<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 September 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)
801 N. Jefferson Street
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 September 30, 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
<TABLE>
<CAPTION>
PAGE
<S> <C>
ITEM 1 Financial Statements
Balance Sheets, September 30, 1997 and December 31, 1996 1-2
Statements of Operations,
Three months and nine months ended September 30, 1997 and 1996 3
Statements of Cash Flows,
Nine months ended September 30, 1997 and 1996 4
Notes to Financial Statements 5-12
Review Report of Arthur Andersen LLP,
Independent Public Accountants 13
ITEM 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 14-20
PART II - OTHER INFORMATION
ITEM 1 Legal Proceedings 20-21
Signatures 22
</TABLE>
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
BALANCE SHEET
ASSETS
------
<TABLE>
<CAPTION>
September 30, December 31,
1997 1996
(unaudited) ----
-----------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 25,979 $ 82,756
Receivables 794,113 1,010,937
Inventories 436,840 593,325
Prepaid expenses and other 106,602 87,381
---------- ----------
Total current assets 1,363,534 1,774,399
---------- ----------
Buildings and equipment at cost:
Construction in progress 1,411,168 838,709
Buildings 688,931 687,509
Machinery and equipment 6,727,980 5,953,000
Transportation equipment 79,900 135,527
Office equipment 168,482 172,597
---------- ----------
9,076,461 7,787,342
Less accumulated depreciation
and amortization 3,998,912 3,182,679
---------- ----------
Net buildings and equipment 5,077,549 4,604,663
---------- ----------
Other assets, at cost less accumulated
amortization of $128,280 at 9-30-97, and
$107,798 at 12-31-96 442,974 346,487
---------- ----------
$6,884,057 $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>
September 30,
1997 December 31,
(unaudited) 1996
------------------ ------------------
<S> <C> <C>
Current liabilities:
Current maturities of long-term debt $ 705,958 $ 705,344
Accounts payable - trade 1,347,715 1,224,711
Payables to related parties 878,176 468,715
Accrued liabilities 252,049 207,065
Notes payable 63,000 61,559
------------ ----------------
Total current liabilities 3,246,898 2,667,394
------------ ----------------
Long-term debt, less current maturities -
Related parties 552,194 799,554
Other 593,471 156,222
------------ -----------------
Total long-term debt 593,471 955,776
------------ -----------------
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 (18,940,428) (18,637,738)
------------ -----------------
Total stockholders' equity 3,043,688 3,102,379
============ =================
$ 6,884,057 $ 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 Nine months ended
September 30, September 30,
------------------------------------- -------------------------------------
1997 1996 1997 1996
------------------------------------- -------------------------------------
<S> <C> <C> <C> <C>
Sales $ 2,420,483 $ 1,901,319 $ 6,115,592 $5,561,072
Cost of Goods Sold 2,063,193 2,185,426 5,819,380 5,867,368
----------- ----------- ----------- ----------
Gross Margin 357,290 (284,107) 296,212 (306,296)
Selling and Administrative Costs 537,938 533,159 1,282,368 1,324,596
----------- ----------- ----------- ----------
Operating Loss (180,648) (817,266) (986,156) (1,630,892)
Other Income (Expense)
Other Income - - - 20,399
Interest Expense (26,904) (43,063) (74,178) (160,500)
----------- ----------- ----------- -----------
Net Loss Before Extraordinary Item $ (207,552) $ (860,329) $(1,060,334) $(1,770,993)
=========== =========== =========== ===========
Extraordinary Gain (105,688) 67,100 757,644 67,100
Net Loss $ (313,240) $ (793,229) $ (302,690) $(1,703,893)
=========== =========== =========== ===========
Net loss per share of common stock
before extraordinary item ($.01) ($.04) ($.05) ($.09)
Extraordinary gain per share of common
stock ($.01) $.00 $.04 -
Net income per share of common stock --- ---- ---- ___
($.02) ($.04) ($.01) ($.09)
Weighted average number of common
shares outstanding 20,801,132 19,663,913 20,778,969 18,708,340
========== ========== ========== ==========
</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>
Nine months Nine months
ended ended
September 30, 1997 September 30, 1996
------------------ ------------------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (302,690) $(1,703,893)
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Depreciation 816,233 909,726
Amortization of other assets 20,482 18,548
Extraordinary gain (757,644) (67,100)
Increase in other assets (116,969) (17,570)
Changes in current assets & current liabilities (84,256) (223,617)
----------- -----------
Net cash used in operating activities (424,844) (1,083,906)
