows. Cash equivalents are
stated at cost, which approximates market value.

45
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

Supplemental disclosures of cash flow information (in thousands):

FOR THE YEARS ENDED
DECEMBER 31,
-----------------------
1994 1995 1996
------ ------ ------
Cash paid during the year for:
Interest ...................................... $2,612 $4,715 $5,795
Income taxes .................................. 2,126 1,994 2,008
Non-cash investing and financing activities:
Capital leases ................................ 907 950 599
Grants ........................................ 616 1,224 859
Conversion of senior subordinated notes payable -- 5,000 --
Tax benefit from exercise of non-qualified stock
options ...................................... -- 2,672 --
Prepaid secondary offering costs .............. -- 247 --

On June 4, 1996, the Company acquired 100.0% of the outstanding capital
stock of Indiana & Ohio Rail Corp. for $8.9 million cash and the assumption
of approximately $3.5 million of long-term debt and approximately $5.3
million of other liabilities (see Note 17).
Fair value of the assets acquired was $17.7 million.

PROPERTY AND EQUIPMENT

Property and equipment are carried at historical cost. Acquired railroad
property is recorded at the purchased cost. Major renewals or betterments are
capitalized while routine maintenance and repairs, which do not improve or
extend asset lives, are charged to expense when incurred. Gains or losses on
sales or other dispositions are credited or charged to income. Depreciation is
computed using the straight-line method over periods ranging from 15 to 30 years
for roadway and structures, five to 15 years for locomotives and other railroad
equipment, and three to five years for other non-railroad equipment. Leasehold
improvements are amortized over the life of the lease or the service lives of
the improvements, whichever is shorter.

INVESTMENTS

Investments represent minority interest in FCA and FSA (see Note 5) and are
accounted for using the cost method of accounting and are valued at the lower of
cost or market.

OTHER ASSETS

Other assets include deferred financing costs and organization and
acquisition costs. Financing costs are amortized over the related loan terms
using the effective interest method. Amortization of these costs is included in
interest expense. Organization and acquisition costs are direct costs incurred
in acquiring and licensing operating properties and consist of directly
attributable legal and other costs. These costs are amortized using the
straight-line method over five years. Amortization of financing and organization
and acquisition costs totaled approximately $1.0 million, $1.4 million and $1.3
million for 1994, 1995 and 1996, respectively. Accumulated amortization of these
costs was approximately $4.2 million and $5.6 million at December 31, 1995 and
1996, respectively.

46
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

NET INCOME PER SHARE

Net income per share is determined by dividing net income by the weighted
average number of shares of Common Stock and Common Stock equivalents
outstanding during the period. Stock options with an exercise price below fair
market value and the effects of convertible senior subordinated notes for any of
the periods presented are considered Common Stock equivalents. If the conversion
of the senior subordinated notes (see Note 9) and the Secondary Offering (see
Note 18) would have occurred as of January 1, 1995, the effect on net income per
share for the year ended December 31, 1995 would not have been material.

REVENUE RECOGNITION

Revenues are recognized on the percentage of completed service method as a
shipment moves across the Company's railroad properties.

INCOME TAXES

The Company files consolidated U.S. Federal income tax returns which include
all of its U.S. subsidiaries. Deferred income taxes are provided when certain
revenues and expenses are reported in different periods for financial reporting
purposes than for income tax reporting purposes.

Deferred tax liabilities and assets are recorded based on the enacted income
tax rates which are expected to be in effect in the periods in which the
deferred tax liability or asset is expected to be settled or realized. A change
in the tax laws or rates results in adjustments to the deferred tax liabilities
and assets. The effect of such adjustments shall be included in income in the
period in which the tax laws or rates are changed.

FOREIGN CURRENCY TRANSLATION

The financial position and results of operations of the Company's Canadian
subsidiaries are measured using the local currency as the functional currency.
Assets and liabilities of operations denominated in foreign currencies are
translated into U.S. dollars at exchange rates in effect at year-end, while
revenues and expenses are translated at average exchange rates prevailing during
the year. The resulting translation gains and losses are charged directly to
cumulative translation adjustment, a component of shareholders' equity, and are
not included in net income until realized through sale or liquidation of the
investment.

CURRENT VULNERABILITY DUE TO CERTAIN CONCENTRATIONS AND MAJOR CUSTOMERS

The Company regularly grants trade credit to all of its customers. In
addition, the Company grants trade credit to other railroads through the routine
interchange of traffic. The Company's accounts receivable are well diversified
except for the concentration of accounts receivable with some Class I carriers.
The Company's management believes these Class I carriers are large, financially
strong companies, and thus believe the Company's exposure to credit risk is
minimized.

In 1996, the Company served more than 940 customers which shipped and
received a wide variety of products. Although most of the Company's railroads
have a well-diversified customer base, several have one or two dominant
customers. The Company's largest customer in 1994, 1995 and 1996 was
Indianapolis Power & Light Company, representing 8.4%, 5.3% and 4.6% of
operating revenues, respectively.

47
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

NEW ACCOUNTING PRONOUNCEMENTS

In March 1995, Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" ("FAS 121"), was issued. Under FAS 121, an impairment loss must
be recognized, for long-lived assets and certain identifiable intangibles to be
held and used by an entity, whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. FAS 121 is
effective for financial statements issued for fiscal years beginning after
December 15, 1995. The Company adopted FAS 121 prospectively in the first
quarter of 1996. The adoption of FAS 121 did not have a material effect on the
financial condition or results of operations of the Company.

In October 1995, Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("FAS 123"), was issued. FAS 123
defines a fair value based method of accounting for employee stock options or
similar equity instruments and encourages all entities to adopt that method of
accounting for all of their employee stock compensation plans. Under the fair
value based method, compensation cost is measured at the grant date based on the
value of the award and is recognized over the service period of the award, which
is usually the vesting period. However, FAS 123 also allows entities to continue
to measure compensation costs for employee stock compensation plans using the
intrinsic value method of accounting prescribed by APB Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"). The Company has adopted
FAS 123 effective January 1, 1996, and has elected to remain with the accounting
prescribed by APB 25. The Company has made the required disclosures prescribed
by FAS 123 (see Note 12).

In June 1996, Statement of Financial Accounting Standards No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities" (FAS 125), was issued. FAS 125 provides accounting and reporting
standards for, among other things, the transfer and servicing of financial
assets, such as factoring receivables with recourse. This statement is effective
for transfers and servicing of financial assets occurring after December 31,
1996, and is to be applied prospectively. Earlier or retroactive application is
not permitted. In 1996, Statement of Financial Accounting Standards No. 127,
"Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125"
("FAS 127"), was issued. This statement moves forward the effective date of
some, but not all, of the provisions under FAS 125 to December 31, 1997. The
Company believes the adoption of this statement will not have an impact on the
financial condition or results of operations of the Company.

RECLASSIFICATIONS

Certain reclassifications have been made in the prior period financial
statements to conform with the current period presentation.

2. RELATED PARTY TRANSACTIONS

The Company purchases, in the normal course of business, various parts for
locomotives and grade crossing signals from certain subsidiaries of Harmon
Industries, Inc. of which the Company's chairman and chief executive officer is
a director. Purchases from Harmon Industries, Inc. and subsidiaries in 1995 and
1996 were approximately $170,000 and $586,000, respectively.

3. SPECIAL CHARGE

One of the Company's railroads, the Austin & Northwestern Railroad Company,
Inc. ("AUNW"), began operations on August 15, 1986 under a ten year management
agreement with Capital Metro, the Austin, Texas

48
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

area transit authority and the City of Austin. This agreement provided for
renewal options for three additional ten year terms. Because the AUNW had
experienced a significant decline in traffic and the Company did not expect
significant improvement in the foreseeable future, the AUNW decided not to
pursue further its rights unilaterally to renew the existing contract for an
additional ten year period and to cease operations on or before the expiration
of the original contract term in August 1996. As a result, the Company, Capital
Metro and the City of Austin entered into an agreement under which a substitute
operator was identified and under which the Company was released from certain
contingent liabilities. Therefore, the Company recorded a Special Charge, in the
second quarter of 1995, in the amount of $2,140,000 before tax and $1,389,000
after tax, or $0.15 per share, representing the write down of the unamortized
value of leasehold improvements of the AUNW. Operations of the AUNW ceased in
May 1996.

4. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following (in thousands):

DECEMBER 31,
-----------------------
1995 1996
--------- ---------
Roadway and structures ............................. $ 154,346 $ 182,186
Locomotives and other railroad equipment ........... 34,403 43,194
Office furniture and other equipment ............... 3,789 8,999
Equipment and vehicles held under capital
leases (see Note 7) ............................. 3,006 3,111
Vehicles ........................................... 1,404 1,671
--------- ---------
196,948 239,161
Less accumulated depreciation and amortization ..... (22,355) (29,741)
--------- ---------
$ 174,593 $ 209,420
========= =========
5. INVESTMENTS

In 1996, a newly formed wholly owned subsidiary of the Company, RailTex
International Holdings, Inc. ("RIHI"), initiated an investment, totaling
approximately R $16.0 million (approximately U.S. $16.1 million), in FCA, which
was awarded a 30 year concession to operate the 4,400 mile Center Eastern
Network of the Brazilian federal railroad. The purchase price of the concession
was approximately R $316.9 million (approximately U.S. $318.0 million). The
Brazilian government structured the transaction as a 30 year concession with a
20.0% down payment and future lease payments due in quarterly installments after
an initial two year grace period. As of February 28, 1997, RIHI owns 12.5% of
the voting stock and 8.9% of the non-voting stock of FCA and will account for
the transaction under the cost method of accounting.

RIHI's initial investment in FCA in June 1996, was approximately R $8.2
million (approximately U.S. $8.2 million) and in September 1996, RIHI invested
another approximately R $7.8 million (approximately U.S. $7.9 million). Both
investments were funded by borrowings under the Company's U.S. Acquisition
Facility (see Note 7).

During December 1996, RIHI purchased a 6% interest, for approximately R $8.6
million (approximately U.S. $8.3 million), in FSA which was awarded the
concession to operate the 4,200 mile Southern Network of the Brazilian federal
railroad. The purchase price for the concession was approximately R $216.6
million (approximately U.S. $208.0 million). The Brazilian government structured
the transaction as a 30 year concession with a down payment consisting of a
20.0% installment and a payment consisting of 100.0% of the difference

49
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

between the Brazilian government's minimum bid price and the purchase price. The
remainder of the purchase price is structured as lease payments due in quarterly
installments after an initial two year grace period.

RIHI's initial investment in December 1996 was approximately R $5.4 million
(approximately U.S. $5.2 million) and was funded by borrowings under the
Company's U.S. Acquisition Facility. RIHI made additional investments totaling
approximately R $3.2 million (approximately U.S. $3.1 million) in 1997. On
February 28, 1997, RIHI sold 2.8 million shares of preferred stock in FCA for
approximately R $2.9 million (approximately U.S. $2.8 million) to fund the
majority of the additional investments. The sale of the FCA preferred shares
reduced RIHI's equity interest in FCA to approximately 11.0%. RIHI will account
for the FSA investment under the cost method of accounting.

6. SHORT-TERM NOTES PAYABLE

As of December 31, 1996, the Company had outstanding unsecured short term
notes payable to insurance companies totaling approximately $352,000. These
notes bear interest at 5.02% and 7.50% and are due in monthly installments of
principal and interest totaling approximately $109,000 through July 1997. For
the year ended December 31, 1996, the weighted average interest rate for the
short term notes payable was 6.50%

As of December 31, 1995, the Company had outstanding unsecured short term
notes payable to an insurance company totaling approximately $1,289,000. These
notes bore interest at 6.57% and 6.95%, were due in monthly installments of
principal and interest totaling approximately $183,000 and $29,000 through June
1996 and November 1996, respectively. For the year ended December 31, 1995, the
weighted average interest rate for short term notes payable was 6.9%.

7. LONG-TERM DEBT

Long-term debt consisted of the following (in thousands):

DECEMBER 31,
------------------
1995 1996
------- --------
Senior unsecured notes payable to banks (U.S. Acquisition
Facility); interest is variable (LIBOR based weighted
average interest rate of 7.07% at December 31, 1996),
interest only due monthly through April 1997, then
principal of $538,413 plus interest due monthly
through April 2002 with remaining balance due April 2002 $ -- $ 38,766

Senior unsecured notes payable to banks (Canadian
Acquisition Facility); interest is variable (at December
31, 1995, 90 day Canadian BA rate of 7.20%; at December
31, 1996, 90 day Canadian BA rate of 4.47% and 4.71% on
a principal balance of U.S. $800,000 and U.S. $734,200,
respectively, and at Canadian prime rate of 5.25% on a
principal balance of U.S. $33,546); interest only due
monthly through April 1997, then principal of
approximately $22,000 plus interest due monthly through
April 2002 with remaining balance due April 2002 ....... 1,132 1,567

Capital lease obligations; interest at rates ranging from
7.25% to 10.37% at December 31, 1996; payable in
variable monthly installments through September 30, 2000 1,794 1,815

Other, primarily due to state agencies; interest at rates
ranging from 5.0% to 7.9%; payable in variable
installments from February 1998 to January 2008 ........ -- 604
------- --------
Total long-term debt ..................................... 2,926 42,752
Less current portion ..................................... (1,718) (6,361)
------- --------
Long-term debt, less current portion ..................... $ 1,208 $ 36,391
======= ========
50
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

On May 17, 1996, the Company entered into a new U.S. acquisition credit
agreement consisting of a $10.0 million U.S. working capital facility ("U.S.
Working Capital Facility") and a $75.0 million U.S. acquisition facility ("U.S.
Acquisition Facility"), replacing the 1995 U.S. Working Capital Facility and the
1995 U.S. Acquisition Facility which expired in May 1996 and May 1997,
respectively. The Company may borrow up to 65.0% of its eligible accounts
receivable under the U.S. Working Capital Facility to provide working capital
and may borrow under the U.S. Acquisition Facility to finance acquisitions of
property and equipment which meet defined criteria. The new facilities expire on
April 30, 1999. Interest is payable monthly under the U.S. Working Capital
Facility until April 30, 1999 when all borrowings become payable. Interest only
is payable on new borrowings under the U.S. Acquisition Facility until April 30
of each year when all such borrowings are rolled into a term note. Term notes
are amortized over a six year period; however, all borrowings become payable not
later than April 30, 2002. Both the U.S. Working Capital Facility and U.S.
Acquisition Facility bear interest based on stated borrowing margins over the
London Interbank Offered Rate ("LIBOR") or the U.S. prime rate. The borrowing
margins are dependent upon the Company's leverage ratio and are adjusted
quarterly. At December 31, 1996, borrowings outstanding and availability under
the U.S. Acquisition Facility were $38.8 million and $36.2 million,
respectively. There were no borrowings under the U.S. Working Capital Facility
at December 31, 1996.

On June 21, 1996, a wholly owned subsidiary of the Company, RailTex Canada
Inc. ("RCI") entered into a new Canadian credit agreement consisting of a CDN
$5.0 million Canadian working capital facility ("Canadian Working Capital
Facility"), which replaced the 1995 Canadian Credit Facility and a new CDN $25.0
million Canadian acquisition credit agreement ("Canadian Acquisition Facility").
The Canadian credit agreements contain terms and conditions similar to the U.S.
agreements. The Canadian facilities bear interest based on stated borrowing
margins over the bankers acceptance rate ("BA Rate") or the Canadian prime rate.
The borrowing margins are dependent upon the Company's leverage ratio and are
adjusted quarterly. In addition, RailTex, Inc., the parent company, is a
guarantor of the Canadian credit facilities. At December 31, 1996, borrowings
outstanding under the Canadian Working Capital Facility and Canadian Acquisition
Facility were CDN $1.04 million (U.S. $767,746) and CDN $1.1 million (U.S.
$800,000), respectively.

During 1995, the Company borrowed $42.3 million and $6.9 million under the
1995 U.S. Acquisition Facility and the 1995 U.S. Working Capital Facility,
respectively. The borrowings under the 1995 U.S. Acquisition Facility were
incurred to fund the acquisition of certain assets of the Central Vermont and
related costs (see Note 17). The borrowings under the 1995 U.S. Working Capital
Facility were incurred to fund locomotive purchases and for general working
capital purposes. During March 1995, the Company utilized $25.3 million of the
net proceeds from the secondary offering (see Note 18) to pay down the 1995 U.S.
Acquisition Facility ($25.0 million) and the 1995 U.S. Working Capital Facility
($300,000).

