NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(In Thousands, Except Per Share Amounts)

1.                                       Nature of Business and Basis of Presentation

 

Appliance Recycling Centers of America, Inc. and subsidiaries (“we,” the “Company” or “ARCA”) are in the business of providing turnkey appliance recycling and replacement services for electric utilities and other sponsors of energy efficiency programs.  We also sell new major household appliances through a chain of Company-owned stores under the name ApplianceSmart ^® .  In addition, we have a 50% interest in a joint venture operating under the name ARCA Advanced Processing, LLC (“AAP”), which recycles appliances from twelve states in the Northeast and Mid-Atlantic regions of the United States for General Electric Company (“GE”) acting through its GE Appliances business component.  These appliances include units manufactured by GE as well as by other manufacturers.

 

The accompanying consolidated financial statements of the Company are unaudited and have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States of America for interim financial information and Article 8 of Regulation S-X promulgated by the United States Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  In the opinion of management, normal and recurring adjustments and accruals considered necessary for a fair presentation for the periods indicated have been included.  Operating results for the three -month and nine -month periods ended September 28, 2013 , and September 29, 2012 , are presented using 13 -week and 39 -week periods, respectively.  The results of operations for any interim period are not necessarily indicative of the results for the year.

 

These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and related notes thereto for the year ended December 29, 2012 , included in the Company’s Annual Report on Form 10-K filed with the SEC on March 22, 2013 .

 

Principles of consolidation :   The consolidated financial statements include the accounts of Appliance Recycling Centers of America, Inc. and our subsidiaries.  All significant intercompany accounts and transactions have been eliminated in consolidation.

 

ApplianceSmart, Inc., a Minnesota corporation, is a wholly owned subsidiary that was formed through a corporate reorganization in July 2011 to hold our business of selling new major household appliances through a chain of Company-owned retail stores.  ARCA Canada Inc., a Canadian corporation, is a wholly owned subsidiary that was formed in September 2006 to provide turnkey recycling services for electric utility energy efficiency programs.  ARCA Recycling, Inc., a California corporation, is a wholly owned subsidiary that was formed in November 1991 to provide turnkey recycling services for electric utility efficiency programs.  The operating results of our wholly owned subsidiaries are consolidated in our financial statements.

 

AAP is a joint venture that was formed in October 2009 between ARCA and 4301 Operations, LLC (“4301”) to support ARCA’s agreement, as amended, with GE acting through its GE Appliances business component.  Both ARCA and 4301 have a 50% interest in AAP.  GE sells its recyclable appliances generated from twelve states in the Northeast and Mid-Atlantic regions of the United States to ARCA, which collects, processes and recycles the appliances.  The agreement requires that ARCA will only recycle, and will not sell for re-use or resale, the recyclable appliances purchased from GE.  AAP established a regional processing center in Philadelphia, Pennsylvania, at which the recyclable appliances are processed.  The term of the agreement is for six years from the first date of appliance collection, which was March 31, 2010.  AAP commenced operations in February 2010 and has the exclusive rights to service the GE agreement as a subcontractor for ARCA.  The financial position and results of operations of AAP are consolidated in our financial statements based on our conclusion that AAP is a variable interest entity and because we have the ability to significantly influence the economic performance of the entity through our contractual agreement with GE.

Reclassifications :   The consolidated statements of comprehensive income (loss) include the reclassification of prior year revenues, cost of revenues and sales, general and administrative expenses related to AAP to conform with the current year presentation. The reclassification is related primarily to facilities costs and certain other costs not directly related to the production of recycled materials from cost of revenues to sales, general and administrative expenses.

 

Fair value of financial instruments :  The following methods and assumptions are used to estimate the fair value of each class of financial instrument:

 

Cash and cash equivalents, accounts receivable and accounts payable:   Due to their nature and short-term maturities, the carrying amounts approximate fair value.