Cash flows from investing activities:
Additions to buildings and equipment (1,289,119) (870,301)
Insurance proceeds 1,882,644 124,602
----------- -----------
Net cash provided by (used in) investing activities 593,525 (745,699)
----------- -----------
Cash flows from financing activities:
Proceeds from issuance of notes - 269,155
Payments on notes (469,459) (539,333)
Proceeds from issuance of common stock, net 244,000 2,100,669
----------- -----------
Net cash provided by (used in) financing activities (225,458) 1,830,491
----------- -----------
Increase (Decrease) in cash & cash equivalents (56,777) 886
Cash and cash equivalents:
Beginning of period 82,756 15,350
----------- -----------
End of period $ 25,979 $ 16,236
=========== ===========
</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 manufacturers a new line of composite building materials from
reclaimed plastic and wood fiber waste for certain specialized applications in
the construction industry and is comprised of two separate, yet interrelated
manufacturing facilities located in Junction, Texas and Springdale, Arkansas. A
third facility in Rogers, Arkansas is currently being rebuilt due to extensive
fire damage suffered in December of 1996. A second composite-manufacturing
operation in Springdale, Arkansas and is scheduled to begin operations late
5
<PAGE>
in the fourth quarter of 1997. The Company's customer base consists of a number
of regional and national door and window manufacturers, industrial flooring 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 September 30, 1997, the Company had a working capital deficit
of $1,883,364 and had incurred operating losses of $986,156 for the nine
months ended September 30, 1997. For the quarter ending September 30, 1997, the
Company showed operations improvement and generated cash flows from operations,
but still yielded a net loss of $313,240 for the quarter. The Company continued
to operate at reduced operating rates and less than desired efficiencies during
the quarter primarily due to raw material limitations created from
6
<PAGE>
the Rogers fire. Since inception, the Company had not achieved a successful
level of operations necessary to generate positive operating income from
operations, nor is there 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 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
although the Company has recently drawn interim bridge financing of $1.3
million. 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 continue to
support existing operations until such time that 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 unlikely be able 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
base at economically feasible levels.
7
<PAGE>
The Company is currently implementing a production plan which management
believes will provide for better product focus, improved operating efficiencies
and elimination of the production problems encountered in the past. Such plan
includes increasing production capacities, dedicating production lines and
manufacturing facilities, bringing its internal plastic reclamation plant on-
line, further automating the production process, improving raw material sourcing
and better utilizing regrindable scrap. In addition, the Company leased, 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. This facility
is scheduled to start up in phases beginning in November 1997. 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 an option for a discounted sales price if the
option is exercised within six months. It is the Company's intention to have the
plastic phase of this facility operational by November 1997. The Company has
entered into a non-binding agreement on the part of the lenders to borrow up to
$3.5 million in a series of bridge loans from accredited institutional investors
and believes that such capital will be sufficient to support the Company for up
to twelve months and until such time as the Company consistently generates
positive cash flow from operations. As of November 1, 1997, $1.3 million had
been borrowed under said agreement. 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. The
Company is also evaluating additional financial sources including both equity
and conventional long-term debt to fund both ongoing operations and future
expansion as well as to refinance the bridge loan within the next twelve months.
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 continue to improve operating efficiencies beyond
current levels or that the Company will be successful in securing sufficient
8
<PAGE>
capital resources to support the Company until such time as the Company is able
to generate positive cash flow sufficient to support its operations and capital
expansion plan.