In October 1995, the Company completed a private placement of senior
unsecured notes with three institutions. These notes consist of U.S. $40.0
million notes and CDN $15.0 million (U.S. $11.0 million) notes. The proceeds
were used to reduce outstanding bank debt under the 1995 U.S. Acquisition
Facility, the 1995 U.S. Working Capital Facility and the 1995 Canadian Credit
Facility. Concurrent with the closing of the private placement, all collateral
securing the 1995 U.S. Acquisition Facility, the 1995 U.S. Working Capital
Facility and the 1995 Canadian Credit Facility was released.

51
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

minimum tangible net worth and certain ratios of leverage and cash flow to debt
service. At December 31, 1996, the Company was in compliance with all covenants.

Maturities of long-term debt as of December 31, 1996 were as follows (in
thousands):

YEAR ENDED DECEMBER 31,
- -----------------------
1997....................................... $ 6,361
1998....................................... 7,169
1999....................................... 7,078
2000....................................... 6,816
2001....................................... 6,711
Thereafter................................. 8,617
-------
Total.............................. $42,752
=======

8. SENIOR UNSECURED NOTES PAYABLE

In October 1995, the Company completed a private placement of senior
unsecured notes with three institutions. These notes consisted of U.S. $40.0
million notes ("U.S. Notes") and CDN $15.0 million (U.S. $11.0 million) notes
("Canadian Notes"). The proceeds were used to reduce outstanding bank debt under
the Company's 1995 U.S. Acquisition Facility, the 1995 U.S. Working Capital
Facility and the 1995 Canadian Credit Facility. The U.S. Notes bear interest at
7.23% and the Canadian Notes bear interest at 9.21% with interest only due
semiannually. Both the U.S. Notes and the Canadian Notes are due in September
and October 2005. Additionally, RailTex, Inc., the parent company, is a
guarantor of the Canadian Notes.

9. SENIOR SUBORDINATED DEBT

On February 16, 1993, the Company issued $5 million of senior subordinated
notes, with interest at 12.0%, payable semi-annually and principal due in
January 2001 and January 2002. The Company also issued $5 million of convertible
senior subordinated notes with interest at 10.0% due semi-annually and principal
due in January 2003, which were converted into 520,833 shares of the Company's
common stock concurrent with the closing of the Secondary Offering in March 1995
(see Note 18).

The Company may prepay the senior subordinated notes subject to penalties.
The senior subordinated notes are unsecured and subject to covenants similar to
those contained in the senior bank debt agreements as discussed in Note 7.

10. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT:

The Company's operations involve managing market risks related to changes in
interest rates and diesel fuel prices. Derivative financial instruments,
specifically swaps and collars are used to manage market risks related to
changes in interest rates and diesel fuel prices, respectively. The Company does
not currently hold or issue financial instruments for trading purposes.

By entering into interest rate swaps, the Company has functionally converted
certain floating-rate debt to fixed-rate debt in order to minimize exposure to
rising interest rates. The Company accounts for interest rate swaps as hedges
due to the fact that the derivative changes the nature of a designated debt
instrument which is on the Company's balance sheet and the underlying debt
obligation has a principal balance equal to or greater than

52
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

the notional amount of the related derivative. Any unrealized gains or losses
from changes in the value of the swaps are deferred and interest expense on the
hedged debt instrument is recorded using the interest rate as effectively
revised by the related swap.

At December 31, 1996, the Company had the following amortizing interest rate
swap agreements in effect which were used to effectively fix future rates of
floating rate obligations:

YEAR YEAR OF NOTIONAL FIXED RATE VARIABLE
ENTERED COMPLETION AMOUNT PAID RATE RECEIVED
- ------- ---------- -------- ---------- ---------------
(in thousands)
1991 1997 $ 139 10.73% Prime + 0.375%
1995 1999 CDN $12,422 9.55% Average three
month CDN BA rate

In April 1996, the Company entered into two commodity collar transactions to
hedge market risks of diesel fuel prices. Each collar is effective July 1, 1996
and terminates on June 30, 1997. The collars represent notional amounts totaling
3,360,000 gallons with a cap price of $0.5900 per gallon and floor prices of
$0.4920 and $0.4695 per gallon.

11. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The following methods and assumptions were used to estimate the fair value
of each class of financial instrument held by the Company:

Current assets and current liabilities: The carrying value approximates fair
value due to the short maturity of these items.

Accrued interest payable: The carrying amount approximates fair value as the
majority of interest payments are made monthly or semiannually.

Long-term investment: The carrying value approximates fair value based on
discounted cash flows.

Long-term debt, senior subordinated debt and senior notes payable: The fair
value of the Company's long-term debt, senior subordinated debt and senior notes
payable is based on secondary market indicators. Since the Company's debt is not
quoted, estimates are based on each obligation's characteristics, including
remaining maturities, interest rates, credit rating, collateral, amortization
schedule and liquidity. The carrying amount approximates fair value.

Interest rate swap agreements: The fair value of interest rate swaps is the
amount at which they could be settled, based on estimates obtained from dealers.
The unrealized loss on interest rate swap agreements at December 31, 1994, 1995
and 1996 is approximately $297,000, $776,000 and $955,000, respectively.

Commodity collar transactions: The fair value of commodity collar
transactions is the amount at which they could be settled, based on estimates
obtained from dealers. The unrealized gain on the commodity collar transaction
at December 31, 1996 is approximately $167,000.

53
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

12. EMPLOYEE BENEFITS

STOCK OPTIONS

The Company grants non-qualified stock options to outside Directors and key
employees of the Company. In September 1993, the Board of Directors and
shareholders of the Company approved an equity incentive plan ("1993 Plan"). On
June 12, 1996, the 1993 Plan was amended which (i) increased the maximum number
of shares of Common Stock issuable under the 1993 Plan from 750,000 to
1,250,000, without reduction for the number of shares issued upon exercise of
options granted outside of the 1993 Plan; (ii) extended the exercise period for
Outside Director's Options from two to ten years and increased the number of
shares which may be purchased under Outside Director's Options from 2,000 to
3,000; (iii) specified 1,250,000 shares as the maximum number of shares issuable
under the 1993 Plan to any employee in any year; (iv) permitted the 1993 Plan
administrator to specify shorter vesting periods for non-qualified options; and
(v) clarified that cashless exercises of stock rights are permitted under the
1993 Plan.

In January 1996, the Company granted each outside Director of the Company
options to purchase 2,000 shares of Common Stock for a total of 12,000 options
under the 1993 Plan. These options are exercisable over a two year period at the
fair market value of Common Stock on the date of the grant of $21.00 per share.

In January, March, June and November 1996, the Company granted options to
purchase 10,000 shares, 22,250 shares, 373,000 shares and 38,500 shares of
Common Stock, respectively, to certain key employees under the 1993 Plan, as
amended. These options are exercisable at the rate of 20.0% per year from the
date of the grant at the fair market value of Common Stock on the date of the
grant of $21.125 per share, $24.75 per share, $24.25 per share and $23.75 per
share, respectively.

A summary of the status of the Company's 1993 Plan for the years ended
December 31, 1994, 1995 and 1996, and changes during the years ending on those
dates is presented below:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------
1994 1995 1996
------------------- -------------------- ------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
-------- ------ -------- ------ -------- ------
<S> <C> <C> <C> <C> <C> <C>
Outstanding, beginning of the year ............................ 530,709 $ 3.92 576,221 $ 5.87 399,792 $13.94
Granted ....................................................... 47,650 27.75 129,311 22.72 455,750 24.08
Exercised ..................................................... (428) 8.80 (305,740) 2.45 (13,684) 7.92
Forfeited ..................................................... (1,710) 8.80 -- -- (97,904) 23.51
-------- -------- --------
Outstanding, end of year ...................................... 576,221 5.87 399,792 13.94 743,954 19.00
======== ======== ========
Options exercisable end of year ............................... 419,172 $ 3.52 197,641 $ 7.34 222,918 $ 8.95
======== ====== ======== ====== ======== ======
Weighted average fair value of options granted during year .... 13.08 15.64
===== ======
</TABLE>
54
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

The following table summarizes the information about the 1993 Plan options
outstanding at December 31, 1996:

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------ --------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
EXERCISE PRICE OUTSTANDING LIFE PRICE EXERCISABLE PRICE
------- ------ ------ ------- ------
$ 3.74 - 8.80 ......... 203,949 4.28 $ 5.70 179,086 $ 5.35
$19.38 - 23.75 ........ 114,500 8.17 21.37 26,000 21.00
$24.25 - 27.75 ........ 425,505 9.25 24.74 17,832 27.55
------- -------
743,954 7.72 $19.00 222,918 $ 8.95
======= ====== ====== ======= ======

Because the Company has elected to remain with the accounting prescribed by
APB 25 (see Note 1), no compensation cost has been recognized for its 1993 Plan.
Had compensation cost for the Company's stock-based compensation plans been
determined on the fair value of the grant dates for awards under those plans
consistent with the method of FAS 123, the Company's net income and earnings per
share would have been decreased to the pro forma amounts indicated below (in
thousands, except per share amounts):
DECEMBER 31,
---------------------
1995 1996
------ ------
Net income:
As reported................................ $6,898 $9,961
Pro forma.................................. $6,427 $8,173

Net income per share:
As reported................................ $0.78 $1.08
Pro forma.................................. $0.72 $0.89

The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1995 and 1996, respectively:

Dividend yield of 0.0% for all years; expected volatility of 42.0 and 42.5
percent; risk-free interest rates of 6.8 and 6.1 percent; and expected lives of
6 and 8.4 years.

