<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(X) Quarterly Report Pursuant To Section 13 Or 15(d)
Of The Securities Exchange Act of 1934
For the Quarterly Period Ended June 30, 1997
Commission File Number 1-10367
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
DELAWARE 71-0675758
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
206 1/2 East Emma Avenue
P.O. Box 1237
Springdale, Arkansas 72765
(Address of Principal Executive Office) (Zip Code)
Registrant's telephone number, including area code: (501)750-1299
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 shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
YES: X NO:
As of August 14, 1997, the number of shares outstanding of the Registrant's
Class A Common Stock, which is the class registered under the Securities
Exchange Act of 1934, was 19,335,602 and the number of shares outstanding of the
Registrant's Class B Common Stock was 1,465,530.
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
FORM 10-Q INDEX
PART I - FINANCIAL INFORMATION
PAGE
ITEM 1 Financial Statements
Balance Sheets, June 30, 1997 and December 31, 1996 1-2
Statements of Operations,
Three months and six months ended June 30, 1997 and 1996 3
Statements of Cash Flows,
Six months ended June 30, 1997 and 1996 4
Notes to Financial Statements 5-10
Review Report of Arthur Andersen LLP,
Independent Public Accountants 11
ITEM 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 12-15
PART II - OTHER INFORMATION
ITEM 1 Legal Proceedings 16-17
Signatures 18
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
BALANCE SHEET
<TABLE>
<CAPTION>
ASSETS
------
June 30, 1997 December 31,
(Unaudited) 1996
------------- -----------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 785,605 $ 82,756
Receivables 697,098 1,010,937
Inventories 571,525 593,325
Prepaid expenses and other 177,680 87,381
---------- ----------
Total current assets 2,231,908 1,774,399
---------- ----------
Buildings and equipment,
at cost, including construction
in progress of $484,182 at 6-30-97,
and $838,709 at 12-31-96:
Buildings 688,931 687,509
Machinery and equipment 7,161,431 6,791,709
Transportation equipment 79,900 135,527
Office equipment 159,597 172,597
---------- ----------
8,089,859 7,787,342
Less accumulated depreciation
and amortization 3,712,553 3,182,679
---------- ----------
Net buildings and equipment 4,377,306 4,604,663
---------- ----------
Other assets, at cost less accumulated
amortization of $121,187 at 6-30-97,
and $107,798 at 12-31-96 640,280 346,487
---------- ----------
$7,249,494 $6,725,549
========== ==========
</TABLE>
The accompanying notes to the financial statements should be read in conjunction
with these statements.
1
<PAGE>
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
<TABLE>
<CAPTION>
June 30, 1997 December 31,
(Unaudited) 1996
-------------- -------------
<S> <C> <C>
Current liabilities:
Current maturities of long-term debt $ 737,507 $ 705,344
Accounts payable - trade 1,039,265 1,224,711
Payables to related parties 1,087,446 468,715
Accrued liabilities 229,422 207,065
Notes payable 100,822 61,559
------------ ------------
Total current liabilities 3,194,462 2,667,394
------------ ------------
Long-term debt, less current maturities -
Related parties 636,657 799,554
Other 61,447 156,222
------------ ------------
Total long-term debt 698,104 955,776
------------ ------------
Commitments and contingencies
Stockholders' equity
Preferred stock, $1 par value;
5,000,000 shares authorized,
none issued - -
Class A common stock, $.01 par value;
50,000,000 shares authorized,
19,335,602 (1997) and 19,201,148
(1996) shares issued and outstanding 193,356 192,012
Class B convertible common stock, $.01
par value; 7,500,000 shares authorized,
1,465,530 shares issued and
outstanding 1997 and 1996 14,655 14,655
Additional paid in capital 21,776,105 21,533,450
Accumulated deficit (18,627,188) (18,637,738)
------------ ------------
Total stockholders' equity 3,356,928 3,102,379
------------ ------------
$ 7,249,494 $ 6,725,549
============ ============
</TABLE>
The accompanying notes to the financial statements should be read in conjunction
with these statements.
2
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
Three months ended Six months ended
June 30, June 30,
------------------------- ------------------------
1997 1996 1997 1996
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Sales $ 1,947,307 $ 2,057,337 $ 3,695,109 $ 3,659,116
Cost of Goods Sold 1,762,641 1,943,021 3,756,187 3,689,251
----------- ----------- ----------- -----------
Gross Margin 184,666 114,316 (61,078) (30,135)
Selling and Administrative Costs 406,292 406,118 744,430 783,489
----------- ----------- ----------- -----------
Operating Income (Loss) (221,626) (291,802) (805,508) (813,624)
Other Income (Expense)
Other Income - 20,291 - 20,399
Interest Expense (11,716) (56,699) (47,274) (117,438)
----------- ----------- ----------- -----------
Net Loss Before Extraordinary Item (233,342) $ (328,210) $ (852,782) $ (910,663)
=========== =========== =========== ===========
Extraordinary Gain 863,332 - 863,332 -
Net Income (Loss) $ 629,990 $ (328,210) $ 10,550 $ (910,663)
=========== ========== =========== ===========
Net loss per share of common stock
before extraordinary item $(.01) $(.02) $(.04) $(.05)
Extraordinary gain per share of common
stock $.04 - $.04 -
----------- ---------- ----------- -----------
Net Income per share of common stock $ .03 $ (.02) - $ (.05)
Weighted average number of
common shares outstanding 20,801,132 18,225,348 20,768,266 18,225,348
=========== =========== =========== ===========
</TABLE>
The accompanying notes to the financial statements should be read in conjunction
with these statements.