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 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 September 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, Junction, and
Springdale manufacturing facilities.) The Company's estimates of these factors
are based upon management's belief that future production volumes will
significantly improve over previous historical production levels achieved by the
Company's manufacturing facilities and that future production costs per unit
will also continue to decrease below previous historical cost levels. The
Company believes that no significant production problems will recur at its
Junction composite-manufacturing facility although the company plans to
streamline its production focus and further automate said facility and further
improve its operating efficiencies. As such, management of the
9
<PAGE>
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 three months of 1997 will provide additional evidence to confirm
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, Junction and Springdale manufacturing
facilities which was $5,077,549 at September 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>
Nine months Nine months
ended ended
September 30, 1997 September 30, 1996
(unaudited) (unaudited)
----------- -----------
<S> <C> <C>
Receivables $(783,176) $(294,083)
Inventories 156,485 128,204
Prepaid expenses and other 89,986 (17,570)
Accounts payable -
trade & related parties 407,465 (202,788)
Accrued liabilities 44,984 162,620
-------- ---------
$ 84,256 $(223,617)
======== =========
Cash paid for interest 76,020 131,862
</TABLE>
10
<PAGE>
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>
September 30, December 31,
1997 1996
(unaudited) -----------
------------
<S> <C> <C>
Raw materials $169,694 $210,483
Work in process 165,468 351,477
Finished goods 101,678 31,365
-------- --------
$436,840 $593,325
======== ========
</TABLE>
11
<PAGE>
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 "Deferral of the Effective Date of Certain
Provisions of SFAS No. 125," SFAS No. 127 moves 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.
12
<PAGE>
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
13
<PAGE>
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
14
<PAGE>
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 December
1995, the Company also moved to supplement its pending March 14, 1995 Motion
with alleged 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 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 would not be considered. 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. The Company will
vigorously defend against Mobil's claim for
15
<PAGE>
attorneys fees and costs, however, there can be no assurances as to the outcome
of this litigation. The Company at present cannot predict when the Mobil motion
for attorney's fees and the AERT prejudicial misconduct motion for a new trial
will be addressed by the Delaware Court. The Company has not recorded any
liability related to such litigation at September 30, 1997.
Mobil divested its composite business in late 1996, and no longer directly
competes with the company.
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, as well as
business in general.
Note 7: NASDAQ Listing Requirements
- -----------------------------------
The Company has recently been formally notified by NASDAQ of increased listing
and maintenance standards for both the NASDAQ National and Small Cap Markets,
which will go into effect on February 24, 1998. Rule changes, which could
affect the Company, include a minimum bid $1.00 common stock price and a $3
million net asset value. Previous maintenance minimums were $2 million net
asset value. As of November 11, 1997, the Company's common stock (AERTA) closed
at $.50 bid. Net assets at September 30, 1997 were $3,043,688. Due to the
Company's continuing operating losses, the Company anticipates that additional
equity will have to be obtained by February 24, 1998, in order for the Company
to maintain it's current listing. In anticipation of the increased listing
requirements the Company's shareholders at the annual meeting in August,
authorized a 6 for 1 reverse stock split. The Company also is planning to raise
additional equity capital, and intends to maintain its minimum asset value for
the new requirements, although there is no assurance the Company will be
successful in its efforts to maintain it's current listing.
Note 8: Extraordinary Item Revision
- -----------------------------------
The Company suffered an extensive fire at its Rogers, Arkansas plastic
reclamation facility during December 1996, and has been reconstructing and
rebuilding said facility since that time. Through the first two quarters of
1997, the Company had recognized an extraordinary gain of $863,332 from the
insurance proceeds received relating to the fire at the Rogers facility. During
the third quarter the extraordinary gain was revised due to a revision in the
estimate of construction costs to repairs buildings owned by other parties that
the Company is responsible for rebuilding.
16
<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 September 30, 1997,
and the related statements of operations for the three-month and nine-month
periods ended September 30, 1997 and 1996, and the statements of cash flows for
the nine-month periods ended September 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 principles.
/s/ Arthur Andersen LLP
Dallas, Texas
November 4, 1997
17
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
General
- -------
The Company manufactures and markets a line of engineered composite building
material products that exhibit superior moisture resistance and dimensional
stability, as well as, several other unique properties over traditional wood
products. The Company's products have been extensively tested and used by
several leading national companies. The Company primarily utilizes waste wood
fiber and reclaimed polyethylene plastic as its raw material sources and
to-date, the Company has received 13 United States Patents on its technologies
and processes and additional patent applications are currently pending. (See
Note 6: Commitments and Contingencies) The Company markets its products under
the trade names Moistureshield (TM) and ChoiceDek (TM) and its 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 during the last half of 1996, a series of extensive
fires that caused substantial damage at its Rogers, Arkansas plastic reclamation
facility. These fires in September and December of 1996 restricted the Company's
plastic raw material supplies and thus limited composite sales growth. The
Company has received $1.95 million in settlement of this claim. The Company
intends to resume initial plastic reclamation operations during November of 1997
at a new location in Springdale, Arkansas. The initial Rogers, Arkansas facility
was leased, and the company added additional leasehold improvements to the site.