EMPLOYEE BONUS PROGRAM

The Company has performance-based, incentive compensation programs which
include all employees. The program for the employees of the short line
railroads, excluding general managers, provides for employees to share in the
profits, as defined, of each railroad on a quarterly basis. The program for
headquarters' employees, excluding executive management and senior management,
provides for cash incentive compensation paid on a quarterly basis based upon a
specified percentage of aggregate salaries for those employees. The incentive
compensation plan for headquarters' senior management and railroad general
managers provides for cash incentive compensation paid on an annual basis based
upon Company and/or railroad performance targets which generate incentive
compensation. In addition, headquarters' senior management and railroad general
managers are also awarded, through the 1993 Plan, a predetermined number of
stock options and performance shares on an annual basis. Employees must be
employed by the Company at the end of three years from the date of the award to
receive the performance shares. During the three year period, the number of
shares to be awarded can increase by a maximum of 200.0% or decrease to zero as
determined by the Company's total shareholder return as compared

55
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

to benchmarks, as defined in the plan. The incentive compensation plan for
executive management provides for cash incentive compensation to be paid on an
annual basis based upon Company performance achieved relative to the business
plan. In addition, executive managers are also awarded, through the 1993 Plan, a
calculated value of stock options and performance shares based upon a multiple
value of the cash incentive compensation, as defined in the plan. Total cash
incentive compensation of approximately $1,936,000, $2,249,000 and $2,350,000
was awarded under the various incentive compensation programs in 1994, 1995 and
1996, respectively.

RETIREMENT PLANS

The Company has a 401(k) profit sharing plan ("401(k) Plan") for all
eligible employees of the Company, as defined in the 401(k) Plan document. The
401(k) Plan qualifies under Section 401(k) of the Internal Revenue Code as a
salary reduction plan. Employees may elect to contribute a certain percentage of
their salary on a before-tax basis. Employees are immediately fully vested in
their contributions and begin vesting in employer contributions after one year
of service, as defined in the 401(k) Plan document. The 401(k) Plan is a defined
contribution plan with employer contributions made solely at the discretion of
the Board of Directors.

Effective July 1, 1995, the 401(k) Plan was amended to provide for a Company
matching contribution for certain employees of RailTex, Inc., the parent
company, who are not covered under the Railroad Retirement and Railroad
Unemployment Insurance Acts ("The Retirement Acts"). The Company matches
employee contributions, for these employees, at the rate of 200.0% on employee
contributions up to 5.0% of eligible compensation. Employees begin vesting in
the employer matching contributions after one year of service. Company matching
contributions to the 401(k) Plan totaled $26,100, $58,000 and $134,000 in 1994,
1995 and 1996, respectively.

EMPLOYEE OPEN MARKET STOCK PURCHASE PLAN

Effective November 15, 1994, the Company adopted and implemented an Employee
Open Market Stock Purchase Plan ("Stock Purchase Plan"). The purpose of the
Stock Purchase Plan is to allow employees of the Company to participate in the
Company's future. The Stock Purchase Plan is a payroll deduction plan which
permits employees who meet specified length of service requirements to purchase
shares, on an after-tax basis, of the Company's common stock on the open market
at prevailing market prices. The Company pays the brokerage commissions on all
purchases and incurs the administrative expenses associated with the Stock
Purchase Plan. Stock Purchase Plan expenses in 1994, 1995 and 1996 were not
significant.

EXECUTIVE DEFERRED COMPENSATION

During 1995, the Company implemented an Executive Deferred Compensation Plan
wherein certain key employees are provided with life insurance protection in an
amount sufficient to provide supplemental income, based upon a percentage of the
employee's base salary, at retirement.

The Executive Deferred Compensation Plan is funded through the purchase of
split-dollar life insurance contracts. Upon death or retirement, the participant
or the participant's estate must reimburse the Company for all policy premiums
paid. Also, should employment terminate prior to death or retirement, the
participant may forfeit, at the discretion of the Compensation Committee, any
future rights in the insurance policy. Premiums paid under this Plan for 1995
and 1996 were approximately $272,000 and $309,000, respectively. The combined
cash surrender value of these policies was approximately $51,000 and $227,000 at
December 31, 1995 and 1996, respectively.

POST-RETIREMENT AND POST-EMPLOYMENT BENEFITS

The Company does not provide post-retirement and post-employment benefits to
its employees.

56
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

13. INCOME TAXES

Income tax expense consisted of the following (in thousands):

YEARS ENDED DECEMBER 31,
------------------------------------
1994 1995 1996
------ ------ ------
United States:
Federal--
Current .................. $1,085 $2,044 $1,702
Deferred ................. 1,487 1,013 2,941
------ ------ ------
2,572 3,057 4,643
------ ------ ------
State--
Current .................. 233 457 771
Deferred ................. 199 67 140
------ ------ ------
432 524 911
------ ------ ------
Foreign:
Current .................. 1,242 904 811
Deferred ................. 372 291 343
------ ------ ------
1,614 1,195 1,154
------ ------ ------
$4,618 $4,776 $6,708
====== ====== ======

The following summarizes the estimated tax effect of significant cumulative
temporary differences that are included in the net deferred income tax liability
(in thousands):

DECEMBER 31,
----------------------
1995 1996
-------- --------
Differences in depreciation and amortization ....... $ 12,202 $ 13,894
Accruals and reserves not deducted for tax
purposes until paid ............................... (857) (985)
Federal benefit of state taxes ..................... (270) (328)
Alternative minimum tax carry forwards ............. (1,235) --
Deferred taxes related to acquisition .............. -- 4,100
Other items, net ................................... 75 (119)
Write down of assets not deducted for tax
until operations cease ......................... (813) --
-------- --------
Net deferred tax liability ...................... $ 9,102 $ 16,562
======== ========

At December 31, 1995, the Company had alternative minimum tax credit ("AMT")
carry forwards of approximately $1,235,000 which were used to reduce federal
taxable income at December 31, 1996. The Company did not record any valuation
allowances against deferred income tax assets at December 31, 1995 or 1996.

The reconciliation of the U.S. statutory tax rate to the effective income
tax rate follows:

YEARS ENDED DECEMBER 31,
--------------------------------
1994 1995 1996
------ ------ ------
United States statutory rate ............ 34.0% 34.0% 34.3%
Effect of foreign operations ............ 2.2 1.2 0.9
State income taxes, net of federal
income tax benefit ..................... 4.0 5.7 5.0
------ ------ ------
40.2% 40.9% 40.2%
====== ====== ======

57
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

14. LEASES

Operating lease expense for the years ended December 31, 1994, 1995, and
1996 was approximately $3,650,000, $4,486,000 and $4,929,000, respectively.