3
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
STATEMENTS OF CASH FLOWS (UNAUDITED)
<TABLE>
<CAPTION>
Six months Six months
ended ended
June 30, June 30,
1997 1996
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 10,550 $ (910,663)
Adjustments to reconcile net income
(loss) to net cash used in operating
activities:
Depreciation 529,874 578,887
Amortization of other assets 13,389 12,309
Increase in other assets (307,182) (14,914)
Changes in current assets & current
liabilities (189,811) (480,579)
Extraordinary gain (863,332) -
---------- ----------
Net cash used in operating activities (806,512) (814,960)
Cash flows from investing activities:
Additions to buildings and equipment (302,517) (674,311)
Insurance proceeds 1,863,332 -
---------- ----------
Net cash provided (used in) by investing
activities 1,560,815 (674,311)
---------- ----------
Cash flows from financing activities:
Proceeds from issuance of notes - 269,155
Payments on notes (295,454) (374,538)
Proceeds from issuance of common
stock, net 244,000 1,592 748
---------- ----------
Net cash provided (used in) in financing
activities (51,454) 1,487,365
---------- ----------
Increase (Decrease) in cash & cash
equivalents 702,849 (1,906)
Cash and cash equivalents:
Beginning of period 82,756 15,350
---------- ----------
End of period $ 785,605 $ 13,444
========== ==========
</TABLE>
The accompanying notes to the financial statements should be read in conjunction
with these statements.
4
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS
Note 1: Unaudited Information
- ------------------------------
The financial statements included herein have been prepared by Advanced
Environmental Recycling Technologies, Inc. (the Company or AERT), without audit,
pursuant to the rules and regulations of the Securities and Exchange Commission
(SEC). However, all adjustments have been made to the accompanying financial
statements which are, in the opinion of the Company's management, necessary for
a fair presentation of the Company's operating results. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations, although the Company believes
that the disclosures are adequate to make the information presented herein not
misleading. It is recommended that these financial statements be read in
conjunction with the financial statements and the notes thereto included in the
Company's latest annual report on Form 10-K. Accordingly, the Company has
reclassified certain prior period amounts to conform to the current period
presentation.
Note 2: Organization and Description of the Company
- ----------------------------------------------------
The Company has developed and commenced the manufacture of a composite building
material from waste plastic and wood fiber waste for certain specialized
applications in the construction industry. The Company has initially marketed
this material as a substitute for wood and plastic filler materials for standard
door frames, window sills, floor blocks, and decking. The Company is comprised
of two separate, yet interrelated manufacturing facilities located in Junction,
Texas and Rogers, Arkansas. A third manufacturing site has recently been
leased in Springdale, Arkansas. The Company's customers primarily consist of
a number of regional and national door and window manufacturers and
Weyerhaeuser, the Company's primary decking customer.
The Company was initially capitalized on December 2, 1988, with a contribution
of machinery and equipment, plant facilities and technology, most of which were
used by certain members of management in an unsuccessful prior business. The
prior business was organized in June 1985 to manufacture artificial firelogs
using certain technology somewhat similar to that used in the Company's
manufacturing process. By 1986, the prior business had incurred substantial
losses from operations, had no further working capital resources and
discontinued its business. The initial contribution consisted of approximately
$3,000,000 in buildings, machinery and equipment, supplies and other tangible
assets, as well as technological rights and expertise. In connection with such
initial organization, the Company assumed $795,000 in bank indebtedness secured
by certain of the contributed assets. All amounts are reflected in the
accompanying financial statements at the contributor's book value.
Note 3: Future Operations
- --------------------------
The financial statements of the Company have been prepared on the basis of
accounting principles applicable to a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. At June 30, 1997, the Company had a working capital deficit of
$962,554 and had incurred operating losses of $805,508 for the six months ended
June 30, 1997. For the quarter ending June 30, 1997 the Company
5
<PAGE>
achieved its first profitable quarter since inception due to a recording of an
extraordinary gain of $863,332 resulting from the insurance settlement of the
Rogers, Arkansas Plastic Reclamation Facility fire that occurred in December
1996. Since inception, and until the quarter ended June 30, 1997, the Company
had not achieved a successful level of operations nor has there been any
assurance that the Company will be able to achieve future revenue levels
sufficient to support existing operations, generate positive cash flow from
operations or recover its investment in its property, plant and equipment.
Further, the Company has limited additional financial resources available to
support its operations and in the past few years has, in large part, been
supported by certain major shareholders. There is no commitment from such
shareholders to continue such support beyond the current line of credit. The
Company also has claims in litigation outstanding against it as described in
Note 6, the outcomes of which are uncertain. There can be no assurance that the
Company's financial resources will be adequate to support existing operations
until such time, if ever, sales and manufacturing levels are sufficient to
consistently generate positive cash flow from operations. Further, if the
litigated claims discussed in Note 6 were to be assessed against the Company,
the Company would likely be unable to pay such claims. These factors, among
others, raise substantial doubt concerning the ability of the Company to
continue as a going concern. The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amount and classification of liabilities that might result should
the Company be unable to continue as a going concern. The ability of the Company
to continue as a going concern is dependent upon the ongoing support of its
stockholders, investors, customers and creditors and its ability to successfully
mass produce and market its products for its increasing customer backlog at
economically feasible levels.
