<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, 1998
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, 1998, 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 22,135,330 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, September 30, 1998 and December 31, 1997 1-2
Statements of Operations,
Three months and nine months ended September 30, 1998 and 1997 3
Statements of Cash Flows,
Nine months ended September 30, 1998 and 1997 4
Notes to Financial Statements 5-16
Review Report of Arthur Andersen LLP,
Independent Public Accountants 17
ITEM 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 18-25
PART II - OTHER INFORMATION
ITEM 1 Legal Proceedings 25-26
Signatures 27
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
BALANCE SHEET
ASSETS
------
September 30, December 31,
1998 1997
(unaudited) -----------
-----------
Current assets:
Cash and cash equivalents $ 70,530 $ 45,428
Accounts receivable 924,770 540,739
Note receivable 66,571 81,571
Inventories 757,946 735,697
Prepaid expenses and other 175,903 181,474
----------- -----------
Total current assets 1,995,720 1,584,909
----------- -----------
Buildings and equipment, at cost:
Buildings 905,952 692,781
Machinery and equipment 9,720,975 6,209,614
Transportation equipment 91,524 98,242
Office equipment 153,463 156,064
Construction in progress 1,857,568 2,586,483
----------- -----------
12,729,482 9,743,184
Less accumulated depreciation
and amortization 5,049,895 4,093,031
----------- -----------
Net buildings and equipment 7,679,587 5,650,153
----------- -----------
Other assets, at cost less accumulated
amortization of $264,412 (1998) and
$242,999 (1997) 385,369 406,266
----------- -----------
$10,060,676 $ 7,641,328
=========== ===========
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, December 31,
1998 1997
(unaudited) ------------
------------
<S> <C> <C>
Current liabilities:
Accounts payable - trade $ 2,222,551 $ 1,571,598
Accounts payable - related parties 805,496 1,136,272
Current maturities of long-term debt:
Related parties 579,881 386,456
Other 124,466 108,454
Current maturities of capital lease obligation 16,165 --
Accrued liabilities 482,534 310,681
Notes payable, net of debt discount
of $192,160 (1998) and $136,111 (1997) 3,023,095 1,189,097
------------ ------------
Total current liabilities 7,254,188 4,702,558
------------ ------------
Long-term debt, less current maturities:
Related parties 193,070 465,656
Other 35,680 122,756
------------ ------------
Total long-term debt 228,750 588,412
------------ ------------
Capital lease obligation 82,608 --
------------ ------------
Commitments and contingencies (Note 6)
Stockholders' equity:
Preferred stock, $1 par value; 5,000,000
shares authorized
Series B Preferred stock, $1 par value; 900 shares
authorized, 500 (1998) shares issued and outstanding 500 --
Series C Preferred stock, $1 par value; 500 shares
authorized, 100 (1998) shares issued and outstanding 100 --
Class A common stock, $.01 par value;
50,000,000 shares authorized, 22,135,330
(1998) and 20,312,969 (1997) shares issued
and outstanding 221,353 203,130
Class B convertible common stock, $.01 par
value; 7,500,000 shares authorized,
1,465,530 shares issued and outstanding 14,655 14,655
Additional paid in capital 24,756,901 21,926,331
Accumulated deficit (22,498,379) (19,793,758)
------------ ------------
Total stockholders' equity 2,495,130 2,350,358
------------ ------------
$ 10,060,676 $ 7,641,328
============ ============
</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,
------------- -------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Sales $ 3,286,357 $ 2,420,483 $ 8,586,980 $ 6,115,592
Cost of Goods Sold 3,186,944 2,063,193 8,231,051 5,819,380
------------ ------------ ------------ ------------
Gross Margin 99,413 357,290 355,929 296,212
Selling and Administrative Costs 745,632 537,938 2,212,663 1,282,368
------------ ------------ ------------ ------------
Operating Loss (646,219) (180,648) (1,856,734) (986,156)
Interest Expense, net (344,004) (26,904) (847,887) (74,178)
------------ ------------ ------------ ------------
Loss Before Extraordinary Item (990,223) (207,552) (2,704,621) (1,060,334)
Extraordinary Gain (Loss) -- (105,688) -- 757,644
------------ ------------ ------------ ------------
Net Loss $ (990,223) $ (313,240) $ (2,704,621) $ (302,690)
============ ============ ============ ============
Loss per share of common stock before
extraordinary item $ (.04) $ (.01) $ (.12) $ (.05)
Extraordinary gain (loss) per share of
common stock $ -- $ (.01) $ -- $ .04
------------ ------------ ------------ ------------
Net loss per share of common stock (Basic
and Diluted) $ (.04) $ (.02) $ (.12) $ (.01)
============ ============ ============ ============
Weighted average number of common shares
outstanding 23,323,319 20,801,132 22,636,210 20,778,969
============ ============ ============ ============
</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, 1998 September 30, 1997
------------------ ------------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $(2,704,621) $ (302,690)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation and amortization 1,009,949 816,233
Amortization of other assets 329,314 20,482
Amortization of debt discount 528,248 --
Interest paid through issuance of Class A
Common Stock 188,519 --
Loss on disposition of equipment 1,964 --
Increase in other assets (516) (116,969)
Changes in current assets & current liabilities 385,913 (84,256)
Extraordinary gain -- (757,644)
----------- -----------
Net cash used in operating activities (261,230) (424,844)
----------- -----------
Cash flows from investing activities:
Additions to buildings and equipment (2,796,063) (1,289,119)
Insurance proceeds 4,722 1,882,644
----------- -----------
Net cash (used in) provided by investing activities (2,791,341) 593,525
----------- -----------
Cash flows from financing activities:
Proceeds from issuance of notes 1,380,842 --
Payments on notes (261,674) (469,458)
Payments on capital lease obligations (11,227) --
Proceeds from issuance of preferred stock 100,000 --
Proceeds from stock options and warrants 1,869,732 --
Proceeds from issuance of common stock, net -- 244,000
----------- -----------
Net cash provided by (used in) financing activities 3,077,673 (225,458)
----------- -----------
Increase (Decrease) in cash and cash equivalents 25,102 (56,777)
Cash and cash equivalents:
Beginning of period 45,428 82,756
----------- -----------
End of period $ 70,530 $ 25,979
=========== ===========
</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.