The minimum future lease payments for equipment and facilities under
non-cancelable leases are as follows (in thousands):

OPERATING CAPITAL
YEAR ENDED DECEMBER 31, LEASES LEASES
- ----------------------- ------- -------
1997 ............................................ $ 4,725 $ 748
1998 ............................................ 3,389 594
1999 ............................................ 1,988 459
2000 ............................................ 1,688 190
2001 ............................................ 564 85
Thereafter ...................................... 2,200 --
------- -------
Total minimum payments .......................... $14,554 2,076
=======
Less amount representing interest at rates
ranging from 7.25% to 10.37% ............. (261)
-------
Present value of minimum lease payments ....... $ 1,815
=======

The Company has entered into various lease agreements covering certain of
its railroad properties. For railroad properties it leases, the Company
ordinarily assumes upon the commencement date all operating and financial
responsibilities including maintenance, payment of property taxes and regulatory
compliance. Lease payments on three railroad properties leased from one lessor
are structured to ensure that the Company interchanges an agreed-upon percentage
of outbound carloads with the lessor railroad. Under these leases, no payments
to the lessor are required as long as a minimum percentage of traffic volume is
interchanged with the lessor, therefore the Company controls the amounts which
may be payable under these leases. These leases are subject to an initial 20
year term with one or more renewal terms at the Company's option. In addition,
lease payments on five properties leased from two other major railroads are
subject to reduction from the base rate, down to zero, depending upon the level
of traffic interchanged with the lessors. The maximum aggregate lease payments
under these leases is approximately $1.7 million. These leases have initial
lease terms of five years to 20 years and leases on four of the five properties
include purchase options which may be exercised by the Company after three years
of operation. No payments have been required under any of the Company's railroad
property leases, and the Company anticipates that its traffic interchange for
the foreseeable future will not result in any rentals being incurred under these
railroad property leases. Therefore, the above table does not include any
rentals pertaining to the Company's railroad property leases.

15. COMMITMENTS AND CONTINGENCIES

The Company has added railroad properties to its portfolio through the
purchase of track and roadbed, lease of such assets, and contracts to operate
such assets under management agreements. These arrangements typically relate
only to the physical assets of the railroad property; and except for the
purchase of the Indiana & Ohio Rail Corp., which was structured as an
acquisition of stock, the Company typically does not contractually assume any of
the operations or liabilities of the divesting carriers.

58
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

operations on the property including maintenance, payment of property taxes and
regulatory compliance. Payments by the Company for the right to conduct rail
operations on these properties are typically calculated as a percentage of
revenues from the respective properties.

In connection with the lease of one of its railroad properties, the Company
has committed to upgrade approximately 107 miles of track, net of abandonments,
to Class II standards as defined by the Federal Railroad Administration ("FRA")
by October 1998. Management now estimates the cost of this upgrade to be
approximately $4.0 million to $5.0 million; however, the Company is negotiating
with the lessor to extend this period.

In June 1990, the United States Railroad Retirement Board notified the
Company that the board's Deputy General Counsel had made a determination that
RailTex, Inc., the parent company, is a "covered employer" under the Retirement
Acts, effective September 17, 1984. The Company had accrued a $1.0 million loss
contingency in 1990 as a result of this determination. This determination was
appealed and on February 17, 1995 the Railroad Retirement Board reversed the
determination of the board's Deputy General Counsel and ruled that RailTex,
Inc., the parent company, is not a "covered employer" under the Retirement Acts.
Therefore in 1995, the $1.0 million loss contingency was reversed and credited
against operating expenses and simultaneously, a $1.0 million charge was
recorded to operating expenses to accrue, among other items, the termination
costs associated with a change in the Company's health insurance carrier.

In August 1995, the Company entered into a ten year Information Technology
Services Agreement ("ITS Agreement") with Electronic Data Systems Corporation
("EDS"). Under the ITS Agreement, EDS will create and manage a management
information systems department for the Company, will develop, obtain licenses
for and maintain new software for the Company, will coordinate the acquisition
and maintenance of computers and related equipment and will coordinate the
maintenance of the Company's existing software. The Company paid a fee to EDS
for the initial 13 months of the services and will pay approximately $1.3
million annually thereafter subject to annual escalation based on the Consumer
Price Index. The ITS Agreement is subject to earlier termination under certain
limited conditions.

Under certain limited circumstances, three of the Company's railroads may be
repurchased by the selling carrier for their original purchase prices. It is
management's opinion that the likelihood of these properties being repurchased
is remote.

In March 1996, one of the Company's railroads received notice from an
individual of his intent to file a citizen's suit under the Resource
Conservation and Recovery Act ("RCRA") primarily as a result of an oil spill
caused by a train derailment that occurred five years prior to the Company's
acquisition of the railroad property. The Company is unable to predict whether a
claim will be filed, the probable outcome of any such claim or the amount or
range of potential loss arising therefrom.

In April 1996, one of the Company's railroads received notice of three
environmental site evaluations being conducted by a state environmental agency.
The evaluations are the result of an alleged fuel spill caused by a train
derailment and alleged on-site burial of railroad ties and unreported leaking
underground storage tanks and an alleged release of diesel fuel during
locomotive refueling. The Company believes these evaluations relate to events
that occurred prior to the Company's acquisition of the railroad property. The
Company is cooperating with the state environmental agency to complete these
evaluations. However, the Company may be held liable for some or all expenses
associated with these evaluations and the expenses associated with any necessary
remedial actions. To the extent the Company incurs expenses in connection with
these evaluations, or remedial actions, it may seek to recover such expenses
from the prior owners of the property or other responsible parties. The Company
is unable
59
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

to predict the probable outcome of these site evaluations or the amount or range
of potential loss arising therefrom.

A Class I Railroad, which interchanges traffic with one of the Company's
railroads has filed a complaint against the Company in the United States
District Court of the Western District of Missouri. In this lawsuit, the
plaintiff seeks recovery of certain switching and joint facility charges
amounting to approximately $632,000. The Company has interposed certain
defenses, including payment of substantially all of the joint facility charges
and the inapplicability of the switching charges. Since the service for which
the switching charges have been asserted is ongoing, it is likely that
additional charges accruing through the date the lawsuit is resolved will be
asserted. Discovery is in progress and trial has been set for April 1997. The
Company believes it has meritorious defenses and is vigorously defending this
litigation, therefore, no amounts are recorded on the books of the Company in
anticipation of a loss as a result of this contingency.

In December 1996, a corporation filed a construction lien against one of the
Company's railroads in the amount of approximately $600,000. The alleged basis
for the construction lien is the provision by the plaintiff of labor and
materials to the Company's railroad in connection with a train derailment in
August 1996. The Company believes that the plaintiff is solely responsible for
any and all damages arising out of the derailment due to the plaintiff's
negligent acts or the omission of its employees and agents. As a result, the
Company believes that the filing and any subsequent enforcement of such lien is
wrongful and constitutes slander of and trespass to title. The Company believes
it has meritorious defenses and is vigorously defending this litigation,
therefore, no amounts are recorded on the books of the Company in anticipation
of a loss as a result of this contingency.

The Company maintains insurance to cover costs associated with personal
injury, including death, and property damage, including derailments. The
Company's primary liability policy is currently subject to a self-insured
retention of $500,000 per occurrence which was increased from $250,000 per
occurrence as of July 15, 1996. With respect to its transportation of hazardous
commodities, the Company's liability policy covers sudden releases of hazardous
materials, including expenses related to evacuation. Personal injuries
associated with grade crossing accidents are also covered under the Company's
liability policy. The Company also maintains all-risk property damage coverage,
including damage to property of shippers, subject to applicable retention.

The Company is a defendant in certain lawsuits resulting from railroad
operations. In management's judgment, based on the opinion of the Company's
legal counsel, the ultimate liability, if any, from such legal proceedings will
not have a material effect on the Company's financial position and results of
operations.
60
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

16. FOREIGN AND DOMESTIC OPERATIONS

Financial information by geographic area is as follows (in thousands):

YEARS ENDED DECEMBER 31,
-----------------------------
1994 1995 1996
-----------------------------
Operating revenues from unaffiliated customers:
United States ............................... $ 59,606 $ 93,586 $106,937
Canada ...................................... 14,922 14,255 14,169
-------- -------- --------
Total operating revenues ................. $ 74,528 $107,841 $121,106
======== ======== ========
Operating income:
United States .............................. $ 8,363 $ 11,559 $ 17,793
Canada ..................................... 4,814 4,096 4,248
-------- -------- --------
Total operating income ................... $ 13,177 $ 15,655 $ 22,041
======== ======== ========
Identifiable assets:
United States .............................. $113,448 $177,719 $220,857
Canada ..................................... 21,732 23,186 21,488
-------- -------- --------
Total identifiable assets ................ $135,180 $200,905 $242,345
======== ======== ========
17. ACQUISITIONS

On December 7, 1996, a wholly owned subsidiary of the Company, the
Pittsburgh Industrial Railroad, Inc. ("PIRR"), purchased from Conrail certain
assets consisting of 42 miles of track located in the Pittsburgh metropolitan
area. The purchase price was $3.0 million and was funded by borrowings under the
Company's U.S. Acquisition Facility. This transaction has been accounted for as
a purchase of assets.