The Company has developed, and is currently implementing, a production plan
which Management believes will provide for better operating efficiencies and
eliminate the production problems encountered in the past. Such plan includes
increasing production capacity, changes to production management, further
automation of the production process, improved raw material sourcing and better
utilization of regrindable scrap. In addition, the Company has entered into an
agreement to lease with the option to buy a 103,000 square foot manufacturing
facility located in Springdale, Arkansas. The Company intends to operate this
site as a dual purpose facility, producing both plastic and composite building
materials. The five year agreement calls for monthly payments of $19,000
starting September 1, 1997, with an option to purchase the facility at any time
during the lease for $1.8 million. The lease also carries and option for a
discounted sales price if the option is exercised within six months. It is the
Company's intention to have this facility operational by November 1, 1997. The
Company is seeking to enter into an agreement to raise approximately $2.2
million in an offering of preferred stock to accredited institutional investors,
and believes that such capital will be sufficient to support the Company until
such time as the Company achieves positive cash flow from operations. In
addition, the Company is also pursuing an additional $2.5 million financing
package through a State Economic Development Agency for acquisition and further
expansion of the Arkansas facility. However, it is possible additional financial
resources may be necessary to fund maturities of debt and other obligations as
they come due. There is no assurance the Company will be able to eliminate prior
production problems and improve operating efficiencies or that the Company will
be successful in securing sufficient capital resources to support the Company
until such time, if ever, the Company is able to generate positive cash flow.
Effective October 1, 1995, the Company adopted Statement of Financial Accounting
Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of, (SFAS 121). SFAS 121 requires an
assessment of the recoverability of the Company's investment in long-lived
assets to be held and used in operations whenever events or circumstances
indicate that their carrying amounts may not be recoverable. Such assessment
requires that the future cash-flows associated with the long-lived assets be
estimated over their remaining
6
<PAGE>
useful lives and an impairment loss recognized when the future cash-flows are
less than the carrying value of such assets.
The Company has assessed the recoverability of its investment in long-lived
assets to be held and used in operations under the guidelines set forth in SFAS
121 and determined that no impairment loss was required as of June 30, 1997.
Such assessment required the Company to make certain estimates of future
production volumes and costs and future sales volumes and prices which are
expected to occur over the remaining useful lives of its long-lived assets.
(such long-lived assets primarily consist of the Company's Rogers and Junction
manufacturing facilities.) The Company's estimates of these factors are based
upon management's belief that future production volumes will significantly
increase over previous historical production levels achieved by the Company's
manufacturing facilities and that future production costs per unit will also
significantly decrease below previous historical cost levels. The Company
believes that no significant production problems will recur at its Junction
composite manufacturing facility. As such, management of the Company believes a
reasonable basis exists for the use of such future estimates which are
significantly better than past historical performance.
Although the Company believes it has a reasonable basis for its estimates of
future production volumes and costs and future sales volumes and prices, it is
reasonably possible that the Company's actual performance could materially
differ from such estimates. Management expects that the Company's performance
during the last six months of 1997 will provide additional evidence to confirm
or disprove such future estimates. Management also believes that if such
estimates are not confirmed, revisions to such estimates could result in a
material impairment loss on its long-lived assets constituting all or a material
portion of the carrying value of the Company's Rogers and Junction manufacturing
facilities which was $4,377,306 at June 30, 1997.
Note 4: Statements of Cash Flows
- --------------------------------
In order to determine net cash used in operating activities, loss from
continuing operations has been adjusted by, among other things, changes in
current assets and current liabilities, excluding changes in cash and cash
equivalents, current maturities of long-term debt and advances from affiliates
included in notes payable - related parties. Those changes, shown as an
(increase) decrease in current assets and an increase (decrease) in current
liabilities, are as follows:
<TABLE>
<CAPTION>
Six months Six months
ended ended
June 30, 1997 June 30, 1996
(unaudited) (unaudited)
-------------- --------------
<S> <C> <C>
Receivables $ (686,161) $(261,456)
Inventories 21,800 149,570
Prepaid expenses and other 18,908 (152,557)
Accounts payable -
trade & related parties 433,285 (265,595)
Accrued liabilities 22,357 49,459
----------- ---------
$ (189,811) $(480,579)
=========== =========
</TABLE>
7
<PAGE>
Cash paid for interest $117,438
Cash paid for taxes - -
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Notes payable for financing of insurance policies $109,207
Note 5: Significant Accounting Policies
- ---------------------------------------
Inventories
-----------
Inventories are stated at the lower of cost (first-in, first-out method) or
market. Inventories consisted of the following:
<TABLE>
<CAPTION>
June 30, 1997 December 31,
(Unaudited) 1996
-------------- ------------
<S> <C> <C>
Raw materials $220,938 $210,483
Work in process 237,227 351,477
Finished goods 113,360 31,365
-------- --------
$571,525 $593,325
======== ========
</TABLE>
Use of Estimates
----------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Recently Issued Accounting Standards
------------------------------------
In June 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities". This statement provides accounting and
reporting standards for, among other things, the transfer and servicing of
financial assets, such as factoring receivables with recourse and will require
the Company to classify its financial assets pledged as collateral separately in
the financial statements. This statement is effective for transactions occurring
after December 31, 1996, and is to be applied prospectively. Earlier or
retroactive application is not permitted. In December 1996, the FASB issued SFAS
No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125,"
SFAS No. 127 moves
8
<PAGE>
forward some, but not all, of the provisions of SFAS No. 125 to December 31,
1997. The Company presently factors, with recourse, receivables to a related
party.