Note 2: Description of the Company
- ----------------------------------
The Company manufacturers a 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.
The Company's customer base consists of a number of regional and national door
and window manufacturers, industrial flooring companies and Weyerhaeuser, the
Company's primary decking customer.
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, 1998, the Company had a working capital deficit of
$5,258,468 and had incurred operating losses of $1,856,734 for the nine months
ended September 30, 1998. For the quarter ending September 30, 1998, the Company
yielded a net loss of $990,223. The Company has incurred operating losses in
each year since its inception and has never operated at successful manufacturing
levels over an extended period. Further, unaudited information subsequent to
September 30, 1998, indicates that losses are continuing. Such continuing losses
have primarily been caused by problems in maintaining significant production
volumes of products and in producing products at economically feasible operating
cost levels. There is no assurance that the Company will be able to improve its
manufacturing process and operating costs to the extent necessary to reach
successful operating levels. Further, the Company has limited additional
financial resources available to support its operations and, in the past few
years has, in large
5
<PAGE>
part, been supported by certain major shareholders in conjunction with several
accredited investors. There is no commitment for such shareholders to continue
such support. The Company also has claims in litigation outstanding against it
as described in Note 6 and Note 11. The outcome of the litigation is uncertain.
As discussed in the following paragraphs, the Company will require additional
financial resources in order to complete its production plan and fund maturities
of debt and other obligations as they become due. There is no assurance the
Company will be successful in obtaining such necessary financial resources.
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 asset
carrying 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 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 correct
the production problems encountered in the past. Such plan includes increasing
production capacity, focusing line production, and further automating the
production process. Implementation of the Company's plan was delayed during the
third quarter, primarily due to start-up problems with the Springdale plant. The
Company has experienced equipment problems with the new air transfer system
acquired for the Springdale plant. The air system as of September 30, 1998, has
yet to operate with its designed efficiencies. The manufacturer has notified the
Company of its intent to upgrade several parts of the system. This system is
covered by a manufacturer's warranty, however, it does not cover lost production
by the Company. The Company is preparing to start-up a second extrusion line in
Springdale, and it will require the successful operation of the new air system
to handle this addition to production capacity. Also, additional financial
resources will be necessary to fund maturities of debt and other obligations as
they come due. There is no assurance that the Company will be able to correct
prior production problems and improve operating efficiencies or that the Company
will be successful in securing sufficient capital resources to complete its
production plan, fund maturities of debt and other obligations as they become
due or to support the Company until such time, if ever, that the Company is able
to generate income from operations.
The Company has recently updated its S-1 registration statement and commenced a
voluntary B Warrant conversion program intended to help recapitalize the
Company. From the effective date of June 26, 1998 to September 30, 1998, the
Company has received net proceeds of $1,243,928, consisting of 760,970 B
Warrants and 275,000 C Warrants at prices ranging from $1.075 - $1.25 per share.
The voluntary warrant conversion is scheduled to run through November 30, 1998,
at which time those not exercised will expire, unless extended by the Company's
Board of Directors. As of September 30, 1998, 3,451,470 B Warrants and 375,000 C
Warrants remained unexercised. The base conversion price of such warrants upon
the
6
<PAGE>
effective date was $1.20 per share, with a conversion range plus or minus 1/8 of
a point. Thus, warrants could be converted from $1.075 to $1.325 during this
period depending on the market value of the Company's common stock. As of
September 30, 1998, the closing price of the Company's Class A Common stock was
$.906 and the 20-day closing average price was $.872. The Company will not
accept conversions below $1.075 per share. The voluntary conversions exercised
to date have been primarily from affiliates or close associates to the Company.