On November 2, 1996, a newly formed wholly owned subsidiary of the Company,
the Ontario L'Orignal Railway, Inc. ("OLOR"), purchased from Canadian National
("CN") certain assets consisting of 26 miles of track in eastern Ontario,
Canada. The OLOR was granted rights by CN to operate the property and commenced
operations on November 2, 1996 and the acquisition closed on December 2, 1996.
The purchase price was CDN $1.1 million (approximately U.S. $800,000) and was
funded by borrowings under the Company's Canadian Acquisition Facility.
This transaction has been accounted for as a purchase of assets.

On September 21, 1996, a newly formed wholly owned subsidiary of the
Company, Connecticut Southern Railroad, Inc. ("CSOR"), purchased from Conrail
certain assets including 23 miles of rail segments located in Connecticut and
six locomotives. The CSOR was also granted rights to operate over an additional
49 miles of track, from just north of New Haven, Connecticut to Springfield,
Massachusetts, under a freight operating agreement with Amtrak. The purchase
price, $3.5 million, was funded by borrowings under the Company's U.S.
Acquisition Facility. This transaction has been accounted for as a purchase of
assets.

On June 4, 1996, the Company acquired 100% of the outstanding stock of the
Indiana & Ohio Railcorp, ("INOH"), an existing short line railroad headquartered
in Cincinnati, Ohio. Through its subsidiaries, the INOH operates ten line
segments totaling 230 miles of track in southwestern Ohio and southeastern
Indiana. The purchase price was $12.4 million including an $8.9 million cash
payment and the assumption of $3.5 million of long-term debt, of which $2.1
million was paid down after completion of the acquisition. This acquisition was
funded by borrowings under the Company's U.S. Acquisition Facility. This
acquisition has been accounted for using the purchase method of accounting. The
purchase price was allocated based on estimated fair values at the date of the
acquisition.
61
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

In May 1994, the Company entered into a letter of intent with an affiliate
of CN to acquire certain assets of the Central Vermont Railway, Inc. ("Central
Vermont"). These assets consisted primarily of a 325 mile line in New England
extending from East Alburgh, Vermont to New London, Connecticut. The purchase
price, including related costs, was $40.2 million. The Central Vermont connects
with several carriers, including the CN, Conrail and nine regional or short line
railroads. On October 6, 1994, a newly formed subsidiary of the Company, New
England Central Railroad, Inc. ("NECR") executed definitive documentation for
the transaction with the selling parties. The NECR commenced operations on
February 4, 1995. In connection with the acquisition, the Company borrowed $41.1
million under its acquisition facility. The Company accounted for this business
combination as a purchase in 1995. Unlike all of its previous acquisitions, the
Company acquired substantially all of the assets of the Central Vermont, hired a
substantial number of the Central Vermont employees to operate the NECR and
assumed certain of the contracts of the Central Vermont.

The following unaudited pro forma results of operations for the years ended
December 31, 1995 and 1996, assumes the acquisition of the NECR and the INOH
occurred as of the beginning of the respective periods. (in thousands, except
per share amounts.)
YEARS ENDED DECEMBER 31,
-----------------------------
1995 1996
--------- ----------
(Unaudited)
Operating revenues ............ $ 116,828 $123,848
========= ========
Net income .................... $ 7,505 $ 9,828
========= ========
Net income per share .......... $ 0.82 $ 1.07
========= ========

These pro forma results have been prepared for comparative purposes only and
include certain adjustments such as depreciation expense as a result of a
step-up in the basis of fixed assets and an adjustment of depreciable lives,
additional amortization expense as a result of organization costs and increased
interest expense on acquisition debt. The unaudited pro forma information is not
necessarily indicative of the results that would have occurred had such
transactions actually taken place at the beginning of the periods specified nor
does such information purport to project the results of operations for any
future date or period.

18. SECURITIES OFFERINGS

In March 1995, the Company completed an underwritten public offering of
Common Stock ("Secondary Offering") of which 1,150,000 shares were sold by the
Company and 1,165,000 shares were sold by certain selling shareholders. The
number of shares sold by the Company reflects the underwriters' exercise of
their over-allotment option. Net proceeds to the Company from the Secondary
Offering were approximately $25.4 million. Approximately $25.3 million of the
net proceeds was used to reduce borrowings outstanding under the Company's
1995 U.S. Acquisition Facility and 1995 U.S. Working Capital Facility (see Note
7). Concurrent with the closing of the Secondary Offering, a former officer and
current director of the Company exercised options to purchase 286,322 shares of
Common Stock and paid such options exercise price by tendering 23,416 shares of
Common Stock to the Company. The shares of Common Stock tendered by such former
officer were canceled by the Company. Also, concurrent with the closing of the
Secondary Offering, the Company's $5.0 million Convertible Senior Subordinated
Notes due January 2003 were converted into 520,833 shares of Common Stock (see
Note 9).
62
<PAGE>
RAILTEX, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

19. UNAUDITED QUARTERLY FINANCIAL DATA

(in thousands, except per share amounts)

FIRST SECOND THIRD FOURTH
QUARTER QUARTER(1) QUARTER QUARTER
------- ---------- ------- -------
1996:
Operating revenues..... $28,609 $30,148 $29,857 $32,492
Operating income....... 4,930 5,658 5,471 5,982
Net income............. 2,183 2,621 2,308 2,849
Net income per share... 0.24 0.28 0.25 0.31

1995:
Operating revenues..... $25,143 $27,295 $27,498 $27,905
Operating income....... 4,026 2,279 4,641 4,709
Net income............. 1,728 645 2,054 2,471
Net income per share... 0.22 0.07 0.22 0.27
- ------------
(1) Results for the second quarter of 1995 include a Special Charge of
$2,140,000 before tax and $1,389,000, or $0.15 per share, after tax
(see Note 3).

20. SUBSEQUENT EVENTS

On February 15, 1997, a wholly owned subsidiary of INOH, Indiana & Ohio
Railway Company ("IORY"), purchased substantially all of the assets of the
former Detroit, Toledo and Ironton ("DTI") from Grand Trunk Western Railroad,
Inc., a subsidiary of CN. IORY acquired 146 miles of track for $22.0 million
and, with trackage rights, will operate over approximately 255 miles track
between Flat Rock, Michigan and Cincinnati, Ohio. The Company expects to spend
approximately $7.2 million in 1997 for organization costs, start up costs and
locomotives. Additionally, IORY has committed to invest over a three year
period, approximately $9.7 million to return the former DTI track to FRA Class
IV standards. The DTI acquisition was funded through borrowings under the
Company's U.S. Acquisition Facility.

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

None.

The remainder of this page is intentionally left blank.

63
<PAGE>
PART III

ITEM 10. EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT

See "Executive Officers of the Registrant" in Part I for information
regarding executive officers of the Company. Information regarding the Directors
of the Company is incorporated by reference to the caption "Election of
Directors" in the Company's definitive Proxy Statement to be filed pursuant to
Regulation 14A within 120 days after the end of the Company's fiscal year
covered by this report.

ITEM 11. EXECUTIVE COMPENSATION

Information regarding Executive Compensation is incorporated by reference to
the caption "Executive Compensation" in the Company's definitive Proxy Statement
to be filed pursuant to the Regulation 14A within 120 days after the end of the
Company's fiscal year covered by this Report on Form 10-K.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information regarding Security Ownership of Certain Beneficial Owners and
Management is incorporated by reference to the caption "Principal and Management
Shareholders" in the Company's definitive Proxy Statement to be filed pursuant
to Regulation 14A within 120 days after the end of the Company's fiscal year
covered by this Report on Form 10-K.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information regarding Certain Relationships and Related Transactions is
incorporated by reference to the caption "Certain Relationships and Related
Transactions" in the Company's definitive Proxy Statement to be filed pursuant
to regulation 14A within 120 days after the end of the Company's fiscal year
covered by this Report on Form 10-K.

The remainder of this page is intentionally left blank.

