Note 1: Unaudited Information

Advanced Environmental Recycling Technologies, Inc. (the Company, AERT, we, our or us) has prepared the financial statements included herein 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 accounting principles generally accepted in the United States of America (U.S. GAAP) 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. Interim reports, such as this one, however, are not necessarily indicative of results to be obtained for the full year.

Note 2: Description of the Company

AERT, founded in 1988, develops and commercializes technologies to recycle waste polyethylene plastics and develops, manufactures, and markets value-added, green building products. The majority of our products are composite building materials that are a superior replacement for traditional wood or plastic products for exterior applications in building and remodeling homes and for certain other industrial or commercial building purposes. Our products are made primarily from approximately equal amounts of recycled polyethylene plastic and waste wood fiber, which have been cleaned, sized and reprocessed utilizing our patented and proprietary technologies. Our products have been extensively tested, and are sold by leading national companies such as Lowe’s Companies, Inc. (Lowe’s) and Therma-Tru Corporation. Our products are primarily used in renovation and remodeling by consumers, homebuilders, and contractors as an exterior environmentally responsible (“Green”) building alternative for decking, railing, and trim products.

AERT currently manufactures all of our composite products at extrusion facilities in Springdale, Arkansas, and we operate a plastic recycling, blending and storage facility in Lowell, Arkansas, where we also lease warehouses and land for inventory storage. We also operate a plastic recycling, cleaning, and reformulation facility in Watts, Oklahoma.

Note 3: Cash Flows

In order to determine net cash provided by operating activities, net income has been adjusted by, among other things, changes in current assets and current liabilities, excluding changes in cash, current maturities of long-term debt and current notes payable. Those changes, shown as an (increase) decrease in current assets and an increase (decrease) in current liabilities, are as follows (in thousands):

Supplemental Disclosures of Non-Cash Investing and Financing Activities (in thousands)

Note 4: Significant Accounting Policies

Revenue Recognition Policy

The Company recognizes revenue when the title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, shipment has occurred or services have been rendered, the sales price is determinable and collectability is reasonably assured. The Company typically recognizes revenue at the time product is shipped or when segregated and billed under a bill and hold arrangement except sales to Lowe’s, in which case we recognize revenue when the product is delivered to Lowe’s. The following table sets forth the amount of discounts, rebates and returns for the periods indicated:

Estimates of expected sales discounts are calculated by applying the appropriate sales discount rate to all unpaid invoices that are eligible for the discount. The Company’s sales prices are determinable given that its sales discount rates are fixed and given the predictability with which customers take sales discounts.

Shipping and Handling

The Company records shipping fees billed to customers in net sales and records the related expenses in cost of goods sold.

Inventories

Inventories are stated at the lower of cost (first-in, first-out method) or market. Material, labor, and factory overhead necessary to produce the inventories are included at their cost. Inventories consisted of the following (in thousands):

Accounts Receivable and Factoring

Accounts receivable are uncollateralized customer obligations due under normal trade terms generally requiring payment within thirty days from the invoice date. Trade accounts are stated at the amount management expects to collect from outstanding balances. Payments of accounts receivable are allocated to the specific invoices identified on the customers’ remittance advice.

Accounts receivable are carried at original invoice amounts less an estimated reserve provided for returns and discounts based on a review of historical rates of returns and expected discounts. The carrying amount of accounts receivable is reduced, if needed, by a valuation allowance that reflects management’s best estimate of the amounts that will not be collected. Management individually reviews all overdue accounts receivable balances and, based on an assessment of current creditworthiness, estimates the portion, if any, of the balance that will not be collected. Management provides for probable uncollectible amounts through a charge to earnings and a credit to an allowance account based on its assessment of the current status of the individual accounts. Balances which remain outstanding after management has used reasonable collection efforts are written off through a charge to the valuation allowance and a credit to trade accounts receivable. Recoveries of trade receivables previously written off are recorded when received.