There can be no assurance that the Company will receive additional warrant
conversions during the effective time-period. As such, the Company has finalized
and successfully completed an alternative plan for an additional equity private
placement of $2.9 million dollars. The Company also has $342,537 remaining on
its bridge loan, although management does not intend to use it at this point.
As of September 30, 1998, approximately $3.16 million had been borrowed in a
series of bridge loans, and the Company converted and or repaid approximately
$1,050,000 of said amount as of November 10, 1998 through a placement of
preferred stock. The Company has extended the remaining $2.11 million until
1999. In addition, the Company is also pursuing an additional $15 million
financing package through the City of Springdale, Arkansas, in conjunction with
a State Economic Development Agency for acquisition and further expansion of the
Arkansas facility. Said financing package was recently approved by the
Springdale, Arkansas City Council. The Company is working to finalize and close
this bond-financing package by early 1999. The Company is also exploring
additional financial sources including conventional long-term debt to repay the
remaining bridge loans within the next six months. The Company is also
finalizing an operating line-of-credit with a major financial institution for up
to $7 million dollars. There is no assurance that the Company will be able
obtain these financing resources or that the Company will be able to improve
operating efficiencies beyond current levels in order to support the Company
until such time as the Company is able to generate positive cash flow sufficient
to support its operations, capital expansion plan and fund maturities of debt
and other obligations as they become due.
7
<PAGE>
Note 4: Statements of Cash Flows
- --------------------------------
In order to determine net cash used in operating activities, net loss 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, capital lease obligations and current notes payable. Those
changes, shown as an (increase) decrease in current assets and an increase
(decrease) in current liabilities, are as follows:
Nine months Nine months
ended ended
September 30, 1998 September 30, 1997
(unaudited) (unaudited)
------------------ ------------------
Receivables $(384,031) $(783,176)
Note receivable 15,000 --
Inventories (22,249) 156,485
Prepaid expenses and other (125,870) 89,986
Accounts payable -
trade & related parties 731,210 407,465
Accrued liabilities 171,853 44,984
--------- ---------
$ 385,913 $ (84,256)
========= =========
Cash paid for interest $ 34,374 $ 76,020
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:
Nine months Nine months
ended ended
September 30, 1998 September 30, 1997
(unaudited) (unaudited)
----------- -----------
8
<PAGE>
Notes payable for financing of
insurance policies $104,027 $109,207
Notes payable for equipment 140,006 --
Capital lease obligation for
equipment 110,000 --
Class A Common Stock issued
in payment of accounts
payable 11,033 --
Series B Preferred stock
issued in payment of accounts
payable - related parties 400,000 --
Series B Preferred stock issued
in payment of notes payable 100,000 --
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:
September 30, December 31,
1998 1997
(unaudited) --------
---------
Raw materials $ 431,055 $257,114
Work in process 244,694 319,034
Finished goods 82,197 159,549
--------- --------
$ 757,946 $735,697
========= ========
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.
SFAS No. 121
------------
The Company has adopted Statement of Financial Accounting Standards (SFAS) No.
121,
9
<PAGE>
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of". SFAS No. 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
No. 121 and has determined that no impairment loss was required as of September
30, 1998. 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 Springdale 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.
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
subsequent to the completion of its production plan 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 Springdale and
Junction manufacturing facilities, which was $7,679,587 at September 30, 1998.
Note 6: Commitments and Contingencies
- -------------------------------------
In June 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.
In December 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
10
<PAGE>
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 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 attorney's 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
11
<PAGE>
Attorney's 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, 1998. Mobil Oil divested its composites business in 1996 and no longer
directly competes with the Company.
In a related matter, the Company received on June 2, 1998, the issuance from the
United States Patent and Trademark Office its fourteenth patent for product by
process, which has been pending throughout the litigation. This was an
application, which was filed on the same date as those currently in litigation,
although substantial additional disclosures have been made.
Note 7: NASDAQ Listing Requirements
- -----------------------------------
The Board of Governors of the National Association of Securities Dealers, Inc.
has established certain standards for the initial listing and continued listing
of a security on the NASDAQ SmallCap Market. The standards for initial listing
require, among other things, that an issuer have total assets of $4,000,000 and
capital and surplus of at least $2,000,000; that the minimum bid price for the
listed securities be $3.00 per share; that the minimum market value of the
public float (the shares held by non-insiders) be at least $2,000,000; and that
there be at least two market makers for the issuer's securities. The maintenance
standards require, among other things, that an issuer have total assets of at
least $2,000,000 and capital and surplus of at least $1,000,000; that the
minimum bid price for the listed securities be $1.00 per share; that the minimum
market value of the "public float" be at least $1,000,000; and that there be at
least two market makers for the issuer's securities. A deficiency in either the
market value of the public float or the bid price maintenance standard will be
deemed to exist if the issuer fails the individual stated requirement for ten
consecutive trading days. If an issuer falls below the bid price maintenance
standard, it may remain on the NASDAQ SmallCap Market if the market value of the
public float is at least $1,000,000 and the issuer has $2,000,000 in equity.