Short- and long-term debt:  The fair value of short- and long-term debt approximates carrying value and has been estimated based on discounted cash flows using interest rates being offered for similar debt having the same or similar remaining maturities and collateral requirements.

 

No separate comparison of fair values versus carrying values is presented for the aforementioned financial instruments since their fair values are not significantly different than their balance sheet carrying amounts.  In addition, the aggregate fair values of the financial instruments would not represent the underlying value of our Company.

 

2.                                       Significant Accounting Policies

 

Trade receivables :   We carry unsecured trade receivables at the original invoice amount less an estimate made for doubtful accounts based on a monthly review of all outstanding amounts.  Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history and current economic conditions.  We write off trade receivables when we deem them uncollectible.  We record recoveries of trade receivables previously written off when we receive them.  We consider a trade receivable to be past due if any portion of the receivable balance is outstanding for more than ninety days .  We do not charge interest on past due receivables.  Our management considers the allowance for doubtful accounts of $10 and $8 to be adequate to cover any exposure to loss at September 28, 2013 , and December 29, 2012 , respectively.

 

Inventories :   Inventories, consisting principally of appliances, are stated at the lower of cost, determined on a specific identification basis, or market and consist of:

We provide estimated provisions for the obsolescence of our appliance inventories, including adjustments to market, based on various factors, including the age of such inventory and our management’s assessment of the need for such provisions.  We look at historical inventory agings and margin analysis in determining our provision estimate.  A revised cost basis is used once a provision for obsolescence is recorded.

Property and equipment :   Property and equipment consists of the following:

 

Software development costs :   We capitalize software developed for internal use and are amortizing such costs over their estimated useful lives of three years.  Costs capitalized were $20 and $30 for the three months ended September 28, 2013 , and September 29, 2012 , respectively. Costs capitalized were $83 and $115 for the nine months ended September 28, 2013 , and September 29, 2012 , respectively.

Restricted cash :   Restricted cash consisted of a reserve required by our bankcard processor to cover chargebacks, adjustments, fees and other charges that may be due from us.

 

Product warranty :   We provide a warranty for the replacement or repair of certain defective units, which varies based on the product sold.  Our standard warranty policy requires us to repair or replace certain defective units at no cost to our customers.  We estimate the costs that may be incurred under our warranty and record an accrual in the amount of such costs at the time we recognize product revenue.  Factors that affect our warranty accrual for covered units include the number of units sold, historical and anticipated rates of warranty claims on these units, and the cost of such claims.  We periodically assess the adequacy of our recorded warranty accrual and adjust the amounts as necessary.

 

Changes in our warranty accrual are as follows:

 

Share-based compensation :   We recognize share-based compensation expense on a straight-line basis over the expected vesting period for share-based awards granted.  We use the Black-Scholes option pricing model to determine the fair value of awards at the grant date.  We calculate the expected volatility for stock awards using historical volatility.  We estimate a 0% - 5% forfeiture rate for stock awards issued to all employees and members of the Board of Directors, but will continue to review these estimates in future periods.  The risk-free rates for the expected terms of the stock awards are based on the U.S. Treasury yield curve in effect at the time of the grant.  The expected life represents the period that the stock awards are expected to be outstanding.  The expected dividend yield is zero as we have not paid or declared any cash dividends on our Common Stock.  Based on these valuations, we recognized share-based compensation expense of $101 and $62 for the three months ended September 28, 2013 , and September 29, 2012 , respectively, and $160 and $130 for the nine months ended September 28, 2013 and September 29, 2012 , respectively.  We estimate that the remaining expense for fiscal 2013 , 2014 , 2015 and 2016 will be approximately $73 , $159 , $97 , and $19 , respectively, based on the value of stock option awards outstanding as of September 28, 2013 .  This estimate does not include any expense for additional awards that may be granted and vest during fiscal 2013 .