64
<PAGE>
PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

A. DOCUMENTS

The following documents are filed as part of this Report:
<TABLE>
<CAPTION>
1. FINANCIAL STATEMENTS PAGE
----
<S> <C>
Report of Independent Public Accountants ....................................... 40
Consolidated Statements of Income for the Three Years Ended December 31, 1996 . 41
Consolidated Balance Sheets at December 31, 1995 and 1996 ...................... 42
Consolidated Statements of Shareholders' Equity for the Three Years Ended
December 31, 1996 .............................................................. 43
Consolidated Statements of Cash Flow for the Three Years Ended December 31, 1996 44
Notes to Consolidated Financial Statements ..................................... 45
</TABLE>
2. FINANCIAL STATEMENT SCHEDULES
None

3. EXHIBITS

EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------- -----------------------
*3(i) Restated Articles of Incorporation of the Company.

*3(ii) Bylaws of the Company.

*4.1 Specimen Common Stock Certificate.

*4.2 Note Agreement, dated as of January 1, 1993, among the Company and
Massachusetts Mutual Life Insurance Company, MassMutual
Participation Investors and MassMutual Corporate Investors.

*4.3 Purchase Agreement, dated as of August 28, 1991, among the Company
and Banc One Capital Partners Corporation, Ventex Partners Ltd.,
and First Century Partnership III.

++10.1 Credit Agreement, dated as of May 17, 1996, between the Company;
First Interstate Bank of Texas, N.A.; as Agent, and the several
financial institutions that are parties to the Credit Agreement.

++10.2 First Amendment to Credit Agreement dated as of June 11, 1996,
between the Company; Wells Fargo Bank (Texas), N.A.; as Agent and
the several financial institutions that are parties to the Credit
Agreement.

++10.3 Second Amendment to Credit Agreement dated as of July 22, 1996,
between the Company; Wells Fargo Bank (Texas), N.A.; as Agent, and
the several financial institutions that are parties to the Credit
Agreement.
65
<PAGE>
++10.4 Loan Agreement, dated as of June 21, 1996, between RailTex Canada,
Inc. as borrower and National Bank of Canada and ABN AMRO Bank
Canada, as lenders and National Bank of Canada, as Agent.

+++10.5 Third Amendment to Credit Agreement, dated August 13, 1996,
between the Company; Wells Fargo Bank (Texas), N.A.; as Agent and
the several financial institutions that are parties to the Credit
Agreement.

10.6 (This exhibit is intentionally left blank).

10.7 (This exhibit is intentionally left blank).

*10.8 Contract for Rail Freight Service, dated July 31, 1986, by and
between the City of Austin, Capital Metropolitan Transportation
Authority and Austin Railroad Company, Inc.

*10.9 Indenture of Lease and Option to Purchase Agreement, dated
February 28, 1990, by and between Southern Railway Company and
Chesapeake and Albemarle Railroad Company, Inc.

*10.10 Lease Agreement, dated February 9, 1992, by and between Missouri
Pacific Railroad Company and Dallas, Garland & Northeastern
Railroad Company, Inc.

*10.11 Line Sale Contract, dated February 5, 1992, by and between
Missouri Pacific Railroad Company and Dallas, Garland &
Northeastern Railroad Company, Inc.

*10.12 Smithville, GA to White Oak, AL Lease and Option to Purchase
Agreement, dated December 22, 1988, by and between Central of
Georgia Railroad Company, the South Western Rail Road Company and
South Carolina Central Railroad Company, Inc.

*10.13 Asset Purchase Agreement, dated October 29, 1990, by and between
the Goderich-Exeter Railway Company Limited and Canadian National
Railway Company.

*10.14 Operating and Marketing Agreement, dated October 29, 1990, between
Goderich-Exeter Railway Company Limited and Canadian National
Railway Company.

*10.15 Purchase and Sale Agreement, dated July 9, 1993, by and between
Central Michigan Railway Company and Grand Rapids Eastern
Railroad.

*10.16 Purchase and Sale Agreement, dated March 19, 1992, by and between
Indiana Southern Railroad, Inc. and Consolidated Rail Corporation.

*10.17 Transportation Contract ICC-CR-C-4553, dated September 28, 1987,
by and between Consolidated Rail Corporation and Indianapolis
Power & Light Company and all amendments thereto.

*10.18 Lease Agreement, dated December 11, 1992, by and between Missouri
Pacific Railroad Company and Missouri & Northern Arkansas Railroad
Company, Inc.

*10.19 Line Sale Contract, dated December 11, 1992, by and between
Missouri Pacific Railroad Company and Missouri & Northern Arkansas
Railroad Company, Inc.

*10.20 Permanent Freight Railroad Operating Easement, dated March 31,
1993, by and between the Union Pacific Railroad Company and the
Salt Lake City Southern Railroad Co., Inc.

66
<PAGE>
*10.21 Administration and Coordination Agreement, dated March 31, 1993,
by and between the Salt Lake City Southern Railroad Co., Inc. and
the Utah Transit Authority.

*10.22 Agreement for Operation of Freight Service and Control Through
Management of SD&AE, dated March 8, 1984, between San Diego and
Arizona Eastern Railway Company, San Diego Metropolitan Transit
Development Board and the Company.

*10.23 Agreement, dated July 15, 1986, between San Diego and Imperial
Valley Railroad and Ferrocarril Sonora-Baja California.

*10.24 Lease Agreement, dated March 2, 1990, between Missouri Pacific
Railroad Company and Mid-Michigan Railroad, Inc.

*10.25 Lease and Option to Purchase Agreement, dated November 10, 1988,
by and between Southern Railway Company and North Carolina &
Virginia Railroad.

*10.26 Asset Purchase Agreement, dated September 18, 1992, by and between
Cape Breton & Central Nova Scotia Railway Limited and Canadian
National Railway Company.

*10.27 Operating and Marketing Agreement, dated September 18, 1992,
between Cape Breton & Central Nova Scotia Railway Limited and
Canadian National Railway Company.

*10.28 Note Agreement, dated as of January 1, 1993, among the Company and
Massachusetts Mutual Life Insurance Company, MassMutual
Participation Investors and MassMutual Corporate Investors
(included as Exhibit 4.2).

*10.29 Purchase Agreement, dated as of August 28, 1991, among the Company
and Banc One Capital Partners Corporation, Ventex Partners Ltd.,
and First Century Partners III (included as Exhibit 4.3).

++10.30 Form of Amended 1993 Stock Plan of the Company.

*10.31 Form of Non-Statutory Stock Option Agreement between the Company
and its officers.

*10.32 Interest Rate Swap Agreement, dated September 16, 1992, between
the Company and First Interstate Bank of Texas, N.A.

*10.33 Form of Indemnification Agreement between the Company and its
officers and directors.

*10.34 Form of Indemnification Agreement between RailTex Service Co.,
Inc. and its officers and directors.

10.35 (This exhibit is intentionally left blank).

*10.36 Right of First Refusal Agreement, dated October 1, 1993, between
Cape Breton & Central Nova Scotia Railway Limited and Canadian
National Railway Company.

***10.37 Sale Agreement--Siskiyou Line, Coos Bay Branch and White City
Branch, dated as of November 21, 1994, by and between Southern
Pacific Transportation Company and Central Oregon & Pacific
Railroad, Inc.
67
<PAGE>
***10.38 First Amendment to Sale Agreement--Siskiyou Line, Coos Bay Branch
and White City Branch, dated as of December 31, 1994, by and
between Southern Pacific Transportation Company and Central Oregon
& Pacific Railroad, Inc.

***10.39 Lease Agreement, dated as of December 31, 1994, by and between
Southern Pacific Transportation Company and Central Oregon &
Pacific Railroad, Inc.

***10.40 Cooperative Marketing Agreement, dated as of December 31, 1994, by
and between Southern Pacific Transportation Company and Central
Oregon & Pacific Railroad, Inc.

*****10.41 The Note Agreement, dated as of September 1, 1995, between the
Company and the Purchasers named on Schedule I on Note Agreement.

10.42 (This exhibit is intentionally left blank).

10.43 (This exhibit is intentionally left blank).

+10.44 Form of Non-Statutory Stock Option Agreement between the Company
and its outside directors.

***10.45 Letter of Intent, dated May 23, 1994, between Central Vermont
Railway, Inc. and RailTex Service Company, Inc.

****10.46 Lease and Sale Agreement, dated October 6, 1994, by and between
New England Central Railroad, Inc. and Central Vermont Railway,
Inc.

*****10.47 The Note Agreement ("Canadian Note Agreement"), dated as of
September 1, 1995, between RailTex Canada, Inc. and the Purchasers
named on Schedule I to the Canadian Note Agreement.