The NASDAQ SmallCap Market has recently adopted new maintenance criteria, which
eliminates the exception to the $1.00 per share minimum bid price and requires,
among other things, $2,000,000 net tangible assets, $1,000,000 market value of
the public float and adherence to certain corporate governance provisions. The
Company was formally notified by NASDAQ that its minimum bid price as of
February 23, 1998 was below $1.00, and it had until May 28, 1998 to bring the
price of its stock up to a minimum $1.00 bid. The Company on April 14, 1998 was
notified by NASDAQ that it had regained minimum bid price compliance. The
Company's stockholders, in August of 1997, authorized up to a 1 for 6 reverse
stock split, which has not yet been implemented. The Company as of October 13,
1998 was again notified that its minimum bid was below $1.00 per share and that
it has until January 13, 1999 to
12
<PAGE>
correct the situation and regain compliance. The Company is currently evaluating
a reduced 1 for 2 reverse stock split although no final decision has been made
as to if or when it might be implemented. There can be no assurance that the
Company will continue to satisfy the requirements for maintaining a NASDAQ
SmallCap Market listing. If the Company's securities were to be excluded from
the NASDAQ SmallCap Market, it would adversely affect the prices of such
securities and the ability of holders to sell them, and the Company would then
be required to comply with the more difficult initial listing requirements to be
re-listed on the NASDAQ SmallCap Market. The Company as of September 30, 1998
had net assets of approximately $2,495,130.
If the Company were unable to satisfy maintenance requirements, the Company's
securities would become subject to certain penny stock rules promulgated by the
SEC. The penny stock rules require a broker-dealer, prior to a transaction in a
penny stock, not otherwise exempt from the rules, to deliver a standardized risk
disclosure document prepared by the SEC that provides information about penny
stocks and the nature and level of risks of penny stock market securities. The
broker-dealer also must provide the customer with current bid and offer
quotations for the penny stock, the compensation of the broker-dealer and its
salesperson in the transaction and monthly account statements showing the market
value of each penny stock held in the customer's account. In addition, the penny
stock rules require that prior to a transaction in a penny stock not otherwise
exempt from such rules, the broker-dealer must make a special written
determination that the penny stock is a suitable investment for the purchaser
and receive the purchaser's written agreement to the transaction. These
disclosure requirements may have the effect of reducing the level of trading
activity in the secondary market for a stock that becomes subject to the penny
stock rules. If the Common Stock becomes subject to the penny stock rules,
investors may find it more difficult to sell their shares.
Note 8: Bridge Financing
- ------------------------
Through September 30, 1998, the Company had completed five bridge financing
agreements. The date of the first agreement was October 30, 1997. The Company
issued notes payable totaling $1.3 million, originally due and payable on July
27, 1998, unless extended, at the option of the Company, to October 30, 1998.
Interest on the notes is payable every three months at 12% with the Company's
Class A Common Stock. In connection with the notes, the Company issued 2,600,000
consulting warrants and 156,000 placement warrants. The warrants expire October
30, 2002, and are exercisable at a price of $0.375 per share of Class A Common
Stock for each warrant exercised. Per the agreement, if the notes were extended,
an additional 650,000 consulting warrants and 78,000 placement warrants would be
issued. As of July 31, 1998, the note holders extended the notes for 60 days
without additional penalty warrants in exchange for voluntary selling
restrictions of the Company's stock by the Company's officers and certain
shareholders over the next 18 months, without prior approval from the issuer of
the note. As of November 5, 1998, the note holders extended the notes through
March 31, 1999, without penalty warrants other than for 310,000 of the Warrants
to be issued to one of the note holders.
13
<PAGE>
The second bridge financing was completed on February 5, 1998. The Company
issued notes payable totaling $800,000, originally due and payable on November
2, 1998, unless extended, at the option of the Company, to January 31, 1999.
Interest on the notes is payable every three months at 12% in either cash or the
Company's Class A Common Stock, at the option of the Company. In connection with
the notes, the Company issued 1,600,000 consulting warrants and 96,000 placement
warrants. The warrants expire February 5, 2003, and are exercisable at a price
of $0.375 per share of Class A Common Stock for each warrant exercised. As of
November 5, 1998, the note holders extended the notes through March 31, 1999,
without additional penalty warrants.
A third bridge financing was completed on April 7, 1998. The Company issued
notes payable totaling $410,000, originally due and payable on January 2, 1999,
unless extended, at the option of the Company, to April 2, 1999. Interest on the
notes is payable every three months at 12% in either cash or the Company's Class
A Common Stock, at the option of the Company. In connection with the notes, the
Company issued 820,000 consulting warrants and 49,200 placement warrants. If the
notes are extended, an additional 205,000 consulting warrants and 24,600
placement warrants will be issued. The warrants expire April 7, 2003, and are
exercisable at a price of $0.375 per share of Class A Common Stock for each
warrant exercised.