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share." SFAS No.
128 replaces the presentation of Primary Earnings Per Share (EPS) with Basic EPS
and requires dual presentation of Basic and Diluted EPS on the face of the
statements of operations and requires a reconciliation of the numerator and
denominator of the Basic EPS computation to the numerator and denominator of the
Diluted EPS computation. Basic EPS excludes dilution and is computed by
dividing income available to common shareholders by the weighted-average number
of common shares outstanding for the period. Diluted EPS reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock or resulted in the issuance of
common stock that then shared in the earnings of the Company. Diluted EPS is
computed similarly to Fully Diluted EPS pursuant to Accounting Principles Board
Opinion No. 15, "Earnings Per Share." SFAS No. 128 is effective for financial
statements issued after December 15, 1997, and earlier application is not
permitted. SFAS No. 128 requires restatement of all prior-period EPS data
presented.
Note 6: Commitments and Contingencies
- -------------------------------------
On June 9, 1992, Mobil Oil Corporation ("Mobil") commenced an action against the
Company in the United States District Court for the District of Delaware
entitled Mobil Oil Corporation v. Advanced Environmental Recycling Technologies,
-----------------------------------------------------------------------
Inc. In its complaint, Mobil sought entry of a declaratory judgment that: (a)
- ----
AERT is without right or authority to threaten suit against Mobil or its
customers for alleged infringement of AERT patents; (b) The AERT patents are
invalid and unenforceable, and (c) Mobil has not infringed the AERT patents
through any products or method. Mobil seeks no monetary damages in this suit,
but does seek reimbursement of its attorneys' fees.
On December 8, 1992, the Company answered Mobil's Complaint. In its Answer, the
Company denied Mobil's claims and asserted counterclaims against Mobil and three
Mobil executives for: (1) an illegal combination or contract in restraint of
trade in violation of federal antitrust laws; (2) a pattern of intentional
misconduct constituting an attempt to monopolize in violation of federal
antitrust laws; (3) breach of a confidential relationship between Mobil and the
Company; and (4) unfair competition. The Company sought monetary damages,
punitive damages and injunctive relief. Mobil filed an answer to AERT's
counterclaims, denying any liability. The Delaware Court then bifurcated the
trial into patent and non-patent issues and ordered the patent issues tried
first.
In February 1994, after a trial on the patent issues, a Delaware jury returned a
verdict that four AERT patents on its composite product technology were invalid.
The jury also determined that Mobil had not infringed two of the four patents
which AERT had asserted against Mobil. The jury verdict answered a number of
interrogatories on the factual issues, and rendered advisory findings for the
Court on Mobil's allegation that AERT had obtained its patents by inequitable
conduct. Thereafter, the Judge adopted the jury's advisory findings on
inequitable conduct and held that each of the four AERT patents were
unenforceable for failure to disclose certain alleged prior art to the patent
office during patent prosecution.
Because of the nature of certain of the jury verdict interrogatory responses,
AERT's counsel concluded that the verdict was adversely affected by improper
conduct by Mobil counsel during trial, and false statements of law and fact made
during closing argument, that caused the jury to misapply the law on inequitable
conduct and to render clearly erroneous findings. Consequently, AERT moved for
a new trial. That motion was denied. The Company's
9
<PAGE>
additional post-trial motions were also denied by the Delaware Court. On March
14, 1995, the Company filed a sealed motion with the Court based upon newly
discovered evidence which alleges prejudicial misconduct by Mobil prior to the
trial. The motion also brings to the Court's attention, evidence which the
Company believes was intentionally withheld from it in direct defiance of the
Delaware Court's January 4, 1994 Motion to Compel, prior to the trial. It also
brings to the Court's attention, an official government safety approval document
which was altered prior to submission to AERT during pre-trial discovery, which
also relates to a portion of the alleged withheld discovery documentation. The
motion seeks further discovery into Mobil's misconduct, and a new trial. In
December 1995, the Company also moved to supplement its pending March 14, 1995
Motion with additional tampered evidence and discovery misconduct by Mobil. The
March 14, 1995 motion is currently stayed before the Delaware Court. The Company
filed an appeal with the U.S. Court of Appeals on July 10, 1995 on the initial
trial arguments. In January 1996, oral arguments were presented before the U.S.
Court of Appeals. In June, 1996, the U.S. Court of Appeals reversed a portion of
the earlier ruling that two of the patents were invalid, and that Mobil did not
infringe. The Company did not further appeal this issue to the Supreme Court.
Should the Delaware Court deny the Company's pending Prejudicial Misconduct
Motion, the Company intends to follow-up with an additional appeal on these
issues. Should the Court not rule in favor of the Company on such motions, all
appellate processes available will be pursued. There can be no assurance that
the Company will receive a more favorable outcome upon appeal.