On February 20, 2015, the Company entered into an accounts receivable purchase agreement (Lowe’s Companies, Inc. Supply Chain Financing Program) with a third party financial institution to sell selected accounts receivable from Lowe’s. The Company, at its sole option, may offer to sell to the financial institution all or part of the Company’s accounts receivable from Lowe’s. The financial institution, upon acceptance of the offer, advances to the Company 95% of the balance due within 15 days of the invoice date with the remaining 5% being paid under agreed upon terms. AERT pays interest on advanced amounts at an agreed-upon rate (1.09% per annum at September 30, 2015). The Lowe’s receivables are sold without recourse. The purchase agreement may be terminated by either party with 30-days’ notice. As of September 30, 2015, the amount due from factor was $0.3 million.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP 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.

Concentration Risk

Credit Risk and Major Customers

The Company’s revenues are derived principally from national and regional building products dealers and distributors. The Company extends unsecured credit to its customers. The Company’s concentration in the building materials industry has the potential to impact its exposure to credit risk because changes in economic or other conditions in the construction industry may similarly affect the Company’s customers.

The Company has significant customer concentration, with one customer, Lowe’s, representing approximately 40% of our accounts receivable at September 30, 2015, as compared to another customer, BlueLinx, which represented approximately 80% at December 31, 2014.

For the nine months ended September 30, 2015, Lowe’s represented approximately 50% of the Company’s revenue compared to less than 10% for the nine months ended September 30, 2014. Our next largest customer, BlueLinx, accounted for approximately 15% of the Company’s revenue for the nine months ended September 30, 2015 compared to approximately 60% for the nine months ended September 30, 2014. While, in prior years, we sold ChoiceDek® to our distributor, BlueLinx, under a bill and hold agreement, in late 2014, we commenced selling directly to Lowe’s.

Cash

The Company maintains bank accounts that are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. At times, cash balances may be in excess of the FDIC limit. The Company believes no significant concentrations of risk exist with respect to its cash.

Note 5: Income Taxes

As of September 30, 2015, the Company had net operating loss (NOL) carryforwards for federal and state income tax purposes of $52.0 million that are available to reduce future taxable income. If not utilized, the NOL carryforwards will expire between 2017 and 2034.

In March 2011, H.I.G. AERT, LLC acquired a controlling interest in the Company, which resulted in a significant restriction on the utilization of the Company’s NOL carryforwards. It is estimated that the utilization of future NOL carryforwards will be limited per Section 382 of the Internal Revenue Code of 1986, as amended (IRC 382), to approximately $0.8 million per year for the next 17 years. The impact of this limitation is that approximately $27.3 million in NOLs will expire before the Company can use them. Of the remaining $24.7 million in NOLs, $15.2 million is subject to the IRC 382 restriction and $10 million is available to reduce taxable income.

As there is insufficient evidence that the Company will be able to generate adequate future taxable income to enable it to realize its NOL carryforwards prior to expiration, the Company maintains a valuation allowance to recognize its deferred tax assets only to the extent of its deferred tax liabilities. The estimated annual effective income tax rate for 2015 is 0% due to the change in the valuation allowance.

Based upon a review of its income tax filing positions, the Company believes that its positions would be sustained upon an audit and does not anticipate any adjustments that would result in a material change to its financial position. Therefore, no reserves for uncertain income tax positions have been recorded. The Company recognizes interest related to income taxes as interest expense and recognizes penalties as operating expense. The Company is subject to routine audits by various taxing jurisdictions. The Company is no longer subject to income tax examinations by taxing authorities for years before 2011, except in the States of California, Colorado and Texas, for which the 2010 tax year is still subject to examination.

Note 6: Earnings per Share

The Company utilizes the two-class method for computing and presenting earnings per share (EPS). The Company currently has one class of common stock (the Common Stock) and one class of cumulative participating preferred stock, Series E (the Preferred Stock). Holders of the Preferred Stock are entitled to receive per share dividends equal to 6% per annum of the stated value of $1,000 per share of the Preferred Stock when declared by the Company’s Board of Directors. In addition, holders of the Preferred Stock are entitled to participate in any dividends declared on shares of the Company’s Common Stock on an as-converted basis. Therefore, the Preferred Stock is considered a participating security requiring the two-class method for the computation and presentation of net income per share – basic.

The two-class computation method for each period segregates basic earnings per common and participating share into two categories: distributed earnings per share (i.e., the Preferred Stock stated dividend) and undistributed EPS, which allocates earnings after subtracting the Preferred Stock dividend to the total of weighted average common shares outstanding plus equivalent converted common shares related to the Preferred Stock. Basic earnings per common and participating share exclude the effect of Common Stock equivalents, and are computed using the two-class computation method.

In computing diluted EPS, only potential common shares that are dilutive—those that reduce EPS or increase loss per share—are included. The exercise of options or conversion of convertible securities is not assumed if the result would be antidilutive, such as when a loss from continuing operations is reported. As a result, if there is a loss from continuing operations, diluted EPS would be computed in the same manner as basic EPS is computed, even if an entity has net income after adjusting for discontinued operations or the cumulative effect of an accounting change.

The following presents the two-class method for the three and nine months ended September 30, 2015 and 2014:

BASIC AND DILUTED EARNINGS PER SHARE

(in thousands, except share and per share data)

⁽¹⁾ Although not included in the basic EPS calculation under the two-class method due to a period of loss, the Company had 349,873,827 shares of common stock issuable upon conversion of the Preferred Stock outstanding at September 30, 2015.  These financial instruments would need to be included with future calculations of basic EPS under the two-class method in periods of income.  

Note 7: Line of Credit

As of September 30, 2015, the Company had an $8.0 million line of credit loan (AloStar Revolver Loan) with the AloStar Bank of Commerce (AloStar), subject to a reserve of $1.0 million and the borrowing base set forth in the agreement governing the AloStar Revolver Loan (AloStar Borrowing Base). Interest was assessed at 4.0% plus the greater of (a) 1.0%, or (b) the LIBOR rate as shown in the Wall Street Journal on such day for United States dollar deposits for the one month delivery of funds in an amount approximately equal to the principal amount of the AloStar Revolver Loan. If the LIBOR rate could not be determined, interest would be calculated using the prime lending rate plus 2.0%. Because the LIBOR rate was less than 1.0% on September 30, 2015, the interest rate was determined to be 5.0%.

There were no outstanding borrowings on the AloStar Revolver Loan at September 30, 2015. The amount available to draw down on the AloStar Revolver Loan at September 30, 2015 was $7.0 million. On October 30, 2015, AERT entered into a Credit and Financing Agreement (the WBCC Agreement) with Webster Business Credit Corporation, a state banking institution organized under the laws of the State of Connecticut (WBCC). For further information, see Note 11: Subsequent Event. Advances received from WBCC on October 30, 2015 were used to pay off and terminate the AloStar Revolver Loan balance on October 30, 2015 of $3.4 million.

Note 8: Related Party Transactions

Advisory Services

The Company entered into an Advisory Services Agreement with H.I.G. Capital, L.L.C. on March 18, 2011 that provides for an annual monitoring fee between $250,000 and $500,000 and reimbursement of all other out-of-pocket fees and expenses incurred by H.I.G. Capital, L.L.C. in connection with administration of the agreement. For each of the quarters ended September 30, 2015 and 2014, we recorded an advisory fee expense of $63,000. For the nine months ended September 30, 2015 and 2014, we recorded an advisory fee of $187,500.

Note 9: Commitments and Contingencies

AERT is involved from time to time in litigation arising in the normal course of business that is not disclosed in its filings with the SEC. In management's opinion, the Company is not involved in any litigation that is expected to materially impact the Company's results of operations or financial condition.