A fourth bridge financing was completed on June 3, 1998. The Company issued
notes payable totaling $359,963, due and payable on February 28, 1999, unless
extended, at the option of the Company, to May 29, 1999. Interest on the notes
is payable every three months at 12% in either cash or the Company's Class A
Common Stock, at the option of the Company. In connection with the notes, the
Company issued 719,926 consulting warrants and 43,195 placement warrants. If the
notes are extended, an additional 179,981 consulting warrants and 21,597
placement warrants will be issued. The warrants expire June 3, 2003, and are
exercisable at a price of $0.375 per share of Class A Common Stock for each
warrant exercised.
A fifth bridge financing was completed on August 21, 1998. The Company issued
notes payable totaling $287,500, due and payable on May 18, 1999, unless the
notes are extended, at the option of the Company, to August 16, 1999. Interest
on the notes is payable every three months at 12% in either cash or the
Company's Class A Common Stock, at the option of the Company. In connection with
the notes, the Company issued 575,000 consulting warrants and 34,500 placement
warrants. If the notes are extended, an additional 143,750 consulting warrants
and 17,250 placement warrants will be issued. The warrants expire August 21,
2003, and are exercisable at a price of $0.375 per share of Class A Common Stock
for each warrant exercised.
In regard to the warrant shares issued under the bridge financing agreements, if
the resale of the warrant shares by the holders is not then registered pursuant
to an effective registration statement under the Securities Act, the warrant
holders may effect a cashless exercise at any time after the first anniversary
of the respective dates of the note agreements until the end of the respective
exercise periods. In the event of a cashless exercise, in lieu of paying the
14
<PAGE>
exercise price in cash, the warrant holder shall surrender his warrant to the
Company for a certain number of shares of Class A Common Stock, based on the
market value of the stock at the time of exercise.
Under a placement agency agreement entered into concurrently with the October
30, 1997 bridge financing agreement, the placement agent has a two year option
to "put" up to an additional $342,537 aggregate principal amount of notes to the
Company. If the additional notes are issued, then the Company will issue 685,074
consulting warrants and 41,104 placement warrants in connection with the notes.
If the notes are extended, an additional 171,268 consulting warrants and 20,552
placement warrants will be issued. Both the additional notes and related
consulting and placement warrants will have terms and provisions similar to
those of previous bridge financings.
Note 9: Issuance of Preferred Stock
- -----------------------------------
From September 30 to November 12, 1998, the Company issued a series of voting
and non-voting preferred stock, which raised an additional $2.9 million dollars
in equity. The Company issued 1,500 Series A shares, 900 Series B shares and 500
Series C shares at a price of $1,000 per share. Such stock was purchased by the
major stockholder, a 5% holder, and accredited institutional investors. The term
of the preferred series stock is for 7 years at 10% interest per year. Said
preferred stock has a conversion feature into common stock at or above a floor
of $1.20 per share. The Company, at its option, can redeem the stock prior to
expiration at a premium of 150 percent. The stock also carries a series of X and
Y warrants, which will convert at $1.20 and $2.50 per share. The X warrants
cannot be exercised for a minimum of 12 months and vest over a period of 24
months. In connection with the 2,900 preferred shares, the Company issued
2,416,657 X warrants and 1,160,000 Y warrants. The Company has performance
milestones, which require minimum sales of $4.5 million and positive cash flow
from operations during the first quarter of 1999 and a minimum sales of $6
million during the second and third quarters of 1999.
Note 10: Stock Options
- ----------------------
During the quarter ended September 30, 1998, 160,000 stock options were issued
to employees of the Company at an exercise price of $.813.
Note 11: Other Litigation
- -------------------------
The Company is currently involved in litigation in North Carolina involving
payment for equipment in its paint facility. The issue involves a dispute over a
final $70,000 payment for equipment, which has yet to operate effectively. The
Company intends to counter-claim and ask that the manufacturer refund its money
or make the equipment function properly.
Note 12: New Accounting Pronouncement
- -------------------------------------
In June 1998, the Financial Standards Board issued Statement of Financial
Accounting
15
<PAGE>
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities". The Statement establishes accounting and reporting standards
requiring that every derivative instrument be recorded in the balance sheet as
either an asset or liability at its fair value. The Company has determined that
the adoption of this statement will have no effect on its financial statements.
Note 13: Subsequent Events
- --------------------------
In November 1998, the City Council of Springdale, Arkansas voted to issue tax
exempt bond financing for up to $15 million dollars for expansion purposes
through acquisition and expansion of the Company's Springdale, Arkansas
facility. The City has scheduled a public hearing on the project for December 8,
1998, and the Company is working with its bond underwriter to close the project
by early 1999. Said financing is intended to acquire additional land and
construct additional plastic recycling and composite extrusion processing and
manufacturing functions. There can be no assurance that the Company will receive
the bond financing.