In August 1994, Mobil filed a motion seeking an award of attorneys' fees and
costs in the amount of $2.7 million. On November 1, 1994, the Court ruled that
the motion was premature and will not be considered at the present time. In
January 1995, Mobil renewed its Motion for Attorneys' Fees. In April 1995, the
Court requested AERT to respond to Mobil's Motion. The Motion is currently
stayed. With the recent appeals court ruling upholding the invalidity of two
patents and the ruling of inequitable conduct, the Company has been advised that
if and when the court decides to entertain Mobil's motion for the attorney's
fees, and if and when Mobil decides to submit documentation and substantiate its
claim, that the Company could face possible risk from an adverse decision from
the court by awarding a portion of said fees to Mobil. The Company has been
advised in a worse case scenario that it could face an aggressive challenge
against it for a significant portion of the said $2.7 million attorney's fees in
an attempt to end this litigation prior to the company's prejudicial misconduct
motion or pending counterclaims against Mobil being heard. The Company will
vigorously defend against Mobil's claim for attorneys' fees and costs, however,
there can be no assurances as to the outcome of this litigation. The Company
believes that the Mobil motion for attorney's fees and the AERT prejudicial
misconduct motion for a new trial could be addressed sometime during 1997 by the
Delaware Court. The Company has not recorded any liability related to such
litigation at June 30, 1997.
In a related matter, the Company recently received a favorable response from the
United States Patent and Trademark Office concerning a related product by
process patent application which has been pending throughout the litigation.
This is an application which was filed on the same date as those currently in
litigation, although substantial additional disclosures have been made.
Allowance of this patent could have a positive impact for the Company in regard
to the motions currently stayed before the Delaware District Court.
10
<PAGE>
ARTHUR ANDERSEN LLP
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of
Advanced Environmental Recycling Technologies, Inc.
We have reviewed the accompanying balance sheet of Advanced Environmental
Recycling Technologies, Inc. (a Delaware corporation), as of June 30, 1997, and
the related statements of operations for the three-month and six-month periods
ended June 30, 1997 and 1996, and the statements of cash flows for the six-month
periods ended June 30, 1997 and 1996. These financial statements are the
responsibility of the company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in
accordance with generally accepted auditing standards, the objective of which is
the expression of an opinion regarding the financial statements taken as a
whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the financial statements referred to above for them to be in
conformity with generally accepted accounting principals.
/s/ Arthur Andersen LLP
San Antonio, Texas
July 31, 1997
11
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
General
- -------
The Company has developed technologies to reclaim polyethylene plastics and
manufacture engineered composite products that exhibit superior moisture
resistance and dimensional stability. To-date, the Company has received 13
United States Patents on its technologies and additional patent applications are
currently pending. (See Note 6: Legal Proceedings) The Company has built and
after completion of the repairs caused by the December 1996 fire will have a
plastics reclamation facility in Rogers, Arkansas (the "Rogers Facility") and a
composites manufacturing facility in Junction, Texas (the "Junction Facility").
The Company is currently doubling the production capacity of the composites
facility and has recently entered into agreements to establish an additional
plastic reclamation facility for high-density polyethylene and a second
composite manufacturing facility. The Company has experienced increased
customer demand for its engineered composite products that are marketed under
the trade-names, Moistureshield(TM) and CHOICEDEK(TM). The Company's efforts are
now primarily directed towards increasing production capacity, and increasing
its production to supply its existing customer base and promptly attaining
positive cash-flows and profitability.
To-date, the Company has experienced a substantial backlog for its CHOICEDEK(TM)
line of residential decking products through Weyerhaeuser Distribution and has
commenced an expansion program intended to increase production capacity for
Weyerhaeuser and its other OEM customers. The Company has been limited in its
ability to supply the residential decking market and has only been able to
supply its CHOICEDEK(TM) line to a limited number of distribution centers. The
Company also has several additional large Moistureshield OEM projects pending
with existing and new customers.
The Company's sales are now primarily focused towards the following three market
areas which are currently supplied by the Company's composites manufacturing
facility in Junction, Texas: (1) components for the national door and window
market, (2) the heavy industrial flooring market as floor blocks for industrial
applications, and (3) as decking components for commercial and residential
applications through Weyerhaeuser. The Company experienced a series of
extensive fires that caused substantial damage during the last half of 1996 at
its Rogers, Arkansas plastic reclamation facility. These fires in September and
December of 1996 set back the Company's plastic reclamation program and limited
composite sales growth. The Company has received $1.95 million in settlement of
this claim. The Company is currently rebuilding said facility and intends to
resume operations during the fourth quarter of 1997 at a new location in
Springdale, Arkansas. Although the Company has established alternate supply
sources and is currently meeting its customers minimum requirements, it will
require its own plastics production facility to come back on line or acquire
additional supply sources to provide the quality, consistency, and volume of
plastic required for the Company to continue to increase composite sales to a
level required to attain and sustain profitability.
The Company, in conjunction with the fires at the Rogers facility mentioned
above, has also experienced production difficulties associated with raw material
problems with its plastic supplies, created when the Company had to purchase all
plastic from outside vendors due to the above mentioned fires. The Company was
also restrained in its efforts to further increase sales due to production
limitations and inefficiencies at the Junction, Texas composites facility. The
Company currently operates three extrusion lines at the Junction facility,
although still at reduced rates,
12
<PAGE>
and due to increased composite sales demands is working to expand its composite
manufacturing capacity by the addition of a fourth extrusion line in the near
future at the new Arkansas facility. The Company intends to operate this fourth
extrusion line and establish a plastic reclamation operation in the newly leased
facility located in Springdale, Arkansas. The Company is planning to add
additional extrusion capacity at this facility once the initial line is
operational, and is also working to establish an additional composite
manufacturing capability with Sutton Engineered Wood Products near Harrison,
Arkansas.
Due to the significant amount of loss from the two Rogers, Arkansas fires
experienced during the second half of 1996, the Company was notified that its
fire insurance carrier had chosen not to renew the policy when it expired on May
1997. The Company has been able to secure coverage for another year through a
different carrier with an increase in premium and deductible, but with no lapse
in coverage.
The Company is currently unable to predict the future size of the markets for
its composite building products, however, the Company believes that the national
door and window and residential decking material markets are significant. The
Company believes that it can further penetrate these markets and/or expands
sales to its existing customer base if the Company's goals for increased
production capacity and efficiency are achieved. By focusing its marketing
strategy on a limited number of large door and window companies, and by
initiating sales of its new decking products through the Weyerhaeuser marketing
and distribution agreement, the Company believes it can increase market
penetration and sales without significantly increasing administrative overhead.
Also, the Company's marketing focus utilizes outside commissioned sales
representatives for a portion of its door and window accounts.
Results of Operations
- ---------------------
Quarter ended June 30, 1997 compared to quarter ended June 30, 1996
- -------------------------------------------------------------------
Net sales of $1,947,307 for the quarter ended June 30, 1997 represented a
decrease in sales of 5% or $110,030 over the second quarter of 1996. The
decrease in sales over the second quarter of 1996 affirms that the Company
continues to have a backlog of orders for its products, and is still restrained
in its efforts to further increase sales primarily by the limited supply and
quality of the raw material plastic. Shipments for the second quarter of 1997
were hampered by two less than standard weeks due to an electrical storm and a
flood in Central Texas which resulted in lost days of production.
Cost of goods sold was $1,762,641 for the second quarter of 1997 compared to
$1,943,021 for the second quarter of 1996. Real dollars and the overall cost of
goods sold to sales ratio decreased from 1996 due to increased emphasis on cost
control, particularly in the manufacturing overhead category. The Company's
material and labor costs were still adversely impacted by the quality and
consistency of the outside vendor raw material plastic. Payroll and payroll
taxes were significantly less and direct material costs were greater than the
comparable period in 1996 due to the Rogers Plastic Reclamation facility not
being in operation in 1997, thus forcing the Company to purchase all plastic
from outside sources. Significant categories are as follows:
13
<PAGE>
<TABLE>
<CAPTION>
Expense Category 1997 1996
--------------------------- ---------- ----------
<S> <C> <C>
Payroll and payroll taxes $ 629,672 $ 873,030
Depreciation 260,660 296,410
Direct material costs 441,001 183,770
Other 431,308 589,811
---------- ----------
Total $1,762,641 $1,943,021
========== ==========
</TABLE>
Selling, general and administrative expenses were $406,292 compare to $406,118
for the second quarter of 1996.
Net income for the quarter ended June 30, 1997 was $629,990 due to the Company
recording an extraordinary gain of $863,332 resulting from final settlement of
an insurance claim. Net income per weighted average common share outstanding
was $.03. This compares to a loss of $328,210, or a net loss per weighted
average common share outstanding of $.02 for the three months ended June 30,
1996.
The Company has developed, and is currently implementing, a production plan
which Management believes will provide for better operating efficiencies and
eliminate the production problems encountered in the past. Such plan includes
increasing production capacity, changes to production management, further
automation of the production process, improved plastic raw material sourcing,
better utilization of regrindable scrap and increased security. The Company has
restructured its operations management regarding the composites division
bringing in a new chief operating officer in February of 1997 and believes that
with the planned additional production line, as well as resuming plastic
production at the Arkansas facility should allow the Company to reduce its
existing backlog, thereby significantly increasing sales to its existing
customer base and to improve existing operating efficiencies as a result of
increased economies of scale. However, the Company's operations remain subject
to numerous risks associated with the continued establishment of its business,
including lack of financing sources and competition from numerous large, well-
established and well-capitalized competitors who manufacture products for the
same applications. In addition, the Company has in the past and may again in
the future, encounter unanticipated problems, including manufacturing,
distribution, and marketing difficulties, some of which may be beyond the
Company's financial and technical abilities to resolve. The occurrence of, or
failure to adequately address such difficulties could have a material adverse
effect on the Company's prospects, including its ability to achieve anticipated
sales levels.
Liquidity and Capital Resources
- -------------------------------
At June 30, 1997, the Company had a working capital deficit of $802,554 compared
to a working capital deficit of $1,781,768 at December 31, 1996. The decreased
deficit is primarily attributable to the Company's recording of a receivable in
1996 from the insurance company regarding the Rogers fire. Cash and cash
equivalents increased $702,849 in the first half of 1997. Significant components
of that increase were: (i) cash used in operating activities of $806,512 which
consisted of net income for the period of $10,550, increased by depreciation and
amortization of $543,264 and other uses of cash of $1,505,800 (ii) cash provided
by investing activities of $1,560,815, and (iii) cash used by financing
activities of $51,454. Payments on notes during the period were $295,454. At
June 30, 1997, the Company had notes payable in the amount of $1,536,433, of
which $838,329 were current notes payable or current portion of long-term debt.
In January 1996, a major stockholder, Marjorie S. Brooks (the "Major
Stockholder"), exercised 500,000 Class F Warrants. The
14
<PAGE>
proceeds from the exercise of these warrants, which amounted to $305,000,
reduced the working capital deficit of the Company and were used to reduce
current liabilities.
The Company maintains an accounts receivable factoring agreement for up to
$700,000 through an affiliated company of a related party. The terms of this
agreement call for the factor to advance 99.12% of the total of invoices
presented by the Company and for the Company to indemnify the factor against
loss of the amounts advanced. At June 30, 1997, approximately $729 was
available to factor additional receivables. The Company also maintains a line of
credit from the Major Stockholder which consists of a long-term note payable,
which had a balance of $1,202,094 at June 30, 1997.
During and since the completion of the second quarter, the Company has not
received any additional sources of capital. Historically, revenues have not
been sufficient to support the Company's current operational needs. However,
the Company continues to attempt to improve production rates and efficiencies in
an effort to reduce or eliminate the need for additional future capital to
support existing operations. Further, continued improvements in production
efficiency and capacity will be required for the Company to increase sales to a
level that will allow the Company to attain profitability. There can be no
assurance that such improvements in production efficiency or capacity will be
achieved.
The Company is seeking to enter into an agreement to raise approximately $2.2
million in an offering of preferred stock to accredited investors, and believes
that such capital will be sufficient to support the Company until such time as
the Company achieves positive cash flow from operations. In addition, the
Company is also pursuing an additional $2.5 million financing package through a
State Economic Development Agency for acquisition and further expansion of the
Arkansas facility.
There can be no assurance that the Company will be able to maintain its current
operating levels or achieve increased production volumes and sales levels or
that the Company will obtain additional capital resources to support
manufacturing operations if required.
If the Company is unable to achieve and maintain a successful level of
operations in the near future or unable to secure additional debt or equity
financing to provide support to ongoing operations, or were it to be assessed
the Mobil legal claims described in Note 6 to the financial statements, it is
likely the Company will be unable to continue as a going concern.
The foregoing discussion contains certain estimates, predictions, projections
and other "forward-looking statements" (within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934)
that involve various risks and uncertainties. While these forward-looking
statements, and any assumptions upon which they are based, are made in good
faith and reflect the Company's current judgment regarding the direction of its
business, actual results will almost always vary, sometimes materially, from any
estimates, predictions, projections, assumptions, or other future performance
suggested herein. Some important factors (but not necessarily all factors) that
could affect the Company's sales volumes, growth strategies, future
profitability and operating results, or that otherwise could cause actual
results to differ materially from those expressed in any forward-looking
statement include the following: market, political or other forces affecting the
pricing and availability of plastics and other raw material accidents or other
unscheduled shutdowns affecting the Company's, its suppliers' or its customers'
plants, machinery, or equipment; competition from products and services offered
by other enterprises; state and federal environmental, economic, safety and
other policies and regulations, any changes therein, and any legal or
15
<PAGE>
regulatory delays or other factors beyond the Company's control; execution of
planned capital projects; weather conditions affecting the Company's operations
or the areas in which the Company's products are marketed; adverse rulings,
judgments, or settlements in litigation or other legal matters. The Company
undertakes no obligation to publicly release the result of any revisions to any
such forward-looking statements that may be made to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.
PART II. Other Information
Item 1. Legal Proceedings
- --------------------------
On June 9, 1992, Mobil Oil Corporation ("Mobil") commenced an action against the
Company in the United States District Court for the District of Delaware
entitled Mobil Oil Corporation v. Advanced Environmental Recycling Technologies,
-----------------------------------------------------------------------
Inc. In its complaint, Mobil sought entry of a declaratory judgment that: (a)
- ----
AERT is without right or authority to threaten suit against Mobil or its
customers for alleged infringement of AERT patents; (b) The AERT patents are
invalid and unenforceable, and 8 Mobil has not infringed the AERT patents
through any products or method. Mobil seeks no monetary damages in this suit,
but does seek reimbursement of its attorneys' fees.
On December 8, 1992, the Company answered Mobil's Complaint. In its Answer, the
Company denied Mobil's claims and asserted counterclaims against Mobil and three
Mobil executives for: (1) an illegal combination or contract in restraint of
trade in violation of federal antitrust laws; (2) a pattern of intentional
misconduct constituting an attempt to monopolize in violation of federal
antitrust laws; (3) breach of a confidential relationship between Mobil and the
Company; and (4) unfair competition. The Company sought monetary damages,
punitive damages and injunctive relief. Mobil filed an answer to AERT's
counterclaims, denying any liability. The Delaware Court then bifurcated the
trial into patent and non-patent issues and ordered the patent issues tried
first.
In February 1994, after a trial on the patent issues, a Delaware jury returned a
verdict that four AERT patents on its composite product technology were invalid.
The jury also determined that Mobil had not infringed two of the four patents
which AERT had asserted against Mobil. The jury verdict answered a number of
interrogatories on the factual issues, and rendered advisory findings for the
Court on Mobil's allegation that AERT had obtained its patents by inequitable
conduct. Thereafter, the Judge adopted the jury's advisory findings on
inequitable conduct and held that each of the four AERT patents were
unenforceable for failure to disclose certain alleged prior art to the patent
office during patent prosecution.
Because of the nature of certain of the jury verdict interrogatory responses,
AERT's counsel concluded that the verdict was adversely affected by improper
conduct by Mobil counsel during trial, and false statements of law and fact made
during closing argument, that caused the jury to misapply the law on inequitable
conduct and to render clearly erroneous findings. Consequently, AERT moved for
a new trial. That motion was denied. The Company's additional post-trial
motions were also denied by the Delaware Court. On March 14, 1995, the Company
filed a sealed motion with the Court based upon newly discovered evidence which
alleges prejudicial misconduct by Mobil prior to the trial. The motion also
brings to the Court's attention, evidence which the Company believes was
intentionally withheld from it in direct defiance of the Delaware Court's
January 4, 1994 Motion to Compel, prior to the trial. It also brings to the
Court's attention, an official government safety approval document which was
altered prior to submission to AERT during pre-trial discovery, which also
relates to a portion of the alleged withheld discovery documentation. The
motion seeks further discovery into Mobil's misconduct, and a new trial. In
16
<PAGE>
December 1995, the Company also moved to supplement its pending March 14, 1995
Motion with additional tampered evidence and discovery misconduct by Mobil. The
March 14, 1995 motion is currently stayed before the Delaware Court. The
Company filed an appeal with the U.S. Court of Appeals on July 10, 1995 on the
initial trial arguments. In January 1996, oral arguments were presented before
the U.S. Court of Appeals. On June, 1996, the U.S. Court of Appeals reversed a
portion of the earlier ruling that two of the patents were invalid, and that
Mobil did not infringe. The Company did not further appeal this issue to the
Supreme Court. Should the Delaware Court deny the Company's pending Prejudicial
Misconduct Motion, the Company intends to follow-up with an additional appeal on
these issues. Should the Court not rule in favor of the Company on such
motions, all appellate processes available will be pursued. There can be no
assurance that the Company will receive a more favorable outcome upon appeal.
In August 1994, Mobil filed a motion seeking an award of attorneys' fees and
costs in the amount of $2.7 million. On November 1, 1994, the Court ruled that
the motion was premature and will not be considered at the present time. In
January 1995, Mobil renewed its Motion for Attorneys' Fees. In April 1995, the
Court requested AERT to respond to Mobil's Motion. The Motion is currently
stayed. With the recent appeals court ruling upholding the invalidity of two
patents and the ruling of inequitable conduct, the Company has been advised that
if and when the court decides to entertain Mobil's motion for the attorney's
fees, and if and when Mobil decides to submit documentation and substantiate its
claim, that the Company could face possible risk from an adverse decision from
the court by awarding a portion of said fees to Mobil. The Company has been
advised in a worse case scenario that it could face an aggressive challenge
against it for a significant portion of the said $2.7 million attorney's fees in
an attempt to end this litigation prior to the companies prejudicial misconduct
motion or pending counterclaims against Mobil being heard. The Company will
vigorously defend against Mobil's claim for attorneys' fees and costs, however,
there can be no assurances as to the outcome of this litigation. The Company
believes that the Mobil motion for attorney's fees and the AERT prejudicial
misconduct motion for a new trial could be addressed sometime during 1997 by the
Delaware Court. The Company has not recorded any liability related to such
litigation at March 31, 1997.
In a related matter, the Company recently received a favorable response from the
United States Patent and Trademark Office concerning a related product by
process patent application which has been pending throughout the litigation.
This is an application which was filed on the same date as those currently in
litigation, although substantial additional disclosures have been made.
Allowance of this patent, could have a positive impact for the Company in regard
to the motions currently stayed before the Delaware District Court
17
<PAGE>
SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
BY: /s/ Joe G. Brooks BY: /s/ Jake M. Bushey
- --------------------- ----------------------
JOE G. BROOKS JAKE M. BUSHEY
President Corporate Controller
Date: August 14, 1997 August 14, 1997
--------------- ---------------
18
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> APR-01-1997
<PERIOD-END> JUN-30-1997
<CASH> 785,605
<SECURITIES> 0
<RECEIVABLES> 697,098
<ALLOWANCES> 0
<INVENTORY> 571,525
<CURRENT-ASSETS> 2,231,908
<PP&E> 8,089,859
<DEPRECIATION> 3,712,553
<TOTAL-ASSETS> 7,249,494
<CURRENT-LIABILITIES> 3,194,462
<BONDS> 0
0
0
<COMMON> 208,011
<OTHER-SE> 3,148,917
<TOTAL-LIABILITY-AND-EQUITY> 7,249,494
<SALES> 3,695,109
<TOTAL-REVENUES> 3,695,109
<CGS> 3,756,187
<TOTAL-COSTS> 744,430
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 47,274
<INCOME-PRETAX> 0
<INCOME-TAX> 0
<INCOME-CONTINUING> (852,782)
<DISCONTINUED> 0
<EXTRAORDINARY> 863,332
<CHANGES> 0
<NET-INCOME> 10,550
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
