ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES INC
10-Q, 1998-08-21
LUMBER & WOOD PRODUCTS (NO FURNITURE)
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<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549


                                   FORM 10-Q


             (X) Quarterly Report Pursuant To Section 13 Or 15(d)
                    Of The Securities Exchange Act of 1934


                 For the Quarterly Period Ended June 30, 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 August 20, 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 21,582,088 and the number of shares outstanding of the
Registrant's Class B Common Stock was 1,465,530.
<PAGE>
 
              ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

                                FORM 10-Q INDEX

                        PART I - FINANCIAL INFORMATION


                                                                           PAGE

ITEM 1    Financial Statements
 
 
          Balance Sheets, June 30, 1998 and December 31, 1997              1-2
 
          Statements of Operations,
          Three months and six months ended June 30, 1998 and 1997         3
 
          Statements of Cash Flows,
          Six months ended June 30, 1998 and 1997                          4
 
          Notes to Financial Statements                                    5-14
 
          Review Report of Arthur Andersen LLP,
          Independent Public Accountants                                   15
 
ITEM 2    Management's Discussion and Analysis of Financial
          Condition and Results of Operations                              16-22
 
                          PART II - OTHER INFORMATION
 
ITEM 1    Legal Proceedings                                                22-23

          Signatures                                                       24
<PAGE>
 
              ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

BALANCE SHEETS
<TABLE>
<CAPTION>
                                                                ASSETS
                                                                ------

 
                                                        June 30, 1998          December 31,
                                                         (unaudited)              1997
                                                         -----------           ----------
<S>                                                     <C>                    <C>
Current assets:
 Cash and cash equivalents                               $     6,303           $   45,428
 Accounts receivable                                         764,074              540,739
 Note receivable                                              67,571               81,571
 Inventories                                                 619,556              735,697
 Prepaid expenses and other                                  270,375              181,474
                                                         -----------           ----------
  Total current assets                                     1,727,879            1,584,909
                                                         -----------           ----------
Buildings and equipment, at cost:
 Buildings                                                   904,995              692,781
 Machinery and equipment                                   9,681,565            6,209,614
 Transportation equipment                                     91,524               98,242
 Office equipment                                            153,463              156,064
 Construction in progress                                  1,500,836            2,586,483
                                                         -----------           ----------
                                                          12,332,383            9,743,184
 Less accumulated depreciation
  and amortization                                         4,648,459            4,093,031
                                                         -----------           ----------
  Net buildings and equipment                              7,683,924            5,650,153
                                                         -----------           ----------
Other assets, at cost less accumulated
 amortization of $257,243 (1998) and
  $242,999 (1997)                                            390,205              406,266
                                                         -----------           ----------
                                                         $ 9,802,008           $7,641,328
                                                         ===========           ==========
</TABLE>



The accompanying notes to the financial statements should be read in conjunction
with these statements.

                                       1
<PAGE>
 
                     LIABILITIES AND STOCKHOLDERS' EQUITY
                     ------------------------------------


<TABLE>
<CAPTION>
                                                                    June 30, 1998         December 31, 
                                                                      (unaudited)             1997
                                                                     ------------         ------------
<S>                                                                  <C>                  <C>
Current liabilities:
  Accounts payable  trade                                            $  2,465,855         $  1,571,598
  Accounts payable  related parties                                     1,155,863            1,136,272
Current maturities of long-term debt:
  Related parties                                                         539,797              386,456
  Other                                                                   241,491              108,454
Current maturities of capital lease obligation                             15,288                    -
Accrued liabilities                                                       473,042              310,681
Notes payable, net of debt discount
 of $351,370 (1998) $136,111 (1997)                                     2,611,061            1,189,097
                                                                     ------------         ------------
   Total current liabilities                                            7,502,397            4,702,558
                                                                     ------------         ------------
Long-term debt, less current maturities:
  Related parties                                                         286,147              465,656
  Other                                                                    59,060              122,756
                                                                     ------------         ------------
   Total long-term debt                                                   345,207              588,412
                                                                     ------------         ------------
 
Capital lease obligation                                                   86,972                    -
                                                                     ------------         ------------
Commitments and contingencies (Note 6)
 