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, 1998,
and the related statements of operations for the three-month and nine-month
periods ended September 30, 1998 and 1997, and the statements of cash flows for
the nine-month periods ended September 30, 1998 and 1997. 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
October 29, 1998
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 14 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(R) 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 facilities in Junction, Texas
and Springdale, Arkansas: (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 operates two facilities, its initial composite extrusion and
millwork facility in Junction, Texas and a second multi-purpose facility in
Springdale, Arkansas which handles plastic recycling and reclamation and
composite extrusion.
The Company expanded its production capacity by adding a second composite
facility in Springdale, Arkansas, and began operations in phases during the
second quarter 1998. In addition to plastic reclamation and composite extrusion,
a moulding and millwork operation and a new paint facility also recently
commenced operations at the Springdale site. The new paint line has experienced
some start-up and equipment difficulties, which has caused the Company to delay
full utilization of the system. A portion of the equipment is not currently
being used and is the focus of a disputed over payment. The Company has
implemented interim processes for painting and by passed certain equipment
functions. The Company intends to attempt to solve the remaining problem during
the fourth quarter of this year. The Company is currently involved in a dispute
with an Italian equipment manufacturer over portions of the paint equipment. A
substantial amount of the Company's MoistureShield product line is currently
being shifted in phases to the new facility to allow the existing Texas facility
to increase and improve efficiency and to focus more on ChoiceDek. This shift
was delayed further during the third quarter due to start-up and equipment
problems at the Springdale plant. Thus, the company maintained dual overheads
during the third quarter at both manufacturing facilities, which was expensive.
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 back on-line, management believes that sufficient raw
materials will be
18
<PAGE>
shortly available so it will be able to increase production and sales to
sufficient levels to sustain positive cash flows and profitability. However, as
additional composite extrusion capacity comes on-line, additional plastic
processing functions will be required. The Company will further expand its
plastic recycling capacity during 1999. The Company's Springdale facility has
also experienced a problem with a defective air transfer system, which weighs,
conveys and feeds the raw materials into the extrusion process. The manufacturer
has guaranteed said system in writing, although it never performed to desired
levels from start-up in May of 1998 to date. The manufacturer has replaced said
system with a larger one, which should be on-line by December. This problem has
held up start-up of additional extrusion lines in Springdale over the past
several months.
The Company has commenced an expansion program intended to increase production
capacity of its residential decking for Weyerhaeuser and its original equipment
manufacturer (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. The Company also intends to attain significant
improvement in manufacturing efficiencies and lower raw material costs at the
new facility, once the start-up problems are resolved.
The Company currently operates three extrusion lines at the Junction facility. A
fourth extrusion line at the new Springdale facility did not attain desired
efficiencies until late in the third quarter. Due to increased composite sales
demands, the Company is working to expand its composite manufacturing capacity
by the addition of a fifth and sixth extrusion line in the near future at the
new Arkansas facility. The Company also intends to further upgrade the Junction
facility with an increased focus on its decking products.
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.
The Company has not yet assessed the impact of the Year 2000 compliance issues.
The Company believes the impact will not be material to its financial
statements.
19
<PAGE>
Results of Operations
- ---------------------
Quarter ended September 30, 1998 compared to quarter ended September 30, 1997
- -----------------------------------------------------------------------------
The Company commenced start-up of its second extrusion and millwork facility
during the second quarter of 1998. Construction was ongoing throughout the third
quarter and additional delays were encountered with attaining desired production
at the Springdale facility. However, the Company set a quarter net sales record
of $3,286,357 for the quarter ended September 30, 1998. This was an increase of
$865,874 or 35.8% over the $2,420,483 reported for the comparable period ended
September 30, 1997. Most of the sales increase was attributable to ongoing
production improvements at the initial Texas facility. With the start-up of the
second plant, cost of goods sold increased to $3,186,944 for 1998 vs. $2,063,193
for the comparable period and one plant in 1997. The initial Texas composite
plant continued to improve in operations and showed an increase in positive
gross margin to $371,948 vs. $357,290 for 1997. The Springdale facility
experienced several startup difficulties and delays, which resulted in a
negative gross margin of $272,535 from operations, which led to an overall
positive gross margin of $99,413 for the quarter. The Springdale facility
experienced a net loss of $1,022,103 for the quarter while the Texas facility
produced a net income of $31,880. The Company reported an operating loss of
$646,219 for 1998 vs. a $180,648 operating loss for the third quarter of 1997.
Interest expense increased significantly to $344,004 for 1998 vs. $26,904 for
1997 primarily due to the short-term bridge loans, in conjunction with debt
discount costs. Debt discount costs totaled $204,210 of said amount. Corporate,
selling and administrative costs were $745,632 for the quarter. This increased
the net loss to $990,223 or $.04 per share vs. a net loss of $313,240 or $.02
per share for the comparable period in 1997, which recognized the revised
extraordinary gain recorded through the first and second quarters of 1997 by
$105,688. Cost of goods sold increased to $3,186,944 for 1998 vs. $2,063,193 for
the comparable period in 1997. Of the third quarter 1998 loss, the majority was
due to a substantial increase in SG&A, plus interest costs i.e.: $745,632 SG&A
for 1998, vs. $537,938 for 1997, which was primarily attributable to startup of
the new Springdale plant in conjunction with fees in regard to professional and
legal expenses. Increased SG&A combined with increased interest expense for the
third quarter 1998 of $344,004 vs. $26,904 for 1997, constitutes the majority of
the loss.
The delays in starting up the additional extrusion lines at the Springdale
facility, has backed-up the Company's plans to streamline production at the
various facilities. In particular it has delayed increasing additional decking
production in Texas, while shifting MoistureShield OEM products to Arkansas.
This in turn led to dual overheads for paint and milling at both facilities, and
reduced extrusion throughputs in extrusion during this transition. Thus, this
resulted in reduced gross margins and profitability for the Texas operation, as
it was required to maintain the customer base, while the Springdale plant comes
on-line. With the Springdale plant now coming on-line and with the warranty air
system work and second extrusion line primarily complete; the Company has
recently shifted a second extrusion line in Texas to decking and has reduced
overhead in Texas in regard to milling and paint products. Management believes
this will now begin to show the desired improvements in efficiencies during the
fourth quarter of 1998.
20
<PAGE>
Cost of goods sold was $3,186,944 for the third quarter of 1998 compared to
$2,063,193 for the third quarter of 1997. Payroll costs and depreciation
increased due to the start-up of the new plant in Springdale, Arkansas. Material
costs increased as the Company is still continuing to purchase a large portion
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 lease payments involving the new
Springdale, Arkansas manufacturing facility. The Company's material and labor
costs were still adversely impacted by less than desired operating efficiencies
and extrusion rates, although significant improvements were attained. The
planned streamlining and product focus of the Texas plant was delayed and
downtime associated with changeovers and the large number of products ran also
restricted extrusion efficiencies. Significant categories are as follows:
Expense Category 1998 1997
---------------- ---- ----
Payroll and payroll taxes $1,135,806 $ 705,308
Depreciation 401,436 281,805
Direct material costs 753,324 576,607
Other 896,378 499,473
----------- ----------
Total $3,186,944 $2,063,193
=========== ==========
Selling, general and administrative expenses were $745,632 for two plants
compared to $537,938 for one plant for the third quarter of 1997. Costs
increased due to salaries, lease expense, overhead, and other costs relating to
the start-up of the new Springdale facility. With the equipment-related delays,
the Company was unable to adequately produce product volume sufficient to cover
these added fixed costs. Additional overhead at the Texas facility also was
required to service the customer base during this transaction period. However,
the largest portion of the increase was legal costs and amortization of debt
acquisitions costs relating to the loan financing activities in regard to
financing the Springdale plant and manufacturing expansion.
Net loss for the quarter ended September 30, 1998 was $990,223. Net loss per
weighted average common share outstanding was $.04. This compares to $313,240,
or net loss per weighted average common share outstanding of $.01 for the three
months ended September 30, 1997. The increased loss was primarily attributable
to the start-up of the Springdale plant and the amortization of debt acquisition
costs.
The Company is currently working to increase production and improve efficiencies
at both manufacturing facilities in Junction, Texas and Springdale, Arkansas.
The MoistureShield(R) product lines are being shifted to the Springdale facility
into dedicated extrusion lines. The existing Texas facility is also currently
being shifted into increased ChoiceDek production. With a recent large purchase
commitment from the Company's decking customer, the
21
<PAGE>
Company also intends to upgrade and increase the size of the decking extrusion
lines during fourth quarter 1998. Several functions in Texas will also be
streamlined and eliminated to reduce costs, as the MoistureShield functions will
be handled from Springdale. Additional automation and process control is also
planned for both facilities in an effort to increase throughputs and reduce
costs.
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 technical, and start-up
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.
Liquidity and Capital Resources
- -------------------------------
At September 30, 1998, the Company had a working capital deficit of $5,258,468
compared to a working capital deficit of $3,117,649 at December 31, 1997. The
increased deficit is primarily attributable to the Company's expansion and
construction program into the Springdale site and start-up delays at the
Springdale facility. Losses from operations were in conjunction with short-term
financing and debt acquisition costs while the Company maintained its customer
base and attempted to start-up its new plant. Cash and cash equivalents
increased $25,102 in the first nine months of 1998. Significant components of
that increase were: (i) cash used in operating activities of $261,230, which
consisted of a net loss for the nine-month period of $2,704,621, decreased by
depreciation and amortization of $1,867,511 and other uses of cash of $575,880
(ii) cash used in investing activities of $2,791,341, and (iii) cash provided by
financing activities of $3,077,673. Payments on notes during the period were
$261,674. At September 30, 1998, the Company had notes payable and capital lease
obligations in the amount of $4,054,965, of which $3,743,607 were current notes
payable or current portion of long-term debt and capital lease obligations. This
amount was primarily due to the major shareholder and the bridge loan lenders.