*****10.48 Guaranty Agreement, dated as of September 1, 1995, by RailTex,
Inc. in favor of Purchasers named on Schedule I to the Canadian
Note Agreement.

+10.49 Interest Rate Swap Agreement, dated January 24, 1995, between
National Bank of Canada and RailTex Canada, Inc.

+10.50 Form of Split Dollar Insurance agreement between the Company and
its Executive Officers.

++10.51 Agreement of Sale among RailTex, Inc. and Indiana & Ohio Rail
Corp. and all of the shareholders of Indiana & Ohio Rail Corp.

11.1 Statement Regarding Computation of Per Share Earnings.

21.1 Subsidiaries of the Company

23.1 Consent of Arthur Andersen LLP.

68
<PAGE>
- ----------------------
* These exhibits are incorporated by reference to the same Exhibit to the
Registrant's Registration Statement No. 33-68938 filed on Form S-1 with
the Securities and Exchange Commission ("Commission") on September 16,
1993, as amended by Amendment No. 1 to Form S-1 Registration Statement
filed with the Commission on November 1, 1993, Amendment No. 2 to Form
S-1 Registration Statement filed with the Commission on November 16,
1993 and Post-Effective Amendment No. 1 to Form S-1 Registration
Statement filed with the Commission on November 19, 1993.

*** These exhibits are incorporated by reference to the same Exhibit to the
Registrant's Registration Statement No. 33-80782 filed on Form S-1 with
the Commission on June 28, 1994, as amended by Amendment No. 1 to Form
S-1 Registration Statement filed with the Commission on September 1,
1994, Amendment No. 2 to Form S-1 Registration Statement filed with the
Commission on February 17, 1995 and Amendment No. 3 to Form S-1
Registration Statement filed with the Commission on March 6, 1995.

**** These exhibits are incorporated by reference to the same Exhibit to the
Registrant's Quarterly Report on Form 10-Q for the quarterly period
ended September 30, 1994.

***** These exhibits are incorporated by reference to the same Exhibit to the
Registrant's Quarterly Report on Form 10-Q for the quarterly period
ended September 30, 1995.

+ These exhibits are incorporated by reference to the same Exhibit to the
Registrants Annual Report on Form 10-K for the year ended December 31, 1995
filed with the Commission on March 29, 1996.

++ These exhibits are incorporated by reference to the same Exhibit to the
Registrant's Quarterly Report on Form 10-Q for the quarterly period ended
June 30, 1996.

+++ These exhibits are incorporated by reference to the same Exhibit to the
Registrant's Quarterly Report on Form 10-Q for the quarterly period ended
September 30, 1996.

B. REPORTS ON FORM 8-K:

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

69
<PAGE>
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized, in
San Antonio, Texas.
RAILTEX, INC.
(Registrant)

By: /s/ BRUCE M. FLOHR
Name: Bruce M. Flohr
Title: Chairman of the Board, Chief Executive
Officer and Director

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 indicated and on the dates indicated.

SIGNATURES TITLE
---------- -----
/s/ BRUCE M. FLOHR Chairman of the Board, Chief Executive
Bruce M. Flohr Officer and Director

/s/ HENRY M. CHIDGEY President, Chief Operating Officer and Director
Henry M. Chidgey

/s/ LAURA D. DAVIES Vice President-Finance and Administration,
Laura D. Davies Chief Financial Officer and Director

/s/ ROBERT R. LENDE Director
Robert R. Lende

/s/ ROBERT M. AYRES, JR. Director
Robert M. Ayres, Jr.

/s/ HEATHER J. GRADISON Director
Heather J. Gradison

/s/ FERD. C. MEYER, JR. Director
Ferd. C. Meyer, Jr.

/s/ PALMER L. MOE Director
Palmer L. Moe

EXHIBIT 11.1
RAILTEX, INC. AND SUBSIDIARIES

COMPUTATION OF NET INCOME PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1994 1995 1996
------ ------ ------
<S> <C> <C> <C>
Net Income ......................................................... $6,881 $6,898 $9,961
====== ====== ======
Weighted average number of Common Stock and
Common Stock equivalents outstanding:
Weighted average number of shares
of Common Stock outstanding ...................................... 7,157 8,699 9,111
Common Stock equivalents applicable to
convertible senior subordinated notes(1) ..................... 218 44 --
Weighted average number of Common
Stock equivalents applicable to stock options ...................... 445 154 120
------ ------ ------
Common Stock and Common Stock equivalents .......................... 7,820 8,897 9,231
====== ====== ======
Earnings per share - primary ....................................... $ 0.88 $0.78 $1.08
====== ====== ======
Net Income ......................................................... $6,881 $6,898 $9,961
====== ====== ======
Weighted average number of Common Stock and Common Stock equivalents
outstanding:
Weighted average number of shares
of Common Stock outstanding .................................. 7,157 8,699 9,111
Common Stock equivalents applicable to
convertible senior subordinated notes(1) ..................... 218 44 --
Weighted average number of Common
Stock equivalents applicable to stock options ...................... 445 154 133
------ ------ ------
Common Stock and Common Stock equivalents .......................... 7,820 8,897 9,244

Increase in dilutive incremental Common
Stock applicable to stock options ............................ -- -- --
------ ------ ------
Common Stock assuming full dilution ................................ 7,820 8,897 9,244
====== ====== ======
Earnings per share - fully diluted(2) .............................. $ 0.88 $0.78 $1.08
====== ====== ======
</TABLE>
(1) Convertible debt issued within one year prior to an initial public
offering with a conversion price below the estimated initial public
offering price has been included as outstanding for all periods
specified by SAB No. 83 (Topic 4-D).

(2) This calculation is submitted in accordance with item 601(b)11 of
regulation S-K although it is not required by APB Opinion No. 15
because it results in dilution of less than 3.0%.

EXHIBIT 21.1
RAILTEX, INC. AND SUBSIDIARIES

LIST OF SUBSIDIARIES

RailTex Service Co., Inc.
San Diego & Imperial Valley Railroad Company, Inc.
Austin & Northwestern Railroad Company, Inc.
North Carolina & Virginia Railroad Company, Inc.
South Carolina Central Railroad Company, Inc.
Mid-Michigan Railroad, Inc.
Chesapeake and Albemarle Railroad Company, Inc.
Michigan Shore Railroad, Inc.
New Orleans Lower Coast Railroad, Inc.
Dallas, Garland & Northeastern Railroad, Inc.
Goderich-Exeter Railroad Company Limited
Indiana Southern Railroad, Inc.
RailTex Distribution Services, Inc.
RailTex Trac Company, Inc.
Missouri & Northern Arkansas Railroad Company, Inc.
Salt Lake City Southern Railroad Company, Inc.
Grand Rapids Eastern Railroad, Inc.
Cape Breton & Central Nova Scotia Railway Limited
RailTex Canada, Inc.
New England Central Railroad, Inc.
Central Oregon & Pacific Railroad, Inc.
Georgia Southwestern Railroad, Inc.
RailTex International Services, Inc.
Connecticut Southern Railroad, Inc.
Indiana & Ohio Rail Corp.
Ontario L'Orignal Railway, Inc.
Pittsburgh Industrial Railroad, Inc.
RailTex Logistics, Inc.
RailTex International Holdings, Inc.

EXHIBIT 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the incorporation
of our report included in this Form 10-K into the Company's previously filed
Registration Statement on Form S-8 (File No. 33-79174).

ARTHUR ANDERSEN LLP
San Antonio, Texas
March 25, 1997

<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1996
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-END> DEC-31-1996
<CASH> 2,108
<SECURITIES> 0
<RECEIVABLES> 27,446
<ALLOWANCES> 612
<INVENTORY> 0
<CURRENT-ASSETS> 32,551
<PP&E> 239,161
<DEPRECIATION> 29,741
<TOTAL-ASSETS> 269,470
<CURRENT-LIABILITIES> 32,782
<BONDS> 42,752
0
0
<COMMON> 912
<OTHER-SE> 121,791
<TOTAL-LIABILITY-AND-EQUITY> 269,470
<SALES> 0
<TOTAL-REVENUES> 121,106
<CGS> 0
<TOTAL-COSTS> 99,065
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 655
<INTEREST-EXPENSE> 6,893
<INCOME-PRETAX> 16,669
<INCOME-TAX> 6,708
<INCOME-CONTINUING> 9,961
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 9,961
<EPS-PRIMARY> 1.08
<EPS-DILUTED> 1.08

</TABLE>