 

Comprehensive income (loss) :   Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under generally accepted accounting principles are included in comprehensive income (loss) but are excluded from net income (loss) as these amounts are recorded directly as an adjustment to shareholders’ equity.  Our other comprehensive income (loss) is comprised of foreign currency translation adjustments.

 

Basic and diluted income (loss) per share :   Basic income (loss) per common share is computed based on the weighted average number of common shares outstanding.  Diluted income (loss) per common share is computed based on the weighted average number of common shares outstanding adjusted by the number of additional shares that would have been outstanding had the potentially dilutive common shares been issued.  Potentially dilutive shares of Common Stock include unexercised stock options and warrants.  Basic per share amounts are computed, generally, by dividing net income (loss) attributable to controlling interest by the weighted average number of common shares outstanding.  Diluted per share amounts assume the conversion, exercise or issuance of all potential Common Stock instruments unless their effect is anti-dilutive, thereby reducing the loss or increasing the income per common share.  In calculating diluted weighted average shares and per share amounts, we included stock options and warrants with exercise prices below average market prices, for the respective reporting periods in which they were dilutive, using the treasury stock method.  We calculated the number of additional shares by assuming the outstanding stock options were exercised and that the proceeds from such exercises were used to acquire Common Stock at the average market price during the quarter.  For the three and nine months ended September 28, 2013 , we excluded 364 and 465 , respectively, options and warrants from the diluted weighted average share outstanding calculation as the effect of these options and warrants were anti-dilutive. For the three and nine months ended September 29, 2012 , we excluded 816 and 798 , respectively, options and warrants from the diluted weighted average shares outstanding calculation as the effect of these options were anti-dilutive due to the net loss incurred.

A reconciliation of the denominator in the basic and diluted income or loss per share is as follows:

 

3.                                       Variable Interest Entity

 

The financial position and results of operations of AAP are consolidated in our financial statements based on our conclusion that AAP is a variable interest entity and because we have the ability to significantly influence the economic performance of the entity through our contractual agreement with GE.

 

The following table summarizes the assets and liabilities of AAP as of September 28, 2013 , and December 29, 2012 :

 

(a)           Other liabilities represent loans between ARCA and AAP that are eliminated in consolidation.

The following table summarizes the operating results of AAP for the three and nine months ended September 28, 2013 , and September 29, 2012 :

 

4.                                       Other Assets

 

Other assets as of September 28, 2013 , and December 29, 2012 , consist of the following:

 

For the three and nine months ended September 28, 2013 , and September 29, 2012 , we recorded amortization expense of $20 and $60 , respectively, related to our recycling contract.  For the three months ended September 28, 2013 , and September 29, 2012 , we recorded non-cash interest expense of $28 and $49 , respectively, related to debt issuance costs. For the nine months ended September 28, 2013 , and September 29, 2012 , we recorded non-cash interest expense of $105 and $148 , respectively, related to debt issuance costs. In connection with the third amendment to our Credit Agreement with PNC Bank, N.A. (“PNC”) executed on March 14, 2013, we incurred additional debt issuance costs of $129 . The additional debt issuance costs were capitalized and will be amortized over the remaining term of the Credit Agreement along with the remaining balance of the previously capitalized costs. See Note 6 for further discussion regarding the amended Credit Agreement entered into with PNC.

 

5.                                       Accrued Expenses

 

Accrued expenses as of September 28, 2013 , and December 29, 2012 , consist of the following:

 

6.                                       Line of Credit

 