The Company's Springdale facility is designed and intended to substantially
increase composite manufacturing capabilities and production through the
addition of a second extrusion and millwork facility. The facility is
substantially larger than the Texas facility. This expansion will continue
through first quarter 1999, as additional extrusion lines are added and the
Company completes Phase 2.
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
22
<PAGE>
indemnify the factor against loss of the amounts advanced. The Company is
evaluating increasing the factor line once the Springdale facility becomes fully
operational.
The Company is also negotiating with a major financial institution for a $7
million dollar operating line-of-credit. Thus, it is now the Company's objective
to eliminate the factoring agreement and attain an operating line-of-credit in
the near future.
Beginning in the fourth quarter of 1997 and through September 30, 1998, the
Company entered into a loan agreement and received bridge loans totaling
approximately $3.16 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 could obtain additional
bridge funding for expansion purposes, from the same source for up to $342,537,
although there is no formal guarantee that said lenders 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 lenders have received two warrants to
acquire Class A common stock for a period of five years for each dollar they
loan the Company. The Company as of November 12, 1998 has converted and repaid
$1,050,000 of the $3.16 million bridge loan. The Company has extended the
remaining bridge notes to March 31, 1999. It is the Company's intent to
eliminate and repay this debt during the first half of 1999. The Company has
recently updated its S-1 registration statement and commenced a voluntary B
Warrant conversion program intended to help recapitalize the Company. From the
effective date of June 26, 1998 to November 2, 1998, the Company has received
net proceeds of $1,243,928, consisting of 760,970 B Warrants and 275,000 C
Warrants at prices ranging from $1.19 - $1.25 per share. The voluntary warrant
conversion is scheduled to run through November 30, 1998, at which time those
not exercised will expire, unless extended by the Company's Board of Directors.
As of September 30, 1998, 3,451,470 B Warrants and 375,000 C Warrants remained
unexercised. The base conversion price upon the effective date was $1.20 per
share, with a conversion range plus or minus 1/8 of a point. Thus, warrants
could be converted from $1.075 to $1.325 during this period depending on the
market value of the Company's common stock. As of September 30, 1998, the
closing price of the Company's Class A Common stock was $.906 and the 20-day
closing average price was $.872. The Company will not accept conversions below
$1.075 per share. The voluntary conversions exercised to date have been
primarily from affiliates or close associates to the Company. There can be no
assurance that the Company will receive additional warrant conversions during
the effective time-period or that the Company might have to consider adjusting
the exercise price or extending the expiration date.
As such the Company has recently completed an additional private placement for
$2.9 million dollars in preferred stock to the major stockholder and close
associates. It is management's intent to extend short-term debt into longer
terms and the remaining bridge loan has been extended until 1999. 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 generate income from operations. Historically, revenues have not
been sufficient to support the Company's current operational needs. However, the
Company has continued to improve and believes it can generate positive cash
flows from operations once two
23
<PAGE>
extrusion lines are operating properly at the Springdale plant. 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 further 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 $15 million financing
package through the City of Springdale, Arkansas in conjunction with a State
Economic Development Agency for acquisition, additional manufacturing equipment
and further production expansion of the Arkansas facility.
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
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 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.
24
<PAGE>
PART II. Other Information
Item 1. Legal Proceedings
--------------------------
In June 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.
In December 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
25
<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. 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 attorney's 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 Attorney's 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, 1998. Mobil Oil divested its
composites business in 1996 and no longer directly competes with the Company.
In a related matter, the Company received on June 2, 1998, the issuance from the
United States Patent and Trademark Office its fourteenth patent for product by
process, which had been pending throughout the litigation. This was an
application, which was filed on the same date as those currently in litigation,
although substantial additional disclosures have been made.
The Company is currently involved in litigation in North Carolina involving
payment for equipment involved in its paint facility. The issue involves a
dispute over a final $70,000 payment for equipment, which has yet to operate
effectively. The Company intends to counter-claim and ask that the manufacturer
refund its money or make the equipment function properly.
26
<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 13, 1998 Date: November 13, 1998
27
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JUL-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 70,530
<SECURITIES> 0
<RECEIVABLES> 991,341
<ALLOWANCES> 0
<INVENTORY> 757,946
<CURRENT-ASSETS> 1,995,720
<PP&E> 12,729,482
<DEPRECIATION> 5,049,895
<TOTAL-ASSETS> 10,060,676
<CURRENT-LIABILITIES> 7,254,188
<BONDS> 0
600
0
<COMMON> 236,008
<OTHER-SE> 2,495,130
<TOTAL-LIABILITY-AND-EQUITY> 10,060,676
<SALES> 3,286,357
<TOTAL-REVENUES> 3,286,357
<CGS> 3,186,944
<TOTAL-COSTS> 745,632
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 344,004
<INCOME-PRETAX> (990,223)
<INCOME-TAX> 0
<INCOME-CONTINUING> (990,223)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (990,223)
<EPS-PRIMARY> (.04)
<EPS-DILUTED> (.04)
</TABLE>