The lease rate was on a per pound of product produced basis. The facility was a
converted feed mill and had scales, a railroad spur, extensive storage bins, and
over 60,000 square feet of manufacturing area. The two fires severely damaged
both the leased portion
18
<PAGE>
as well as the Company's leasehold improvements. The Company's manufacturing
equipment was also extensively damaged in the fires. Since the fire, the Company
has been notified of additional building code requirements at this site. The
Company is also renegotiating with its landlord regarding said lease on the
facility. The Company has used insurance proceeds to rebuild the initial part of
the facility destroyed in the first September fire, and is working to
rebuild the Company's leasehold improvements damaged in the December fire.
However, the Company has not yet resolved the building code issue, nor has
concluded a formal written lease agreement with its landlord. Therefore, if
these issues are not resolved during the fourth quarter of 1997, the Company may
be required to write down all or a portion of the $141,000 in leasehold assets
at the Rogers facility. Although the Company has established alternate supply
sources for plastic and is currently meeting its customers minimum requirements,
it will require its own plastics production capabilities to come back on-line to
provide the quality, consistency, price, and volumes of plastic required for the
Company to increase and maintain composite sales to levels required to attain
and sustain positive cash flows and profitability. The Company is currently
expanding its production capacity by adding a second composites facility in
Springdale, Arkansas, which is intended to commence operations during early
1998. In addition to plastic reclamation and composite extrusion, a moulding and
millwork operation and a new paint facility is also currently under construction
at the Springdale site. The new paint line has experienced startup and equipment
delays and has caused the Company to miss some orders during the third quarter.
The Company has implemented interim processes for painting while the equipment
problems are ironed out. A substantial amount of the Company's Moistureshield
product line will be shifted to the new facility to allow the existing Texas
facility to focus more on ChoiceDek. The Company has experienced increased
customer demand for its engineered composite products and the Company's efforts
are now primarily directed towards increasing production capacity, improving
production efficiencies, and promptly attaining positive cash flows and
profitability. With its internal plastic reclamation facilities now coming back
on-line, management believes that sufficient raw
19
<PAGE>
materials will shortly become available so it will be able to further increase
production and sales to sufficient levels to sustain positive cash flows and
profitability.
The Company has commenced an expansion program intended to increase production
capacity of its residential decking for Weyerhaeuser and its other OEM
customers. The Company has to-date experienced production limitations regarding
its ability to increase supply for the residential decking market and has only
been able to supply its ChoiceDek line to a limited number of distribution
centers in markets primarily in the Southwest and West. The Company also has
several additional large Moistureshield OEM projects pending with existing and
new customers, which it intends to commence during the fourth quarter 97 to
bring on-line in conjunction with upcoming increased capacity. The Company also
intends to obtain substantial manufacturing efficiencies and lower raw material
costs at the new facility.
The Company currently operates three extrusion lines at the Junction facility,
although still at reduced rates. Due to increased composite sales demands the
Company is working to expand its composite manufacturing capacity by the
addition of a fourth and fifth extrusion line in the near future at the new
Arkansas facility. The Company also intends to also further upgrade the Junction
facility with an increased focus on its decking products. The Company has
commenced construction on its fourth extrusion line and has established a
plastic reclamation operation, which will commence operations in early November
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 in conjunction with additional moulding and painting
capabilities.
20
<PAGE>
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 expand 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. In addition, the
Company's marketing focus utilizes outside commissioned sales representatives
for a portion of its sales accounts.