On January 24, 2011, we entered into a Revolving Credit, Term Loan and Security Agreement, as amended, (“Credit Agreement”) with PNC Bank, National Association (“PNC”) that provides us with a $15,000 revolving line of credit.  See Note 8 for further discussion regarding the Term Loan entered into with PNC.  The Credit Agreement has a stated maturity date of January 24, 2016, if not renewed.  The Credit Agreement includes a lockbox agreement and a subjective acceleration clause and as a result we have classified the revolving line of credit as a current liability.  The Credit Agreement is collateralized by a security interest in substantially all of our assets and PNC is also secured by an inventory repurchase agreement with Whirlpool Corporation for Whirlpool purchases only.  We also issued a $750 letter of credit in favor of Whirlpool Corporation.  The Credit Agreement requires starting with the fiscal quarter ending December 28, 2013, and continuing at the end of each quarter thereafter, that we meet a minimum fixed charge coverage ratio of 1.10 to 1.00, measured on a trailing twelve -month basis.  The Credit Agreement limits investments we can purchase, the amount of other debt and leases we can incur, the amount of loans we can issue to our affiliates and the amount we can spend on fixed assets, along with prohibiting the payment of dividends.  The interest rate on the revolving line of credit is PNC Base Rate plus 2.75% . If certain interest rate reduction conditions are met starting January 31, 2014, the rate will change to PNC Base Rate plus 1.75% , or 1-, 2- or 3-month PNC LIBOR Rate plus 2.75% .  The PNC Base Rate shall mean,

for any day, a fluctuating per annum rate of interest equal to the highest of (i) the interest rate per annum announced from time to time by PNC at its prime rate, (ii) the Federal Funds Open Rate plus 0.5% , and (iii) the one-month LIBOR rate plus 100 basis points ( 1% ).  As of September 28, 2013 , the outstanding balance under the Credit Agreement was $6,823 with an interest rate of 6.00% .  As of December 29, 2012 , the outstanding balance under the Credit Agreement was $10,559 with a weighted average interest rate of 3.07% , which included both PNC LIBOR Rate and PNC Base Rate loans.  The amount of revolving borrowings under the Credit Agreement is based on a formula using accounts receivable and inventories.  We may not have access to the full $15,000 revolving line of credit due to the formula using accounts receivable and inventories, the amount of the letter of credit issued in favor of Whirlpool Corporation and the amount of outstanding loans between PNC and our AAP joint venture.  As of September 28, 2013 , and December 29, 2012 , our available borrowing capacity under the Credit Agreement was $6,801 and $2,531 , respectively.

On March 14, 2013, we executed the third amendment to the Credit Agreement that extended the agreement from January 24, 2014, until January 24, 2016, waived our prior “events of default,” reset our financial covenants and increased our interest rate, among other things. The material amended terms under the Credit Agreement are as follows:

On September 27, 2013, we executed the fourth amendment to the Credit Agreement. The material amended terms under the Credit Agreement are as follows:

7.                                       Deferred Gain

 

In connection with the September 25, 2009, sale-leaseback of our St. Louis Park, Minnesota, building, we recorded a deferred gain of $2,436 .  The deferred gain is being amortized over the initial lease period of five years.  For both the three months ended September 28, 2013 , and September 29, 2012 , we amortized $122 of the deferred gain.  For the nine months ended September 28, 2013 , and September 29, 2012 , we amortized $365 and $366 , respectively, of the deferred gain. The deferred gain amortization is netted against rent expense as a component of selling, general and administrative expenses in the consolidated statements of comprehensive income (loss).

 

8.                                       Borrowings

 

Long-term debt, capital lease and other financing obligations as of September 28, 2013 , and December 29, 2012 , consist of the following:

 

 

On January 24, 2011, we entered into a $2,550 Term Loan (“Term Loan”) with PNC Bank to refinance the mortgage on our California facility.  The Term Loan is payable as follows, subject to acceleration upon the occurrence of an event of default or termination of the Revolving Credit Agreement: 119 consecutive monthly principal payments of $21 plus interest commencing on February 1, 2011, and continuing on the first day of each month thereafter followed by a 120th payment of all unpaid principal, interest and fees on February 1, 2021. If the Revolving Credit Agreement is not renewed, a balloon payment of $1,275 in principal plus interest and additional fees will be due on January 24, 2016. The Term Loan is collateralized with our California facility located in Compton, California. The interest rate is PNC Base Rate plus 3.25% . If certain interest rate reduction conditions are met starting January 31, 2014, the rate will change to PNC Base Rate plus 2.25% , or 1-, 2- or 3-month PNC LIBOR Rate plus 3.25% . As of September 28, 2013 , and December 29, 2012 , the interest rate was 6.50% and 5.50% , respectively.