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, 21,238,508 (1998)
  and 20,312,969 (1997) shares issued and outstanding                     212,386              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                                            23,148,547           21,926,331
 Accumulated deficit                                                  (21,508,156)         (19,793,758)
                                                                     ------------         ------------
   Total stockholders' equity                                           1,867,432            2,350,358
                                                                     ------------         ------------
                                                                     $  9,802,008         $  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              Six months ended
                                                    June 30,                      June 30,
                                                    --------                      --------

                                             1998            1997            1998            1997
                                         ------------    ------------    ------------    ------------

<S>                                      <C>             <C>             <C>             <C>         
Sales                                    $  2,793,323    $  1,947,307    $  5,300,623    $  3,695,109

Cost of Goods Sold                          2,821,617       1,762,641       5,044,107       3,756,187
                                         ------------    ------------    ------------    ------------

Gross Margin                                  (28,294)        184,666         256,516         (61,078)

Selling and Administrative Costs              821,847         406,292       1,467,031         744,430
                                         ------------    ------------    ------------    ------------

Operating Loss                               (850,141)       (221,626)     (1,210,515)       (805,508)

Interest Expense, Net                        (345,316)        (11,716)       (503,883)        (47,274)
                                         ------------    ------------    ------------    ------------

Loss Before Extraordinary Item             (1,195,457)       (233,342)     (1,714,398)       (852,782)

Extraordinary Gain                                 --         863,332              --         863,332
                                         ------------    ------------    ------------    ------------

Net Income (Loss)                        $ (1,195,457)   $    629,990    $ (1,714,398)   $     10,550
                                         ============    ============    ============    ============

Loss per share of common stock
 before extraordinary item               ($       .05)   ($       .01)   ($       .08)   ($       .04)
Extraordinary gain per share of common
 stock                                             --    $        .04              --    $        .04
                                         ------------    ------------    ------------    ------------
Net income (loss) per share of common
 stock (Basic and Diluted)               ($       .05)   $        .03    ($       .08)             --
                                         ============    ============    ============    ============

Weighted average number of common
 shares outstanding                        22,320,249      20,801,132      22,173,620      20,768,266
                                         ============    ============    ============    ============
</TABLE>


The accompanying notes to the financial statements should be read in conjunction
with these statements.


                                       3
<PAGE>
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

STATEMENTS OF CASH FLOWS (UNAUDITED)


<TABLE>
<CAPTION>
                                                         Six months     Six months
                                                           ended          ended
                                                          June 30,       June 30,
                                                            1998           1997
                                                            ----           ----
<S>                                                     <C>            <C>        
Cash flows from operating activities:
 Net income (loss)                                      $(1,714,398)   $    10,550
 Adjustments to reconcile net income (loss) to net
  cash provided by (used in) operating activities:
 Depreciation and amortization                              608,513        529,874
 Amortization of other assets                               220,097         13,389
 Amortization of debt discount                              324,038             --
 Interest paid through issuance of Class A Common
  Stock                                                     102,867             --
 Loss on disposition of equipment                             1,964             --
 Increase (decrease) in other assets                          1,817       (307,182)
 Changes in current assets & current liabilities            824,646       (189,811)
 Extraordinary gain                                              --       (863,332)
                                                        -----------    -----------
 Net cash provided by (used in) operating activities        369,544       (806,512)
                                                        -----------    -----------

Cash flows from investing activities:
 Additions to buildings and equipment                    (2,398,964)      (302,517)
 Insurance proceeds                                           4,722      1,863,332
                                                        -----------    -----------

 Net cash (used in) provided by investing activities     (2,394,242)     1,560,815
                                                        -----------    -----------


Cash flows from financing activities:
 Proceeds from issuance of notes                          1,138,342             --
 Payments on notes                                         (133,600)      (295,454)
 Payments on capital lease obligations                       (7,740)            --
 Proceeds from stock options and warrants                   988,571             --
 Proceeds from issuance of common stock, net                     --        244,000
                                                        -----------    -----------

 Net cash provided by (used in) financing activities      1,985,573        (51,454)
                                                        -----------    -----------
(Decrease) increase in cash and cash equivalents            (39,125)       702,849
                                                        -----------    -----------
Cash and cash equivalents:
  Beginning of period                                        45,428         82,756
                                                        ===========    ===========
  End of period                                         $     6,303    $   785,605
                                                        ===========    ===========
</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:  Organization and Description of the Company
- ----------------------------------------------------

The Company developed and manufactures a line of composite building materials
from waste 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.

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 such contributed amounts are
reflected in the accompanying financial statements at the contributor's book
value.

Note 3:  Future Operations
- --------------------------

The financial statements of the Company have been prepared on the basis of
accounting principles applicable to a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business.  At June 30, 1998, the Company had a working capital deficit of
$5,774,518 and had incurred operating losses of $1,210,515 for the six months
ended June 

                                       5
<PAGE>
 
30, 1998. For the quarter ending June 30, 1998, the Company yielded a net loss
of $1,195,457. 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 June 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
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 10. 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 second quarter, primarily due to start-up problems with the Springdale
plant.  The 

                                       6

<PAGE>
 
Company has experienced equipment problems with the moulders and the new air
transfer system acquired for the Springdale plant. The moulder problem was
favorably resolved during the latter part of the second quarter, however, the
air system as of August 14, 1998, has yet to operate with its designed
efficiencies. The manufacturer has notified the Company of its intent to change
out and upsize 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 is currently questionable as to if the existing air system can
handle more than one line. The Company must promptly resolve the air system
problem in order to meet its production objectives. However, completion of the
production plan will, beyond the second extrusion line in Springdale (i.e. the
third line), require additional debt or equity financing beyond those resources
currently available to the Company. Also, additional financial resources will be
necessary to fund maturities of debt and other obligations as they come due in
1998. 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 in 1998 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 28, 1998 to August 15, 1998, the
Company has received net proceeds of $1,189,357, consisting of 710,450 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 September 4, 1998,
at which time those not exercised will expire, unless extended by the Company's
Board of Directors. As of August 14, 1998, 3,501,990 B Warrants and 375,000 C
Warrants remained unexercised. The base conversion price of such warrants 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
Friday, August 14, 1998, the closing price of the Company's Class A Common stock
was $1.125 and the 20-day closing average price was $1.16. 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 developed an alternative plan for an additional equity private
placement for up to $2 million dollars. The Company also has $630,037 remaining
on its bridge loan, although management is trying to avoid its use.

As of June 30, 1998, approximately $2.9 million had been borrowed in a series of
bridge loans. 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
exploring additional financial sources including both equity and conventional
long-term debt to refinance the bridge loans within the next six months as well
as be in a position to fund additional expansions. It is probable additional
financial resources will be necessary to fund maturities of debt and other
obligations, including bridge loans, as they come due. There is no assurance the
Company will be able to improve operating efficiencies beyond current levels or
that the Company will be successful in securing sufficient capital resources 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.

Note 4: Statements of Cash Flows
- --------------------------------

In order to determine net cash provided by (used in) operating activities, net
income (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 and capital lease obligation and current
notes payable.  Those changes, shown as an (increase) decrease in current assets
and an

                                       7

<PAGE>
 
increase (decrease) in current liabilities, are as follows:

<TABLE>
<CAPTION>
                                                     Six months          Six months
                                                        ended              ended
                                                    June 30, 1998       June 30, 1997
                                                     (unaudited)        (unaudited)
                                                  -----------------  ------------------
<S>                                              <C>                 <C>
 
                                   
       Receivables                                     $(223,335)          $(686,161)
       Note receivable                                    14,000                   -
       Inventories                                       116,141              21,800
       Prepaid expenses and other                       (158,369)             18,908
       Accounts payable -          
        trade and related parties                        913,848             433,285
       Accrued liabilities                               162,361              22,357
                                                       ---------           ---------
                                                       $ 824,646           $(189,811)
                                                       =========           =========
               Cash paid for interest                  $  13,076           $  42,240
               Cash paid for taxes                             -                   -
</TABLE>
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:
<TABLE>
<CAPTION>
                                                     Six months ended   Six months ended
                                                       June 30, 1998      June 30, 1997
                                                        (unaudited)        (unaudited)
                                                     ----------------   ----------------
<S>                                                  <C>                <C>
Notes payable for financing of insurance policies         $104,027           $109,207
Notes payable for equipment                               $140,006                  -
Capital lease obligation for equipment                    $110,000                  -
</TABLE>

Note 5: Significant Accounting Policies
- ---------------------------------------

     Inventories
     -----------

Inventories are stated at the lower of cost (first-in, first-out method) or
market.  Inventories consisted of the following:
<TABLE>
<CAPTION>
                                                       June 30, 1998           December 31,
                                                        (unaudited)                1997
                                                       -------------           ------------     
<S>                                                    <C>                     <C>
       Raw materials                                      $404,191                $257,114
       Work in process                                     176,869                 319,034
       Finished goods                                       38,496                 159,549
                                                          --------                --------
                                                          $619,556                $735,697
                                                          ========                ========
</TABLE>
                                                                               
                                       8

<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.

     SFAS No. 121
     ------------

The Company has adopted Statement of Financial Accounting Standards (SFAS) No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of". SFAS No. 121 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 June 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 $7,683,924 at June 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 

                                       9

<PAGE>
 
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
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 

                                      10

<PAGE>
 
$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
June 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 it's 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. 

                                      11

<PAGE>
 
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 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.  As of June 30, 1998, the Company did 
not meet the maintenance requirements for net tangible assets. Management 
believes that such maintenance requirements were met as of August 20, 1998.  
The Company as of June 30, 1998, had net assets of approximately $1,867,432 and
is currently implementing a plan to recapitalize and raise a minimum of an
additional $2 million in equity capital to expand its business, as well as, to
maintain its NASDAQ listing. There can be no assurance that its recapitalization
efforts will be successful or that it can through other methods maintain the
minimum $2 million net asset value for continued listing.

If the Company is unable to satisfy maintenance requirements, the Company's
securities would become subject to certain penny stock rules promulgated by the
SEC (the "Commission").  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 June 30, 1998, the Company had completed four bridge financing
agreements.  The date of the first agreement was October 30, 1997.  The Company
issued notes payable totaling $1.3 million, due and payable on July 27, 1998
unless the notes are extended, at the option of the Company, to October 30,
1998.  Interest on the notes is payable every three months at 12% in the

                                      12

<PAGE>
 
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 are extended, an additional 650,000 consulting warrants and 78,000
placement warrants will 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.

The date of the second financing agreement was February 5, 1998.  The Company
issued notes payable totaling $800,000, due and payable on November 2, 1998
unless the notes are 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.  If the notes are extended, an additional 400,000
consulting warrants and 48,000 placement warrants will be issued.  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.

A third bridge financing was completed on April 7, 1998.  The Company issued
notes payable totaling $410,000, due and payable on January 2, 1999 unless the
notes are 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
the notes are 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.

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
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 $630,037 

                                      13

<PAGE>
 
aggregate principal amount of notes to the Company. If the additional notes are
issued, then the Company will issue 1,260,074 consulting warrants and 75,604
placement warrants in connection with the notes. If the notes are extended, an
additional 315,018 consulting warrants and 37,802 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: Other Additional Financing
- ----------------------------------

During the quarter, the Company entered into a capital lease for $110,000
relating to equipment.  The lease contains a bargain purchase option of $1 at
the end of the lease term.  The Company also entered into a note payable for
$104,027 to finance insurance policies, due February 5, 1999 at 8.25% interest.
The Company also entered into a note payable for $123,107 for the purchase of
equipment, due December 1, 1999 at 9.5% interest.

Note 10: Stock Options   
- ----------------------   

During the six months ended June 30, 1998, 450,000 stock options were issued to 
employees of the Company at an exercise price of $.469.

Note 11: Other Litigation
- -------------------------

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.

Note 12: New Accounting Pronouncement
- -------------------------------------

In June 1998, the Financial Standards Board issued Statement of Financial
Accounting 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
- ---------------------------

Subsequent to June 30, 1998, 710,450 Class B Warrants were exercised resulting
in the issuance of 710,450 Bonus Warrants.  275,000 Class C Warrants were
exercised resulting in the issuance of 275,000 Bonus Warrants.  Proceeds
received from the exercise of the Class B and C Warrants totaled $1,189,357.  In
addition, a cashless-exercise occurred relating to 40,434 Placement Warrants.

                                      14

<PAGE>
 
                              ARTHUR ANDERSEN LLP



                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To the Board of Directors and Stockholders of
Advanced Environmental Recycling Technologies, Inc.

We have reviewed the accompanying balance sheet of Advanced Environmental
Recycling Technologies, Inc. (a Delaware corporation), as of June 30, 1998, and
the related statements of operations for the three-month and six-month periods
ended June 30, 1998 and 1997, and the statements of cash flows for the six-month
periods ended June 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
July 31, 1998


                                      15

<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's initial plastic reclamation facility from inception to 1996 was
located in Rogers, Arkansas.  Said facility suffered two extensive fires during
the last half of 1996, which caused substantial damage and closed the facility.
The Company spent most of the first half of 1997 attempting to settle the
resulting fire claim.  The Company during the third quarter of 1997 began
rebuilding and relocating it's LDPE plastic reclamation function in the newly
leased 103,000 square foot multi-purpose facility in Springdale, Arkansas.

The Company then commenced expanding 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
experienced startup and equipment delays, which caused the Company to miss and
backup some orders during the first and second quarters.  The Company has
implemented interim processes for painting and by passed certain equipment
functions.  The Company intends to attempt to iron out 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 second quarter due to
start-up and equipment problems at the Springdale plant.  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 materials are
now available so it will be able to increase production and sales to sufficient
levels to sustain positive cash flows and profitability.  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 


                                      16

<PAGE>
 
guaranteed said system in writing, although it has yet to perform to desired
levels. The Company intends to resolve this problem, shortly. The Company has
commenced an expansion program intended to shortly 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 obtain substantial
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 recently commenced operation at the new Springdale
facility, although it did not attain desired efficiencies during the second
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.

Results of Operations
- ---------------------

Quarter ended June 30, 1998 compared to quarter ended June 30, 1997
- -------------------------------------------------------------------

The Company commenced start-up of its second extrusion and millwork facility
during April of 1998. Additional construction was ongoing throughout the quarter
and additional delays were encountered with attaining commercial production at
the Springdale facility. The Company set a quarter net sales record of
$2,793,323 for the quarter ended June 30, 1998. This was an increase of $846,016
or 43% over the $1,947,307 reported for the comparable period ended June 30,
1997. Most of the sales increase was attributable to ongoing production
improvements at the initial Texas facility. Sales for the six months ended June
30, 1998 were $5,300,623, which was a 43% increase over sales for the six months
ended June 30, 1997 of $3,695,109. With the start-up of the second plant cost of
goods sold increased to $2,821,617 for 1998 vs. $1,762,641 for the comparable
period and one plant in 1997. Cost of goods sold for the six months ended June
30, 1998 were $5,044,107 compared to $3,756,187 for the six months ended June
30, 1997. The initial Texas composite plant continued to improve in operations
and showed an increase in positive gross margin of $233,621 vs. 184,666 for
1997. The Springdale facility experienced several startup difficulties and
delays during the quarter which resulted in a negative gross margin of
($261,915)from operations, which led to an overall negative gross margin of
($28,294) for the quarter. This compares to


                                      17

<PAGE>
 
a positive gross margin of $184,666 for the comparable period in 1997, when the
Company operated one plant. Gross margin for the six months ended June 30, 1998
was $256,516 compared to a negative margin of $61,078 for the six months ended
June 30, 1997, which was a $317,594 improvement. The Company reported an
operating loss of ($850,141) for 1998 vs. a ($221,626) operating loss for the
second quarter of 1997. Interest expenses increased significantly to $345,316
for 1998 vs. $11,716 for 1997 primarily due to the short-term bridge loan, in
conjunction with debt discount costs. Debt discount costs totaled $243,000 of
said amount. Corporate, selling and administrative costs were $392,616 for the
quarter. This increased the net loss to ($1,195,457) or ($.05) per share vs. a
net income of $629,990 or $.03 per share for the comparable period in 1997,
which recognized a one-time extraordinary gain of $863,332. Cost of goods sold
increased to $2,821,617 for 1998 vs. $1,762,641 for the comparable period in
1997. Of the second quarter 1998 loss, the majority was due to a substantial
increase in SG&A, plus interest costs i.e.: $821,877 SG&A for 1998, vs. $406,292
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 second quarter
1998 of $345,316 vs. $11,716 for 1997 constitutes the majority of the loss. The
Company has expanded its Springdale plant with short-term debt and intends to
restructure said debt and recapitalize later in 1998, once the Springdale plant
is fully operational, thus reducing these extraordinary expenses in subsequent
periods while continuing to increase and improve gross margins in order to
obtain positive cash flows and profitability from operations. There can be no
assurance that the Company will be successful in its efforts to restructure its
bridge loans and or outstanding debt and recapitalize, or if it does that it can
be done on terms which are favorable to the Company.

The net sales of $2,793,323 for the quarter ended June 30, 1998, represented a
significant increase over the second quarter of 1997.  The increase in sales
over the second quarter of 1997 was attained primarily by the Company's initial
Junction, Texas facility, as the Company's new Springdale, Arkansas, facility
was in a start-up phase and experienced several significant equipment problems
during the quarter and did not contribute substantially to the increase.  Cost
of goods sold was $2,821,617 for the second quarter of 1998 compared to
$1,762,261 for the second 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 second 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:

<TABLE>
<CAPTION>
        Expense Category                                                     1998                  1997
        ----------------                                                 ----------             ----------
<S>                                                                      <C>                    <C>
        Payroll and payroll taxes                                        $1,030,894             $  629,672
        Depreciation                                                        335,520                260,660
        Direct material costs                                               612,068                441,001
        Other                                                               843,135                431,308
                                                                         ----------             ----------
         Total                                                           $2,821,617             $1,762,641
                                                                         ==========             ==========
</TABLE>

                                      18

<PAGE>
 
Selling, general and administrative expenses were $821,877 for two plants
compared to $406,292 for one plant for the second 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 cost.  However, the largest portion of the increase was legal costs
and amortization of debt acquisitions costs relating to the recent short-term
bridge loan financing activities in regard to financing the Springdale plant and
manufacturing expansion.

Net loss for the quarter ended June 30, 1998 was $1,195,457.  Net loss per
weighted average common share outstanding was $.05. This compares to $629,990,
or net income per weighted average common share outstanding of $.03 for the
three months ended June 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 then being
shifted over into increased ChoiceDek production, in order to increase
production and reduce line changeovers.  Several functions in Texas will also be
streamlined in an effort to reduce costs.  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 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.

Liquidity and Capital Resources
- -------------------------------

At June 30, 1998, the Company had a working capital deficit of $5,774,518
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 at the Springdale
facility with short-term debt.  Losses from operations were in conjunction with
short term financing costs while the Company maintained its customer base and
started up its new plant.  Cash and cash equivalents decreased $39,125 in the
first half of 1998.  Significant components of that decrease were: (i) cash
provided by operating activities of $369,544, which consisted of a net loss for
the period of $1,714,398, decreased by depreciation and amortization of
$1,152,648 and other uses of cash of $931,294 (ii) cash used in investing
activities of $2,394,242, and (iii) cash provided by financing activities of
$1,985,573.  Payments on notes during the period were $133,600.  At June 30,
1998, the Company had notes payable and a capital lease obligation in the amount
of $3,839,816, of 


                                      19

<PAGE>
 
which $3,407,637 were current notes payable or current portion of long-term
debt. 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 and the Company experienced several
start-up equipment and construction related problems during the second quarter,
which resulted in limited production and less than desired efficiencies.  This
also delayed further streamlining and improvement at the Texas facility.  The
payable increase during the quarter ended June 30, 1998 is directly attributable
to this expansion program.  This expansion will continue through third 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 is evaluating increasing the factor
line once the Springdale facility becomes fully operational.

Beginning in the fourth quarter of 1997 and through June 3, 1998, the Company
entered into a loan agreement and received bridge loans totaling approximately
$2.9 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 $630,037, 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
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 28, 1998 to August 15, 1998, the Company has received net
proceeds of $1,189,357, consisting of 710,450 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 September 4, 1998, at which time those not exercised
will expire, unless extended by the Company's Board of Directors. As of August
14, 1998, 3,501,990 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 Friday, August 14, 1998, the closing price of the
Company's Class A Common stock was $1.125 and the 20-day closing average price
was $1.16. 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 developed an
alternative plan for an additional equity private placement for up to $2 million
dollars. The Company also has $630,037 remaining on its bridge loan, although
management is trying to avoid its use. It is management's intent to extend 
short-term debt into longer terms. 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

                                      20

<PAGE>
 
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 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 $2.5 million financing package through a State Economic
Development Agency for acquisition, additional manufacturing equipment and
further production expansion of the Arkansas facility. The Company is also
working to attain additional conventional refinancing of its short-term debt.

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
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 


                                      21

<PAGE>
 
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
  --------------------------


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
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 


                                      22

<PAGE>
 
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 June 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 it's 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.


                                      23

<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: August 20, 1998                          Date: August 20, 1998
 

                                      24


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