Results of Operations
- ---------------------
Quarter ended September 30, 1997 compared to quarter ended September 30, 1996
- -----------------------------------------------------------------------------
Net sales of $2,420,483 for the quarter ended September 30, 1997, set an all
time record and represented an increase in sales of $519,164 over the third
quarter of 1996. The increase in sales over the third quarter of 1996 affirms
that the Company continues to have strong demand for its products, and is
continuing to increase production. Shipments for the third quarter of 1997 were
also hampered by two reduced production and manufacturing months in July and
August, and limitations regarding meeting customers orders for primed window
parts and delays associated with the introduction of the Company's new Moisture
Shield (TM) Plus line of primed window components, which restricted the
Company's efforts to further increase sales during the quarter.
Cost of goods sold was $2,063,193 for the third quarter of 1997 compared to
$2,185,426 for the third quarter of 1996. Payroll costs and depreciation
decreased overall, while direct material costs increased. This was partially
21
<PAGE>
caused by the loss of the Rogers, Arkansas plastics facility and the Company
having to purchase all of its raw materials from outside sources. The Company
also experienced higher overhead during the third quarter vs. the comparable
period a year ago regarding insurance premiums, security costs, and acquisition
and lease payments involving the new Springdale, Arkansas manufacturing
facility. The Company continued to improve in operations and generated a
positive gross margin of $357,290 for the quarter vs. a negative gross margin of
$284,107 for the comparable quarter a year ago. Real dollars and the overall
cost of goods sold to sales ratio decreased from 1996 due to increased emphasis
on production efficiencies and cost control. The Company's material and labor
costs were still adversely impacted by the quality and consistency of the
outside vendor raw material plastic and less than desired extrusion rates,
although significant improvements were attained. Downtime associated with
changeovers and the large number of products run also restricted extrusion
efficiencies. 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:
<TABLE>
<CAPTION>
Expense Category 1997 1996
---------------- ---- ----
<S> <C> <C>
Payroll and payroll taxes $ 705,308 $ 911,371
Depreciation 281,805 326,360
Direct material costs 576,607 317,093
Other 499,473 630,602
---------- ----------
Total $2,063,193 $2,185,426
========== ==========
</TABLE>
22
<PAGE>
Selling, general and administrative expenses were $537,938 compared to $533,159
for the third quarter of 1996. The costs also reflect increased marketing
expenses as the Company has for the first time commenced advertising, marketing
and distribution program aimed at substantially increasing decking sales for
1998.
Operating loss for the quarter ended September 30, 1997, was $180,648, a
significant reduction over the $817,266 loss reported for the comparable period
in 1996. Net loss per weighted average common share outstanding was $.01. This
compares to a net loss per weighted average common share outstanding of $.04 for
the three months ended September 30, 1996. The Company revised the extraordinary
gain through the first and second quarters of 1997 by $125,000. The revision
related to a change in the estimate of construction costs to repair buildings
owned by other parties that the Company is responsible for rebuilding. This
increased the net loss to $313,240 or $.02 per share. The Company is currently
implementing, a production plan, which management believes, will provide for
better operating efficiencies and streamline the production limitations
encountered in the past. The Company is also adding a second composite facility
in conjunction with rebuilding its internal plastic reclamation capabilities.
Such plan includes increasing production capacity, to streamline production runs
and reduce line change overs, further automation and process control of the
production processes, improved plastic raw material sourcing, lower raw material
costs, and better utilization of regrindable scrap and increased security.
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 efficiencies and manufacturing sales levels.
23
<PAGE>
Liquidity and Capital Resources
- -------------------------------
At September 30, 1997, the Company had a working capital deficit of $1,883,364
compared to a working capital deficit of $892,995 at December 31, 1996. The
increased deficit is partly attributable to the Company's expansion and
construction program into the Springdale site and construction of a new paint
line at the Springdale facility. Losses from operations, while the Company
maintained its customer base and recovered from the fires is the primary reason
for the deficit. Cash and cash equivalents decreased $56,777 in the first nine
months of 1997. Significant components of that decrease were: (i) cash used in
operating activities of $424,844, which consisted of a net loss for the period
of $302,690, decreased by depreciation and amortization of $836,715, increased
by an extraordinary gain of $757,644 and other uses of cash of $201,225 (ii)
cash provided by investing activities of $593,525, and (iii) cash used by
financing activities of $225,458. Payments on notes during the period were
$469,458. At September 30, 1997, the Company had notes payable in the amount of
$1,362,429, of which $768,958 were current notes payable or current portion of
long-term debt.
The Company has commenced a substantial expansion program at its Springdale
facility, which is intended to substantially increase composite manufacturing
capabilities and production through the addition of a second extrusion and
millwork facility. The payables increase during the quarter ended September 30,
1997 is directly attributable to this expansion program. This expansion will
continue through second quarter 1998, as additional extrusion lines are added.
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. 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 $1,004,805 at September 30, 1997.
24
<PAGE>
Since the completion of the third quarter, the Company has entered into a loan
agreement and received a bridge loan of $1.3 million from a group of
institutional and accredited investors for ongoing operations and expansion of
the Springdale facility. In addition, under terms of the agreement the Company
can obtain additional bridge funding for expansion purposes, from the same
source for up to $3.5 million although there is no formal guarantee that said
funders must continue to fund the company. Said Bridge loans are at 12% and
interest can be paid in cash or Class A common stock. In addition, the funders
have received two warrants to acquire Class A common stock for a period of five
years for each dollar they loan the company. Historically, revenues have not
been sufficient to support the Company's current operational needs. However, the
Company has continued to improve and has generated positive cash flows from
operations during the quarter. Furthermore, 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 and its
expansion program. Further, continued improvements in production efficiency and
capacity along with consistent and reliable raw material supplies will be
required for the Company to increase and maintain sales to levels that will
allow the Company to attain and sustain profitability. There can be no assurance
that such improvements in production efficiency or capacity will continue to
improve or can be sustained. The Company is also evaluating additional equity
sources of capital, including possible conversion of existing and outstanding
warrants. Although, there is no guarantee warrant holders would convert to help
re-capitalize the Company, proceeds would be used to further expand production
capabilities of the Springdale facility. In addition, the Company is also
pursuing an additional $2.5 million financing package through a State Economic
Development Agency for acquisition, additional manufacturing equipment and
further production expansion of the Arkansas facility.
25
<PAGE>
There can be no assurance that the Company will be able to achieve increased
production volumes to support increasing customer requirements or sales levels
or that the Company can continue to obtain additional capital resources to
support manufacturing operations if required.
If the Company is unable to achieve and maintain a successful level of operation
in the near future or unable to secure additional debt or equity financing to
provide support its expansion program in conjunction with 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 regulatory
delays or other factors beyond the Company's control; execution
26
<PAGE>
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 (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
27
<PAGE>
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
28
<PAGE>
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. 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. The Company will vigorously defend against Mobil's claim for attorney's
fees and costs; however, there can be no assurances as to the outcome of this
litigation. The Company at present cannot predict when the Mobil motion for
attorney's fees and the AERT prejudicial misconduct motion for a new trial will
be addressed by the Delaware Court. The Company has not recorded any liability
related to such litigation at September 30, 1997. Mobil Oil divested its
composites business in 1996 and no longer directly competes with the Company.
29
<PAGE>
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 and its
business in general.
30
<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/ David Sparks
- ------------------------------ ----------------------------
JOE G. BROOKS DAVID SPARKS
President Corporate Controller
Date: November 12, 1997
Date: November 12, 1997 ----------------------
--------------------
31
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JUL-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 25,979
<SECURITIES> 0
<RECEIVABLES> 794,113
<ALLOWANCES> 0
<INVENTORY> 436,840
<CURRENT-ASSETS> 1,363,534
<PP&E> 9,076,461
<DEPRECIATION> 3,998,912
<TOTAL-ASSETS> 6,884,057
<CURRENT-LIABILITIES> 3,426,898
<BONDS> 0
0
0
<COMMON> 208,011
<OTHER-SE> 2,835,677
<TOTAL-LIABILITY-AND-EQUITY> 6,884,057
<SALES> 6,115,592
<TOTAL-REVENUES> 6,115,592
<CGS> 5,819,380
<TOTAL-COSTS> 1,282,368
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 74,178
<INCOME-PRETAX> 0
<INCOME-TAX> 0
<INCOME-CONTINUING> (1,060,334)
<DISCONTINUED> 0
<EXTRAORDINARY> 757,644
<CHANGES> 0
<NET-INCOME> (302,690)
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