On March 10, 2011, ARCA Advanced Processing, LLC entered into three separate commercial term loans (“AAP Term Loans”) with Susquehanna Bank, pursuant to the guidelines of the U.S. Small Business Administration 7(a) Loan Program.  The total amount of the AAP Term Loans is $4,750 , split into three separate loans for $2,100 ; $1,400 ; and $1,250 .  The AAP Term Loans mature in ten years and bear an interest rate of Prime plus 2.75% .  As of September 28, 2013 , and December 29, 2012 , the interest rate was 6.00% .  Borrowings under the AAP Term Loans are secured by substantially all of the assets of AAP along with liens on the business assets and certain personal assets of the owners of 4301 Operations, LLC. We are a guarantor of the AAP Term Loans along with 4301 Operations, LLC and its owners.

Capital leases and other financing obligations :   We acquire certain equipment under capital leases and other financing obligations.  The cost of the equipment was approximately $2,031 and $1,969 at September 28, 2013 , and December 29, 2012 , respectively.  Accumulated amortization at September 28, 2013 , and December 29, 2012 , was approximately $1,620 and $1,574 , respectively.  Depreciation and amortization expense is included in cost of revenues and selling, general and administrative expenses.

 

9.                                Commitments and Contingencies

 

Contracts :   We have entered into material contracts with three appliance manufacturers.  Under the agreements there are no minimum purchase commitments; however, we have agreed to indemnify the manufacturers for certain claims, allegations or losses with respect to appliances we sell.

 

Litigation :   We are party from time to time to ordinary course disputes that we do not believe to be material or have merit.  We intend to vigorously defend ourselves against these ordinary course disputes.

 

10.                                Income Taxes

 

For the three and nine months ended September 28, 2013 , we recorded a provision for income taxes of $227 and $372 , respectively. For the three and nine months ended September 29, 2012 , we recorded a provision for income taxes of $113 and $90 , respectively. We have available net operating losses to utilize in 2013 to offset a portion of our projected full-year taxable income for the United States. We also expect to receive $250 carr yback refund in 2013 related to taxable losses incurred in 2012. We expect to realize a Canadian tax benefit in fiscal 2013 as a result of carrying back the fiscal 2013 Canadian losses. We regularly evaluate both positive and negative evidence related to retaining a valuation allowance against our deferred tax assets.  The realization of deferred tax assets is dependent upon sufficient future taxable income during the periods when deductible temporary differences and carryforwards are expected to be available to reduce taxable income. We have concluded based on the weight of negative evidence

that a valuation allowance should be maintained against our deferred tax assets that we do not expect to utilize as of September 28, 2013 .

 

We recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position.  For tax positions meeting the more-likely-than-not threshold, the amount recognized in the consolidated financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority.  As of September 28, 2013 , and December 29, 2012 , we did not have any material uncertain tax positions.

 

It is our practice to recognize interest related to income tax matters as a component of interest expense and penalties as a component of selling, general and administrative expense.  As of September 28, 2013 , and December 29, 2012 , we had an immaterial amount of accrued interest and penalties.

 

We are subject to income taxes in the U.S. federal jurisdiction, foreign jurisdictions and various state jurisdictions.  Tax regulations from each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply.  With few exceptions, we are no longer subject to U.S. federal, foreign, state or local income tax examinations by tax authorities for the years before 2010.  We are not currently under examination by any taxing jurisdiction.