Financing Agreement

Banc of America Leasing & Capital, LLC (BOA)

In 2007, AERT entered into an operating lease with the LaSalle National Leasing Company (presently BOA). The equipment leased was identified as “Schedule 1 Equipment” and “Schedule 2 Equipment”. The operating lease contained a provision for a fair market value buy out at the end of the lease. The lease for the Schedule 1 Equipment expired on December 31, 2014. On January 22, 2015, AERT entered into a new financing agreement with BOA to finance the equipment buy out for the Schedule 1 Equipment. The terms of the financing agreement required 18 equal monthly payments of $39,000, which commenced on February 1, 2015 and were to continue until July 1, 2016. The stated interest rate was 6%.

The Company’s lease obligation for the Schedule 2 Equipment expired on March 31, 2015, at which time AERT entered into another financing agreement with BOA for the buyout of this equipment with 16 equal monthly payments of $46,000 that commenced on April 1, 2015 and were to continue until July 1, 2016. The stated interest rate was 6%.

Advances under the WBCC Term Loan consummated on October 30, 2015 were used to pay off the BOA loan balances of $0.8 million and to terminate the BOA financing agreements. See Note 11: Subsequent Event for more information.

Note 10: New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP.

The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures).  We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our financial statements and have not yet determined the transition method we will utilize upon adoption of the standard.

On July 9, 2015, the FASB voted to defer the effective date of ASU 2014-09 by one year to December 15, 2017 for interim and annual reporting periods beginning after that date and permitted early adoption of the standard, but not before the original effective date.

Note 11: Subsequent Event

Webster Business Credit Corporation

On October 30, 2015, AERT entered into the WBCC Agreement for an asset-based revolver loan capped at $8.5 million for the period June 1 to December 31 of each calendar year and capped at $15.0 million for the five months ended May 31 of each calendar year (WBCC Revolver Loan), a $5.5 million machinery and equipment loan (WBCC M&E Loan), a $7.2 million real estate loan (WBCC RE Loan), a $1.5 million asset-based loan (WBCC Term Loan) and a $1.2 million capital expenditure loan (WBCC CAPEX Loan).

The purpose of the WBCC Agreement is to refinance a portion of the Company’s senior and subordinated debt, to cover the costs and expenses associated with the loan transactions and to provide working capital to fund business operations. The WBCC Agreement expires on October 30, 2020. The WBCC Agreement requires that WBCC hold first security interest on the majority of AERT’s property, plant, equipment and real estate. The uses of the funds received under the WBCC Agreement at closing are as follows:

Payments on the principal portion of the WBCC M&E Loan, WBCC RE Loan and WBCC Term Loan will commence on November 30, 2015 and will be made in 60 equal monthly installments of $0.12 million plus interest. The final installment of $7.0 million is due and payable on October 30, 2020. AERT will borrow on the WBCC Revolver Loan at the domestic base rate set forth in the WBCC Agreement (Domestic Base Rate), which at October 30, 2015 was 3.25% plus an applicable margin. At its option, the Company may convert advances on the WBCC Revolver Loan to a LIBOR rate loan plus an applicable margin. Conversion of Domestic Base Rate advances to LIBOR rate loans must be made in increments of $250,000. Only ten LIBOR rate loans may be outstanding at any time. Loan interest periods are available for one, two or three months. The LIBOR rate on October 30, 2015 was 0.87%. The applicable margin for each loan is as follows:

The WBCC Revolver Loan is secured by amounts equal to 85% of the qualifying accounts receivable balance and 85% of the net orderly liquidation value of the inventory. The available balance on the WBCC Revolver Loan at October 30, 2015 was $2.4 million.

Advances on the WBCC CAPEX Loan will be subject to an amount equal to 80% of the hard cost of the equipment to be purchased. The total amount of all WBCC CAPEX Loans outstanding cannot exceed the aggregate of the maximum WBCC CAPEX Loan amount of $1.2 million and any advance must be greater than $25,000.

Loans under the WBCC Agreement are subject to the following debt covenants: (a) fixed charge coverage ratio of greater than 1.10:1.0, and (b) maximum capital expenditures annually of $4.0 million.

Deferred financing costs of approximately $1.0 million incurred in connection with negotiating and entering into the WBCC Agreement will be capitalized and amortized over the five-year life of the WBCC Agreement.