 

We had no significant unrecognized tax benefits as of September 28, 2013 , and December 29, 2012 , that would reasonably be expected to affect our effective tax rate during the next twelve months.

11.                                Shareholders’ Equity

 

Stock options :  On May 12, 2011, our shareholders approved and adopted the 2011 Stock Compensation Plan (the “2011 Plan”).  The 2011 Plan authorizes the granting of awards in any of the following forms: (i) stock options, (ii) stock appreciation rights, and (iii) other share-based awards, including but not limited to restricted stock, restricted stock units or performance shares and expires on the earlier of May 12, 2021, or the date that all shares reserved under the 2011 Plan are issued or no longer available. 

The 2011 Plan provides for the issuance of up to 700 shares of Common Stock pursuant to awards granted under the 2011 Plan.  Options granted to employees typically vest over two years while grants to non-employee directors vest in six months.  As of September 28, 2013 , 367 options were outstanding under the 2011 Plan.  Our 2006 Stock Option Plan (the “2006 Plan”) expired on June 30, 2011, but the options outstanding under the 2006 Plan continue to be exercisable in accordance with their terms.  As of September 28, 2013 , 391 options were outstanding under the 2006 Plan.  Our Restated 1997 Stock Option Plan (the “1997 Plan”) has expired, but the options outstanding under the expired 1997 Plan continue to be exercisable in accordance with their terms.  As of September 28, 2013 , options to purchase an aggregate of 8 shares were outstanding under the 1997 Plan.

On May 9, 2013 , we granted 30 stock options from our 2011 Plan to non-employee directors with an exercise price of $1.89 per share, a vesting period of six months and a weighted average fair value of $1.66 per share. Also on May 9, 2013, we granted 185 stock options from our 2011 Plan to management with an exercise price of $1.89 per share and a weighted average fair value of $1.47 per share. The stock options granted to management have both time and performance vesting, of which 135 stock options vest equally over two years and 50 stock options vest based on the achievement of performance targets. For performance-based options, the Company evaluates the likelihood of the targets being met and records the expense over the probable vesting period.

On July 22, 2013 , we granted 100 stock options from our 2011 Plan to management with an exercise price of $2.65 pe r share and a weighted average fair value of $2.06 pe r share. The stock options granted to management have both time and performance vesting, of which 50 st ock options vest equally over 3 ye ars an d 50 stoc k options vest based on the achievement of performance targets. For performance-based options, the Company evaluates the likelihood of the targets being met and records the expense over the probable vesting period.

The following table summarizes the weighted-average assumptions used to estimate the fair value of stock options granted using the Black-Scholes Model:

Stock warrants :   As of September 28, 2013 , we had 278 warrants outstanding that were fully vested and have exercise prices ranging from $0.73 per share to $3.55 per share, which begin to expire in October 2019.

 

Preferred Stock :   Our amended Articles of Incorporation authorize two million shares of Preferred Stock that may be issued from time to time in one or more series having such rights, powers, preferences and designations as the Board of Directors may determine.  To date no such preferred shares have been issued.

 

12.                          Segment Information

 

We operate within targeted markets through two reportable segments: retail and recycling.  The retail segment is comprised of income generated through our ApplianceSmart stores, which includes appliance sales and byproduct revenues from collected appliances.  The recycling segment includes all fees charged and costs incurred for collecting, recycling and installing appliances for utilities and other customers and includes byproduct revenue, which is primarily generated through the recycling of appliances. We have included the results from consolidating AAP in our recycling segment.  The nature of products, services and customers for both segments varies significantly.  As such, the segments are managed separately.  Our Chief Executive Officer has been identified as the Chief Operating Decision Maker (“CODM”).  The CODM evaluates performance and allocates resources based on revenues and income from operations of each segment.  Income from operations represents revenues less cost of revenues and operating expenses, including certain allocated selling, general and administrative costs.  There are no inter-segment sales or transfers.

The following tables present our segment information for periods indicated: