**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**ý****Annual Report Pursuantto Section 13 or 15(d)**

**of the Securities Exchange Act of1934**

 

**For the fiscal year ended January 3,2004**

 

**or**

 

**o****Transition ReportPursuant to Section 13 or 15(d)**

**of the Securities Exchange Act of1934**

 

**Commission File No. 0-19621**

 

| **APPLIANCE RECYCLING CENTERS OF AMERICA, INC.**                                                             |
|--------------------------------------------------------------------------------------------------------------|
| (Exact name of registrant as specified in  its charter)                                                      |
|                                                                                                         |   |   |
| **Minnesota**                                                                                                |   | **41-1454591** |
| (State or other jurisdiction of  incorporation or organization)                                              |   | (I.R.S. Employer  Identification No.) |
|                                                                                                         |   |   |
| **7400 Excelsior Boulevard, Minneapolis, Minnesota**                                                         |   | **55426-4517** |
| (Address of principal executive offices)                                                                     |   | (Zip Code) |
|                                                                                                         |   |   |
| Registrant’s telephone number, including  area code:  **952-930-9000**                             |
|                                                                                                         |   |   |
| Securities registered pursuant to  Section 12(b) of the Act:  **None**                             |
| Securities registered pursuant to  Section 12(g) of the Act:  **Common  Stock, without par value** |
| (Title of class)                                                                                             |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý   No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act). Yes  o  No  ý

 

As of March 5, 2004, the aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant, computed byreference to the price at which the common equity was last sold as reported bythe OTC Bulletin Board, was $4,327,750.

 

As of March 5, 2004, there were outstanding 2,413,777 shares ofthe registrant’s Common Stock, without par value.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the registrant’s definitive proxy statement datedMarch 19, 2004, are incorporated by reference into Part III hereof.

 

 

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**TABLEOF CONTENTS**

 
| **PART I**             |
|------------------------|
|                   |   |   |
| Item 1.                | Business | 3 |
|                   |   | General | 3 |
|                   |   | Industry Background | 3 |
|                   |   | Company Background | 4 |
|                   |   | Customers and Source of Supply | 6 |
|                   |   | Company Operations | 7 |
|                   |   | Principal Products and Services | 8 |
|                   |   | Sales and Marketing | 8 |
|                   |   | Seasonality | 9 |
|                   |   | Competition | 9 |
|                   |   | Government Regulation | 9 |
|                   |   | Employees | 10 |
| Item 2.                | Properties | 10 |
| Item 3.                | Legal Proceedings | 10 |
| Item 4.                | Submission of Matters to a Vote of Security  Holders | 11 |
|                   |   |   |
| **PART II**            |
|                   |   |
| Item 5.                | Market for the Company’s Common Equity,  Related Shareholder Matters and Issuer Purchases of Equity Securities | 11 |
| Item 6.                | Selected Financial Data | 12 |
| Item 7.                | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 13 |
| Item 7A.               | Quantitative and Qualitative Disclosure  About Market Risk | 23 |
| Item 8.                | Financial Statements and Supplementary Data | 23 |
| Item 9.                | Changes in and Disagreements With  Accountants on Accounting and Financial Disclosure | 36 |
| Item 9A.               | Controls and Procedures | 36 |
|                   |   |   |
| **PART  III**          |
|                   |   |   |
| Item 10.               | Directors and Executive Officers of the  Registrant | 36 |
| Item 11.               | Executive Compensation | 36 |
| Item 12.               | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters | 36 |
| Item 13.               | Certain Relationships and Related  Transactions | 37 |
| Item 14.               | Principal Accountant Fees and Services | 37 |
|                   |   |   |
| **PART IV**            |
|                   |   |
| Item  15.              | Exhibits,  Financial Statement Schedules and Reports on Form 8-K | 37 |
|                   |   |   |
| **SIGNATURES**         | 39 |
| **INDEX  TO EXHIBITS** | 40 |

 

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**PART I**

 

**ITEM 1.          BUSINESS**

 

**General**

 

Appliance Recycling Centers of America, Inc., together with itsoperating subsidiaries (ARCA or  Company),is a leading provider of reverse logistics, energy-efficiency and appliancerecycling services for appliance manufacturers and retailers, utilitycompanies, waste management businesses, vending machine companies, propertymanagers, local governments and the general public.  The Company generates revenues from the retail sale of appliancesthrough a chain of Company-owned retail stores under the name ApplianceSmart®,fees charged for the collection and environmentally sound recycling of unwantedappliances, and sales of byproduct materials generated from processedappliances.

 

The Company was incorporated in Minnesota in 1983,although through its predecessors it commenced the appliance retail andrecycling business in 1976.  TheCompany’s principal office is located at 7400 Excelsior Boulevard, Minneapolis,Minnesota 55426-4517.  References hereinto the Company include its operating subsidiaries.  (See Exhibit 21.1.)

 

**Industry Background**

 

There are more than 500 million major household appliances, such asrefrigerators, freezers, ranges, dishwashers, microwaves, washers, dryers, roomair conditioners, water heaters and dehumidifiers, currently in use in theUnited States.  The Steel RecyclingInstitute estimates that in 2001, 39 million major household appliances weretaken out of use in the United States. The disposal of these appliances is a serious problem as a result of anumber of factors including (i) decreasing landfill capacity in many parts ofthe country; (ii) the inability of incinerators, composting facilities andother landfill alternatives to process appliances; and (iii) the presence inappliances of certain hazardous and other environmentally harmful materialsthat require special processing.

 

Legislation affecting appliance disposal has been adopted in more than30 states.  This legislation includeslandfill restrictions, disposal bans, advance disposal fees and other types ofregulations.  As a result, appliancesmust be dealt with outside the ordinary municipal solid waste system.

 

Landfill restrictions arise in part because some appliance componentscontain certain hazardous and other environmentally harmful materials,including polychlorinated biphenyls (PCBs), mercury, refrigerants such aschlorofluorocarbons (CFCs) and sulfur dioxide, and oils.  PCBs are suspected as carcinogens, areresistant to degradation when deposited in landfills and can cause groundwatercontamination.  The production of PCBswas banned by the Environmental Protection Agency (EPA) in 1979, althoughbusinesses were allowed to continue using remaining inventories of componentsthat contained PCBs.  Mercury is toxicto humans and can enter the body through inhalation, skin absorption oringestion, and it vaporizes at high temperatures, forming extremely toxic fumes.  CFCs are believed to cause long-term damageto the earth’s stratospheric ozone layer and may contribute to global warmingwhen released into the atmosphere.  The1990 Amendments to the Clean Air Act prohibit the venting of CFCs and sinceJuly 1, 1992 have required the recovery of CFC refrigerants during theservice, repair and disposal of appliances. See “Government Regulation” below.

 

In addition to these solid waste management and environmental issues,utility companies, motivated by economic and environmental factors to controlenergy consumption, sponsor various programs to encourage and assistresidential consumers to conserve energy, including programs for turning insurplus,

 

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energy-inefficient appliances. Many residential consumers own and operate room air conditioners,freezers or more than one refrigerator, contributing significantly toresidential energy use and peak energy demand. In addition, many of the refrigerators manufactured in the 1960s andearly 1970s consume up to 1,750 kilowatt-hours of electricity each year.  The 1987 National Appliance EnergyConservation Act requires that new refrigerators use less than half of theenergy as refrigerators built twelve years ago.  As more efficient appliances become available, utility companieshave begun to encourage the use of newer models and the disposal of older, lessefficient models.

 

The Federal Energy Policy Act of 1992 gives individual states theoption of deregulating their electric utility industry.  The potential of deregulation has causeduncertainty about the future and form of energy conservation programs sponsoredby electric utilities.  The Company believes,however, that energy conservation and efficiency programs will remain a long-termcomponent of the nation’s electric utility industry.  See “Government Regulation” below.

 

**Company Background**

 

The Company began business in 1976 as a retailer of reconditionedappliances.  Initially, the Companycontracted with national and regional retailers of appliances such as Sears,Roebuck & Company, Inc. (Sears) and Montgomery Ward & Co. (MontgomeryWard) to collect major appliances in Minneapolis/Saint Paul and two othermetropolitan areas.  As part of theirnew appliance sales efforts, these retailers arranged for the removal of oldappliances from consumers’ residences. The Company collected old appliances on behalf of its customers,reconditioned and sold suitable used appliances through its own retail storesand sold the remaining appliances to scrap metal processors.

 

In the late 1980s, in response to stricter environmental protectionlaws, the Company developed and marketed programs to process and dispose ofappliances in an environmentally sound manner. These programs were offered to appliance manufacturers and retailers ofnew appliances, waste management companies, property management companies andthe general public.  See “Customers andSource of Supply” below.

 

In 1989, the Company expanded its appliance recyclingconcept to the electric utility industry when it established an applianceprocessing center in Milwaukee, Wisconsin, pursuant to a contract with autility company.  From 1989 to 1994, theCompany focused its resources on the expansion of its business with electricutility companies.  During this timeperiod the Company opened nine centers throughout the U.S. and Canada,primarily serving seventeen electric utility customers.  The Company’s electric utility business hasbeen negatively impacted by the potential of electric utility industryderegulation.  The potential ofderegulation has caused electric utilities to decrease their sponsorship ofenergy conservation programs such as the one the Company offers.

 

In October 2000, the Company signed a contract with Southern CaliforniaEdison Company (Edison) to implement a recycling program (Summer Initiative) inthe service areas of Pacific Gas & Electric (PG&E), primarily the SanFrancisco Bay area and San Diego Gas & Electric (SDG&E).  This contract was in accordance with a rulingissued by the California Public Utilities Commission (CPUC).  Under this contract, the Company recycledapproximately 36,000 units.  InSeptember of 2000, the Company began providing services for the SummerInitiative, which was completed in the third quarter of 2001.  The Company was responsible for advertisingthe Summer Initiative.

 

In June 2001, the Company began providing services for theAppliance Early Retirement and Recycling Program serving utility customers inSan Diego and surrounding areas; a six-county region in California’s CentralValley, including the cities of Fresno and Stockton; and the seven-county BayArea,

 

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including San Francisco.  Theprogram, which included refrigerators, freezers and room air conditioners, wascompleted in August 2002.  TheCompany was responsible for advertising the program.

 

During fiscal year 2003, the Company had one majorelectric utility customer, Edison, which accounted for approximately 9% or $3.8million of the Company’s total revenues. In September 2003, the Company signed a contract with Edison tosupport the 2003 Statewide Residential Appliance Recycling Program in theterritories served by Edison and SDG&E. Since January 2003, the Company had handled appliance recyclingoperations for this energy conservation initiative under an extension of the2002 program. The 2003 program ran through December 31, 2003.  In January 2004, the Company signed acontract with Edison to handle appliance recycling operations in Edison’sservice territory for the years of 2004 and 2005.  In March 2004, the Company signed a contract with SDG&Eto handle appliance recycling operations in SDG&E’s service territory for 2004.

 

The Company also is aggressively pursuing new and potentiallysignificant appliance recycling programs in other states, reflecting growingnational interest in residential energy conservation programs.  Nevertheless, the Company’s ability toproject recycling revenue for 2004 continues to be limited.

 

In response to the decrease in demand for services by electricutilities beginning in the mid-1990s, the Company increased its marketing ofservices to appliance manufacturers and retailers, waste management companiesand property management companies.  TheCompany also increased its focus on the sale of used/refurbishedappliances.  In 1995, under the nameEncore Recycled Appliances®, the Company began operating a chain of Company-ownedretail stores.  In 1998, the Companybegan using the name ApplianceSmart®for its retail stores.  The retailstores now offer special-buy appliances (defined below) to value-consciousindividuals and property managers.

 

Adeveloping market for the Company is in providing fully integrated reverselogistics services—the handling of product that does not fit into a company’snormal distribution channels—for appliance manufacturers and retailers.  Manufacturers traditionally disposed ofthese “special-buy” appliances, including manufacturer closeouts, factoryoverruns, floor samples, returned or exchanged items, and scratch and dentappliances, through their small-dealer network.  Large retailers have not wanted to handle these types ofappliances because the merchandise is often out of carton, requiring specialhandling and pricing.  In addition, thisproduct often requires some repair or needs to be recycled; functions majorretailers are unwilling or unable to perform. As small dealers are struggling to compete with large appliance chains(the top 10 retailers control 80 percent of the appliance sales market),manufacturers are seeing their traditional channel for these distressedappliances shrink.  It is anticipatedthat small appliance retailers will also be negatively affected by manufacturers’direct sale of appliances to consumers via the Internet.

 

In 1997, the Company entered into pilot program agreements withWhirlpool Corporation (Whirlpool), the nation’s largest manufacturer of majorhousehold appliances, to develop a program for handling Whirlpool’s returnedappliances and new appliances that cannot be handled through the manufacturer’snormal distribution channels.  Through asubsequent 1998 contract with Whirlpool, the Company purchases these appliancesfrom Whirlpool’s distribution centers serving the Midwest and certain westernstates.  This merchandise, whichincludes manufacturer closeouts, factory overruns, floor samples, returned orexchanged items, and scratch and dent appliances, is sold through the Company’snetwork of ApplianceSmart retail stores. With an increased supply of product, the Company began to focus onopening larger factory outlet facilities to offer consumers a wider selectionof special-buy appliances and began to close its smaller stores.  The Company has also decided not to expandits used/refurbished appliance business.

 

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In the latter part of 1998, the Company scaled back its agreement withWhirlpool to a level consistent with the Company’s financial resources andpurchased inventory mainly from Whirlpool’s Ohio distribution center.  Currently, the Company purchases inventorymainly from Whirlpool’s St. Louis, Missouri, distribution center.  The Whirlpool agreement for 2004 does notprovide for any required or minimum number of units to be offered for sale tothe Company.  The Whirlpool agreementmay be terminated by either party upon thirty (30) days’ prior writtennotice.  In addition, the Company hasagreed to indemnify Whirlpool for certain claims, allegations or losses withrespect to Whirlpool appliances sold by the Company.

 

InOctober 2001, the Company entered into an agreement with MaytagCorporation (Maytag) for the acquisition of distressed appliances (MaytagAgreement).  Under the Maytag Agreement,there are no minimum purchase requirements. The Maytag Agreement may be terminated by either party upon 60 days’written notice or may be terminated immediately if a default is not curedwithin ten (10) days after notice of default. In addition, the Company has agreed to indemnify Maytag for all claims,losses, liability and expenses with respect to Maytag appliances sold by theCompany.

 

In December 2001, the Company announced that all retail storeswould be carrying a full line of Frigidaire household appliances.

 

In January 2003, the Company announced that it had entered into acontract with GE Consumer Products (GE) to purchase from GE and sell toconsumers special-buy GE appliances.

 

The Company believes purchases from these four manufacturers willprovide an adequate supply of high-quality appliances for its retailoutlets.  There are no set numbers ofunits to be sold to the Company by any of the four manufacturers.

 

In January 2001, the Company opened a 24,000-square-foot store inthe Minneapolis/Saint Paul market.  TheCompany opened another 42,000-square-foot store in the Dayton, Ohio, market inMarch 2001.  In addition, theCompany closed a smaller store and opened a 32,000-square-foot store in theColumbus, Ohio, market in May 2001.  TheCompany opened a 49,000-square-foot store in the Minneapolis/Saint Paul marketin October 2001.  InMarch 2002, the Company opened another 30,000-square-foot store inColumbus, Ohio.  In December 2002,the Company closed an underperforming store in the Dayton, Ohio, market.  In February 2003, the Company closed asmaller store and opened a 33,000-square-foot store in the Minneapolis/SaintPaul market.  In March 2003, theCompany closed an underperforming store in the Dayton, Ohio, market.  In December 2003, the Company opened a30,000-square-foot store in the Atlanta, Georgia, market.  The Company currently has three recyclingcenters, located in Columbus, Ohio; Minneapolis, Minnesota; and Los Angeles,California.  Also, the Company currentlyhas nine retail stores:  four inMinneapolis/Saint Paul, one in Los Angeles, one in Atlanta and three inColumbus.

 

During the second quarter of 2003, the Company became a majority (60%)owner in North America Appliance Company LLC (NAACO).  NAACO commenced operations in June 2003 as a retailer ofspecial-buy appliances in McAllen, Texas.

 

**Customers and Source of Supply**

 

The Company offers its services to entities that as part of theiroperations become responsible for disposing of large quantities of new,distressed and unwanted appliances. These entities include appliance manufacturers and retailers of newappliances, waste management businesses, vending machine companies, propertymanagement companies and utility companies.

 

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*Appliance Manufacturers and Retailers of New Appliances.*  The Company began its business by offeringappliance recycling programs to Sears, Montgomery Ward and other retailers ofnew appliances by collecting appliances from either the retailers’ facilitiesor from their customers.  Recently theCompany has focused its marketing efforts on appliance manufacturers, includingWhirlpool, Maytag, Frigidaire and GE, the primary sources of products sold inthe Company’s stores.

 

The Company believes its current sources for appliances are adequate tosupply its retail stores and allow the Company to grow its retail sales;however, there is a risk that one or more of these sources could be lost.

 

*Waste Management Companies.*  The Company provides services to wastemanagement companies and the general public for the collection and recycling ofappliances for specified fees.

 

*Vending Machine Companies.*  The Company provides services to vendingmachine companies for the recycling of vending machines containing refrigerantsfor specified fees.

 

*Property Management Companies.*  The Company provides comprehensive applianceexchange and recycling services for property managers of apartment complexes aswell as local housing authorities.

 

*Electric Utility Companies.*  The Company contracts with utility companiesto provide comprehensive appliance recycling services tailored to the needs ofthe particular utility.  The contractshistorically have had terms of one to four years, with provisions for renewalat the option of the utility company. Under some contracts the utility retains the Company to manage allaspects of its appliance recycling program, while under other contracts theCompany provides only specified services. Pricing for the Company’s services is on a per-appliance basis anddepends upon several factors, including the total number of appliancesprocessed, the length of the contract term and the specific services selectedby the utility.  Contracts with electricutility customers require that the Company does not recondition for resaleappliances received from utility company energy conservation programs.  Currently, the Company has a contract withEdison to handle recycling operations in Edison’s territory for 2004 and 2005and a contract with SDG&E to handle recycling operations in SDG&E’sterritory for 2004.

 

**Company Operations**

 

TheCompany provides an integrated range of reverse logistics, energy efficiencyand appliance recycling services. Appliances are acquired from a wide range of sources, includingappliance manufacturers and retailers, utility companies, waste managementbusinesses, vending machine companies, property managers, local governments andthe general public.

 

Appliances acquired from manufacturers that are deemed suitable forsale are repaired, if necessary, before being tested and distributed to theCompany’s ApplianceSmart retail outlets. Every appliance is under warranty and carries a 100 percent money-backguarantee.  The Company also offersconsumers extended warranties, delivery, factory-trained technician service andrecycling of old appliances.

 

Appliances acquired from manufacturers that do not meet qualitystandards for the Company’s retail operations and appliances collected throughutility customers’ energy conservation programs and other sources are processedand recycled in an environmentally sound manner.  Appliances are inspected and categorized according to the typesof hazardous materials they may contain, and processed according to allapplicable federal, state and local regulations by company-trainedtechnicians.  When processing at theCompany’s recycling center is complete and the appliances are free of allenvironmentally hazardous

 

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substances, the appliances are delivered to a local metal processingfacility for shredding.  The shreddedmaterials are then sold to steel mini-mills or other metal recovery facilitiesfor reuse.

 

Management believes that the uncertainties in the electric utilityindustry regarding deregulation will persist at least through 2004.  The reaction to deregulation among statesand utilities has been varied.  TheCompany believes, however, that energy conservation and efficiency programswill remain a long-term component of the nation’s electric utility industry.

 

In 2003, the Company focused on a carefully managed growth plan ofopening showroom outlet stores, located in heavily trafficked, convenientlylocated retail malls, and adding additional sources of supply of product soldin the retail stores.  The Companybelieves that the growth of its retail business in the near future will likelyoccur primarily through the expansion of revenues from the Company’s currentand proposed retail stores.

 

**Principal Products and Services**

 

The Company generates revenues from three sources:  retailing, recycling and byproduct.  The table below reflects the percentage oftotal revenues from each source.  Seealso “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.”

 
|      |   | **2003** |   | **2002** |   | **2001** |   |
|-----------|--------|----------|--------|----------|--------|----------|--------|
| Revenues: |   |     |   |     |   |     |   |
| Retail    |   | 79.8     | %      | 65.4     | %      | 50.3     | %      |
| Recycling |   | 18.4     | %      | 32.0     | %      | 46.8     | %      |
| Byproduct |   | 1.8      | %      | 2.6      | %      | 2.9      | %      |
|      |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |

#  

Although the Company has two main sources of revenues,management believes that the Company has only one operating segment.  That is, even though certain separatefinancial information by retail store or retail store and recycling center isavailable to management, the Company is managed as a single unit.  Specifically, the Company does not measureprofit or loss or maintain asset information separately for its revenuesources.  Recycling and byproductrevenues are the result of both retail revenues and recycling contracts.  Retail includes the free removal andrecycling of the customer’s existing appliance.  Recycling includes the recycling of appliances per a contract oragreement.

 

**Sales and Marketing**

 

The Company uses various means to promote awareness of its products andservices and believes it is recognized as a leader in the retailing ofappliances on a reverse logistics basis and in the recycling industry.

 

ApplianceSmart’s outlet store concept includes establishing largefactory showrooms in convenient metropolitan locations to offer consumers aselection of hundreds of appliances.  Inkeeping with ApplianceSmart’s branding, both the exterior and interior of ApplianceSmart’sstores display Whirlpool, Maytag, Frigidaire and GE signage along withcustom-designed ApplianceSmart materials. In every market, the Company actively promotes its stores throughvarious forms of print advertising, including daily classified ads in majornewspapers, telephone yellow pages ads and direct mail.  In addition, the Company uses radio andtelevision advertisements in some markets, along with other types ofpromotions.  Through the Company’swebsite at www.ApplianceSmart.com, consumers can also access appliance-specificand general Company information.

 

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**Seasonality**

 

The Company does not experience seasonal fluctuations in its operatingresults.  However, utility companiesthat sponsor appliance turn-in programs generally reduce their promotionalefforts for such programs during the first and fourth calendar quarters.

 

**Competition**

** **

Competition for the Company’s retail stores comes from appliancemanufacturers and retailers of new appliances and other special-buyretailers.  Each retail location willcompete not only with local and national chains of new-appliance retailers,many of whom have been in business longer than the Company and may havesignificantly greater assets than the Company, but will also compete withnumerous independently owned retailers of new and special-buy appliances.

 

Many factors, including existing and proposed governmental regulation,may affect competition in the waste management and environmental servicesindustry.  The Company generallycompetes with two or three other companies which are based in the geographicarea to be served under appliance recycling contracts and which generally offeronly some of the services provided by the Company.

 

The Company expects its primary competition for appliance recyclingcontracts with existing or new customers to come from entrepreneurs enteringthe appliance recycling business, energy management consultants, currentrecycling companies, major waste hauling companies and scrap metalprocessors.  In addition, customers suchas utility companies and local governments may operate appliance recyclingprograms internally rather than contracting with the Company or other thirdparties.  There can be no assurance thatthe Company will be able to compete profitably in any of its chosen markets.

 

**Government Regulation**

 

The business of recycling major appliances is subject to certaingovernmental laws and regulations. These laws and regulations include landfill disposal restrictions,hazardous waste management requirements and air quality standards, as well asspecial permit and license conditions for the recycling of appliances.  In some instances, there are bonding,insurance and other conditions for bidding on appliance recycling contracts.

 

The Company’s appliance recycling centers are subject to variousfederal, state and local laws, regulations and licensing requirements relatingto the collection, processing and recycling of household appliances.  Requirements for registrations, permits andlicenses vary among the Company’s market areas.  The Company’s centers are registered with the EPA as hazardouswaste generators and are licensed, where required, by appropriate state andlocal authorities.  The Company has agreementswith approved and licensed hazardous waste companies for transportation anddisposal or recycling of hazardous materials from its centers.

 

The 1990 Amendments to the Clean Air Act provide for the phaseout ofthe production of CFCs over a period of years. Effective July 1, 1992, the act prohibited the venting of CFCs inthe course of maintaining, servicing, repairing or disposing of anappliance.  The act also requires therecovery of CFC refrigerants from appliances prior to their disposal or deliveryfor recycling.  In 1995, the venting ofCFC substitute refrigerants was also prohibited.

 

In 1992, Congress adopted the Energy Policy Act of 1992 to encourageenergy efficiency. Requirements under this act establish, among other things,mandatory energy performance standards that

 

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affect the manufacture and sale of major household appliances.  Another component of this act allows forderegulation of the nation’s energy providers, including the electric utilityindustry.  The ultimate impact ofderegulation on the electric utility industry is yet unknown; therefore, therecan be no assurance that the Company will be able to continue certain of itscurrent operations in a deregulated environment.

 

Company management believes that further government regulation of theappliance recycling industry could have a positive effect on the Company’sbusiness; however, there can be no assurance what course future regulation mayhave.  Under some circumstances, furtherregulation could materially increase the costs of the Company’s operations andhave an adverse effect on the Company’s business.  In addition, as is the case with all companies handling hazardousmaterials, under some circumstances the Company may be subject to contingentliabilities.

 

**Employees**

 

At March 1, 2004, the Company had 232 full-timeemployees, approximately 46% of whom were involved in the collection,transportation and processing of appliances at the Company’s centers,approximately 34% of whom were in sales and approximately 20% of whom were inadministration and management.  TheCompany has not experienced any work stoppages and believes its employeerelations are good.

 

**ITEM 2.          PROPERTIES**

 

The Company’s executive offices are located in Minneapolis, Minnesota,in a Company-owned facility that includes approximately 11 acres of land.  The building contains approximately 122,000square feet, including 27,000 square feet of office space, 24,000 square feetof retail space and 71,000 square feet of operations and processing space.  The California center building, which alsois owned by the Company, is located in Compton, California, and consists of46,000 square feet:  6,000 square feetof office space and 40,000 square feet of warehouse space.  All properties and equipment owned by theCompany currently secure outstanding loans of the Company.

 

The Company generally leases the other facilities it operates.  The Company usually attempts to negotiatelease terms for a recycling center that correspond to the term of the principalcontract or contracts in connection with which the center is to beoperated.  The Company’s recyclingcenters typically range in size from 25,000 to 40,000 square feet.  The Company usually attempts to negotiatelease terms of two to five years for retail stores with 25,000 to 35,000 squarefeet.  However, the retail stores may belarger depending on favorable demographics, availability and other businessfactors.

 

The Company believes that the facilities and equipment at each of itscenters are adequate to meet its anticipated needs for the near term and thatalternate facilities will readily be available to the Company to meet itsfuture needs.

 

**ITEM 3.          LEGALPROCEEDINGS**

 

The Company and its subsidiaries are involved in various legalproceedings arising in the normal course of business, none of which is expectedto result in any material loss to the Company or any of its subsidiaries.

 

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**ITEM 4.          SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

The Company did not submit any matters to a vote of security holdersduring the last quarter of the fiscal year covered by this report.

 

**PART II**

 

**ITEM5.****          MARKETFOR THE COMPANY’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASESOF EQUITY SECURITIES**

 

**Market for CommonStock**

 

The Company’s Common Stock, which trades under the symbol “ARCI,” begantrading on the OTC Bulletin Board on September 8, 1998.  Prior to that time, the Common Stock tradedas follows:  on the Nasdaq SmallCapMarket from February 26, 1997 to September 7, 1998; on the NasdaqNational Market from January 8, 1993 to February 25, 1997; on theNasdaq SmallCap Market from January 7, 1991 to January 7, 1993; andon the local over-the-counter market prior thereto.  The following table sets forth, for the periods indicated, thehigh and low closing bid quotations for the Common Stock, as reported by theOTC Bulletin Board.

 
|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
|           |   |     |   |    |   |
| **2002**       |   |     |   |    |   |
|           |   |     |   |    |   |
| First Quarter  |   | $        | 5.30   |    | $      | 3.70 |   |
| Second Quarter |   | 4.35     |   | 3.60    |   |
| Third Quarter  |   | 3.90     |   | 2.30    |   |
| Fourth Quarter |   | 2.65     |   | 1.63    |   |
|           |   |     |   |    |   |
| **2003**       |   |     |   |    |   |
|           |   |     |   |    |   |
| First Quarter  |   | $        | 2.08   |    | $      | 1.05 |   |
| Second Quarter |   | 1.80     |   | 1.02    |   |
| Third Quarter  |   | 2.10     |   | 1.11    |   |
| Fourth Quarter |   | 2.75     |   | 1.50    |   |

 

On March 5, 2004, the last reported sale price of the Common Stockon the OTC Bulletin Board was $3.15 per share. As of March 5, 2004, there were approximately 862 beneficialholders of the Company’s Common Stock.

 

The Company’s line of credit limits the Company’s ability to paydividends.

 

During 1999, the Company privately placed 1,050,000 unregistered sharesand 138,000 warrants to purchase shares. In 2000, the Company registered 1,030,000 of such shares for resale bythe holders.

 

In February 1999, the Company sold in a private placement1,030,000 shares of Common Stock at a price of $0.50 per share.  The sale represented approximately 45% ofthe Common Stock outstanding after such sale. The Company paid $31,500 of the proceeds and issued warrants to purchase83,000 shares of Common Stock at $0.50 per share, subject to adjustment, to aninvestment banker as a placement fee. The

 

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remaining proceeds were used to repay certain indebtedness, to purchaseinventory and for other general corporate purposes.

 

In March 1999, the Company issued to a board member at that time,as payment for certain consulting services, 5,000 warrants to purchase theCompany’s Common Stock at $0.625 per share, the market value of the Company’sstock at the date of grant.  Thewarrants are currently exercisable and expire March 1, 2009.

 

In April 1999, the Company issued to a vendor 50,000 warrants topurchase the Company’s Common Stock at $0.625 per share.  The warrants expire March 31, 2004.

 

**ITEM6.****                             SELECTEDFINANCIAL DATA**

 

The selected financial information set forth below should be read inconjunction with “Item 7.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and“Item 8.  Financial Statements and SupplementaryData.”

 
| **Fiscal Years Ended**                                        |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|---------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| **(In thousands, except  per-share data)**                    |   |     |   |     |   |     |   |     |   |     |   |
|                                                          |   |     |   |     |   |     |   |     |   |     |   |
| **Statement of Operations**                                   |   |     |   |     |   |     |   |     |   |     |   |
| Total revenues                                                |   | $        | 43,609 |     | $      | 45,720   |   | $        | 43,810 |     | $      | 21,479 |   | $ | 15,582 |   |
| Gross profit                                                  |   | $        | 11,879 |     | $      | 15,774   |   | $        | 17,329 |     | $      | 8,921 |   | $ | 6,666 |   |
| Operating income (loss)                                       |   | $        | (1,776 | )        | $      | 1,742    |   | $        | 4,749  |     | $      | 1,963 |   | $ | 1,139 |   |
| Net income (loss)                                             |   | $        | (1,541 | )        | $      | 332      |   | $        | 2,646  |     | $      | 927 |   | $ | 505 |   |
| Basic earnings (loss) per common share                        |   | $        | (0.66  | )        | $      | 0.14     |   | $        | 1.15   |     | $      | 0.41 |   | $ | 0.24 |   |
| Diluted earnings (loss) per common share                      |   | $        | (0.66  | )        | $      | 0.11     |   | $        | 0.86   |     | $      | 0.32 |   | $ | 0.22 |   |
| Basic weighted average number of common  shares outstanding   |   | 2,343    |   | 2,320    |   | 2,291    |   | 2,287    |   | 2,142    |   |
| Diluted weighted average number of common  shares outstanding |   | 2,343    |   | 3,025    |   | 3,068    |   | 2,889    |   | 2,274    |   |
|                                                          |   |     |   |     |   |     |   |     |   |     |   |
| **Balance Sheet**                                             |   |     |   |     |   |     |   |     |   |     |   |
| Working capital                                               |   | $        | 3,446  |     | $      | 5,003    |   | $        | 3,188  |     | $      | 1,183 |   | $ | 545 |   |
| Total assets                                                  |   | $        | 20,833 |     | $      | 20,239   |   | $        | 18,936 |     | $      | 12,651 |   | $ | 9,517 |   |
| Long-term liabilities                                         |   | $        | 5,658  |     | $      | 5,797    |   | $        | 4,348  |     | $      | 4,431 |   | $ | 4,831 |   |
| Shareholders’ equity                                     |   | $        | 4,209  |     | $      | 5,737    |   | $        | 5,397  |     | $      | 2,751 |   | $ | 1,809 |   |

 

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**QUARTERLY FINANCIALDATA**

 

The following table sets forth certain unaudited quarterly financialdata for the eight quarters ended January 3, 2004.  In the Company’s opinion, the unauditedinformation set forth below has been prepared on the same basis as the auditedinformation and includes all adjustments necessary to present fairly theinformation set forth herein.  Theoperating results for any quarter are not indicative of results for any futureperiod.  All data is in thousands exceptper-common share data.

 
|                                                               |   | **Fiscal  2003** |   |
|--------------------------------------------------------------------|--------|------------------|--------|
|                                                               |   | **1st  Quarter** |   | **2nd  Quarter** |   | **3rd  Quarter** |   | **4th  Quarter** |   |
| Total revenues                                                     |   | $                | 10,026 |   | $ | 10,722 |   | $ | 11,865 |   | $ | 10,996 |   |
| Net income (loss)                                                  |   | $                | (816   | ) | $ | (475 | ) | $ | 41 |   | $ | (291 | ) |
| Basic earnings (loss) per common share                             |   | $                | (0.35  | ) | $ | (0.20 | ) | $ | 0.02 |   | $ | (0.12 | ) |
| Diluted earnings (loss) per common share                           |   | $                | (0.35  | ) | $ | (0.20 | ) | $ | 0.01 |   | $ | (0.12 | ) |
| Basic weighted average number of  common shares outstanding   |   | 2,335            |   | 2,344 |   | 2,344 |   | 2,350 |   |
| Diluted weighted average number of  common shares outstanding |   | 2,335            |   | 2,344 |   | 2,897 |   | 2,350 |   |

 
|                                                               |   | **Fiscal  2002** |   |
|--------------------------------------------------------------------|--------|------------------|--------|
|                                                               |   | **1st  Quarter** |   | **2nd  Quarter** |   | **3rd  Quarter** |   | **4th  Quarter** |   |
| Total revenues                                                     |   | $                | 11,699 |   | $ | 11,734 |   | $ | 13,079 |   | $ | 9,208 |   |
| Net income (loss)                                                  |   | $                | 238    |   | $ | 537 |   | $ | 274 |   | $ | (717 | ) |
| Basic earnings (loss) per common share                             |   | $                | 0.10   |   | $ | 0.23 |   | $ | 0.12 |   | $ | (0.31 | ) |
| Diluted earnings (loss) per common share                           |   | $                | 0.07   |   | $ | 0.16 |   | $ | 0.09 |   | $ | (0.31 | ) |
| Basic weighted average number of  common shares outstanding   |   | 2,311            |   | 2,320 |   | 2,324 |   | 2,324 |   |
| Diluted weighted average number of  common shares outstanding |   | 3,310            |   | 3,291 |   | 3,176 |   | 2,324 |   |

 

**ITEM7.****          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORTHE FISCAL YEARS 2003, 2002 AND 2001**

 

**OVERVIEW**

 

The Company’s 2003 fiscal year (2003) ended January 3, 2004, its2002 fiscal year (2002) ended December 28, 2002 and its 2001 fiscal year(2001) ended December 29, 2001.

 

The Company generates revenues from three sources:  retail, recycling and byproduct.  Retail revenues are sales of appliances,warranty and service revenue and delivery fees.  Recycling revenues are fees charged for the disposal ofappliances.  Byproduct revenues aresales of scrap metal and reclaimed chlorofluorocarbons (CFCs) generated fromprocessed appliances.  The Company ismanaged as a unit and does not measure profit or loss separately for its threeprimary revenue sources.  Therefore, theCompany believes that it has one operating segment.

 

In 2003, the Company focused on a carefully managed growth plan ofopening large showroom outlet stores, located in heavily trafficked,conveniently located retail malls, and adding additional sources of supply ofproduct sold in the retail stores. During 2003, the Company opened one retail store in theMinneapolis/Saint Paul market and one retail store in the Atlanta, Georgia,market.  The Company also

 

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closed a smallerretail store in the Minneapolis/Saint Paul market.  Retail revenues accounted for 79.8% of total revenues in 2003.

 

**Critical AccountingPolicies and Estimates**

 

The Company’s significantaccounting policies are summarized in the footnotes to the financialstatements.  Some of the most criticalpolicies are also discussed below.

 

**Revenue****recognition:**  The Company recognizes revenue from appliance sales in the periodthe appliances are purchased and paid for by the consumer.  Revenue from appliance recycling isrecognized when a unit is collected and processed.  Byproduct revenue is recognized upon shipment.

 

TheCompany defers revenue under certain appliance extended warranty arrangementsit services and recognizes the revenue over the related terms of the warrantycontracts.  On extended warrantyarrangements sold by the Company but serviced by others for a fixed portion ofthe warranty sales price, the Company recognizes revenue for the net amountretained at the time of sale of the extended warranty to the consumer.

 

Shippingand handling charges to customers are included in the revenues.  Shipping and handling costs incurred by theCompany are included in cost of revenues.

 

**Productwarranty: **The Company provides a warranty for thereplacement or repair of certain defective units.  The Company’s standard warranty policy requires the Company torepair or replace certain defective units at no cost to its customers.  The Company estimates the costs that may beincurred under its warranty and records a liability reserve in the amount ofsuch costs at the time product revenue is recognized.  Factors that affect the Company’s warranty liability reserve forcovered units include the number of units sold, historical and anticipatedrates of warranty claims on these units, and the cost of these claims.  The Company periodically assesses theadequacy of its recorded warranty liability reserve and adjusts the amounts asnecessary.  The Company believes the warrantyliability of $54,000 is adequate.

 

**Trade receivables:**  Trade receivables are carried at originalinvoice amount less an estimate made for doubtful receivables based on a reviewof all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by regularlyevaluating individual customer receivables and considering a customer’sfinancial condition, credit history and current economic conditions.  Trade receivables are written off whendeemed uncollectible.  Recoveries oftrade receivables previously written off are recorded when received.  A trade receivable is considered to be pastdue if any portion of the receivable balance is outstanding for more than 90days.  The current reserve for doubtfulaccounts of $117,000 should be adequate for any exposure to loss in theCompany’s January 3, 2004 accounts receivable.

 

**Inventories:** Inventories, consisting principally of appliances, are stated at thelower of cost, first-in, first-out (FIFO), or market.  The Company provides estimated reserves for the realizability ofits appliance inventories, including adjustments to market, based on variousfactors including the age of such inventory and management’s assessment of theneed for such allowances.  Managementlooks at historical inventory agings and margin analysis in determining itsreserve estimate.  The Company believesthe reserve of $324,000 is adequate. Because of a decrease in volume and a change in business, the Company nolonger inventories unrefurbished units.

 

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**Propertyand equipment:**  Depreciation is computed using straight-lineand accelerated methods over the following estimated useful lives:

 
|                       |   | **Years** |   |
|----------------------------|--------|-----------|--------|
| Buildings and improvements |   | 18 - 30   |   |
| Equipment                  |   | 3 - 8     |   |

 

TheCompany did not identify any items that were impaired as of January 3,2004.

 

**Incometaxes:**  Deferred taxes are provided on an asset andliability method whereby deferred tax assets are recognized for deductibletemporary differences and operating loss and tax credit carryforwards, anddeferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differencesbetween the reported amounts of assets and liabilities and their taxbasis.  Deferred tax assets are reducedby a valuation allowance when, in the opinion of management, it is more likelythan not that some portion or all of the deferred tax assets will not berealized.  Deferred tax assets andliabilities are adjusted for the effects of changes in tax laws and rates onthe date of enactment.  Realization ofdeferred tax assets is dependent upon sufficient future taxable income duringthe periods when deductible temporary differences and carryforwards are expectedto be available to reduce taxable income. The valuation allowance at January 3, 2004 principally relates tonet operating loss and tax credit carryforwards whose use is limited underSection 382 of the Internal Revenue Code.

 

**Stock-basedcompensation:**  The Company regularly grants options to itsemployees under various plans as described in Note 8 to the financialstatements.  As permitted underaccounting principles generally accepted in the United States of America, thesegrants are accounted for following APB Opinion No. 25 and related interpretations.  Accordingly, compensation cost would berecognized for those grants where the exercise price is less than the fairmarket value of the stock on the date of grant.  There was no compensation expense recorded for employee grantsfor the fiscal years 2003, 2002 and 2001.

 

TheCompany also grants options and warrants to nonemployees for goods and servicesand in conjunction with certain agreements. These grants are accounted for under FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, based on the grant date fair values.

 

**Recently IssuedAccounting Pronouncements**

** **

InJanuary 2003, the FASB issued FASB No. 148, *Accounting for Stock-Based Compensation– Transition and Disclosure*. This statement provided alternative methods of transition for avoluntary change to the fair value-based method of accounting for stock-basedemployee compensation.  In addition,this statement also amended the disclosure requirements of SFAS No. 123 torequire more prominent and frequent disclosures in the financial statementsabout the effects of stock-based compensation. The Company began applying disclosure provisions of this statement inits December 28, 2002 consolidated financial statements.  Because the Company continues to account foremployee stock-based compensation under APB Opinion No. 25, SFAS No. 148 had noeffect on the Company’s consolidated financial statements.

 

InJanuary 2003, the FASB issued Interpretation No. 45 (FIN 45),*Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*.  FIN 45**clarifiesthat a guarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing certainguarantees.  It also**elaborates on the disclosures in SFAS No.5, *Accounting for Contingencies,*which are to be made by a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it has issued,even when the likelihood of making any payments under the guarantees isremote.  The January 3, 2004,consolidated

 

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financialstatements have incorporated the enhanced disclosure requirements of FIN 45, aspresented in Note 1 to the financial statements under the caption “Productwarranty.”

 

InJanuary 2003, the FASB issued Interpretation No. 46 (FIN 46), *Consolidation of Variable Interest Entities* and its amendment (FIN 46R)*. *Thisinterpretation establishes standards for identifying a variable interest entityand for determining under what circumstances a variable interest entity shouldbe consolidated with its primary beneficiary. Until now, a company generally has included another entity in its consolidatedfinancial statements only if it controlled the entity through votinginterests.  FIN 46 changes that byrequiring a variable interest entity to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the variable interestentity’s activities or is entitled to receive a majority of the entity’sresidual returns or both.  FIN 46applies to the Company’s consolidated financial statements for the year endedJanuary 3, 2004.  The adoption ofthis pronouncement did not have a significant effect on the Company’sconsolidated financial statements.

 

TheFASB has issued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity*.  SFAS No. 150 requires that certainfreestanding financial instruments be reported as liabilities in the balancesheet.  Depending on the type offinancial instrument, it will be accounted for at either fair value or thepresent value of future cash flows determined at each balance sheet date withthe change in that value reported as interest expense in the statement ofoperations.  Prior to the application ofSFAS No. 150, either those financial instruments were not required to berecognized, or if recognized, were reported in the balance sheet as equity andchanges in the value of those instruments were normally not recognized in netincome.  The Company adopted SFAS No.150 for the year ended January 3, 2004 and it had no effect on reportedresults for that year.  The Company doesnot expect the application of SFAS No. 150 to have a material effect on itsfuture consolidated financial statements.

 

**REVENUES**

 

The Company’s total revenues for 2003 were $43,609,000 compared to$45,720,000 in 2002.

 

Retailrevenues increased to $34,805,000 in 2003 from $29,893,000 in 2002, an increaseof 16.4%. Same-store sales for 2003 (a sales comparison of six stores open thefull year in both 2003 and 2002) increased 24%.  The increase in retail revenues was primarily due to an increasein sales of new in-the-box product of approximately $5,000,000 due toadditional purchases of new product, offset slightly by a decrease inspecial-buy sales of approximately $500,000 as a result of opening two storesand closing one small store and one underperforming store during 2003 comparedto the same period in the previous year. Special-buy appliances include manufacturer closeouts, factory overruns,floor samples, returned or exchanged items and scratch and dent appliances.

 

In January 2003, the Company announced that it had entered into acontract with GE Consumer Products (GE) to purchase from GE and sell toconsumers special-buy GE appliances. There are no minimum purchase requirements.

 

TheCompany continues to purchase appliances from Whirlpool Corporation(Whirlpool), Maytag Corporation (Maytag), GE Corporation (GE) andFrigidaire.  There are no minimumpurchase requirements with any of these manufacturers.  The Company believes purchases fromthese four manufacturers will provide an adequate supply of high-qualityappliances for its retail outlets; however there is a risk that one or more ofthese sources could be lost.  Because ofthe large available supply of special-buy appliances from these manufacturersand the limited supply of used/refurbished appliances, the Company has decidednot to expand its used/refurbished appliance business.

 

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The Company operated nine retail stores atthe end of the current fiscal year and at the end of the previous fiscalyear.  In March 2002, the Companyopened a 30,000-square-foot store in the Columbus, Ohio, market.  In December 2002, the Company closed anunderperforming store in the Dayton, Ohio, market.  In February 2003, the Company closed a smaller store andopened a 33,000-square-foot store in the Minneapolis/Saint Paul market.  In March 2003, the Company closed anunderperforming store in the Dayton, Ohio, market.  In December 2003, the Company opened a 30,000-square-footstore in the Atlanta, Georgia, market.

 

Recycling revenues decreased to $8,014,000 in2003 from $14,625,000 in 2002.  Thedecrease was primarily due to an overall decrease in total recycling volumesfrom all the various recycling contracts in California of approximately$6,500,000.  Southern California EdisonCompany (Edison) accounted for approximately 9% of the Company’s total revenuesfor 2003 and 13% for 2002.  The Companyrecycled appliances during the first eight months of 2003 under an extension ofthe 2002 Statewide Residential Appliance Recycling Program, which wasadministered by Edison.  Recyclingservices for this statewide energy-efficiency program included customers ofEdison, Pacific Gas & Electric (PG&E) and San Diego Gas & Electric(SDG&E).  The Company wasresponsible for advertising in the PG&E and SDG&E service territoriesonly; Edison was responsible for advertising in the Edison area.  During the third quarter of 2003, theCompany was awarded a contract by Edison for the 2003 Statewide ResidentialAppliance Recycling Program in the territories served by Edison andSDG&E.  This contract endedDecember 31, 2003.  Under thiscontract, the Company was responsible for advertising in the SDG&E serviceterritory only; Edison was responsible for advertising in the Edison area.  In January 2004, the Company signed acontract with Edison to handle appliance recycling operations in Edison’sservice territory for the years of 2004 and 2005.  In March 2004, the Company signed a contract with SDG&Eto handle appliance recycling operations in SDG&E’s service territory for2004.  The Company is also aggressivelypursuing new appliance recycling programs in other states.

 

Inthe first quarter of 2002, the Company recycled appliances for Edison under anextension of Edison’s 2001 Residential Appliance Recycling Program.  In July 2002, the Company signed acontract in support of California’s Statewide Residential Appliance RecyclingProgram for 2002 to be administered by Edison. This contract was effective April 1, 2002 and endedDecember 31, 2002.  Recyclingservices for this statewide program included customers of Edison, PG&E andSDG&E.  The Company was responsiblefor advertising in the PG&E and SDG&E service territories only; Edisonwas responsible for advertising in the Edison area.

 

Duringthe first eight months of 2002, the Company was handling recycling operationsunder the Appliance Early Retirement and Recycling Program with the CaliforniaPublic Utilities Commission (CPUC). This refrigerator/freezer/room airconditioner recycling program included San Diego and surrounding areas; asix-county region in California’s Central Valley, including the cities ofFresno and Stockton; and the seven-county Bay area, including the city of SanFrancisco.  The CPUC accounted forapproximately 12% of the Company’s revenues in 2002.

 

Byproduct revenues decreased to $790,000 in 2003 from $1,202,000 in2002.  The decrease was primarily due toa decrease in the volume and price of CFCs of approximately $360,000 and volumeof scrap metal offset slightly by an increase in the price of scrap metal.

 

The Company’s total revenues for 2002 were $45,720,000 compared to$43,810,000 in 2001.

 

Retailrevenues increased to $29,893,000 in 2002 from $22,037,000 in 2001, an increaseof 35.6%. Same-store sales for 2002 (a sales comparison of five stores open thefull year in both 2002 and 2001) increased 12%.  The increase in retail revenues was primarily due to an increasein sales of new in-the-box

 

17

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product of approximately $5,500,000 due to additional purchases of newproduct and an increase in special-buy sales of approximately $2,300,000 as aresult of operating three additional stores during 2002 compared to the sameperiod in the previous year.  TheCompany purchased appliances from Whirlpool, Maytag and Frigidaire.

 

In October 2001, the Company entered into anagreement with Maytag Corporation for the acquisition of distressed appliances(Maytag Agreement).  Under the MaytagAgreement, there are no minimum purchase requirements.  The Maytag Agreement may be terminated by eitherparty upon 60 days’ written notice or may be terminated immediately if adefault is not cured within ten (10) days after notice of default.  In addition, the Company has agreed toindemnify Maytag for all claims, losses, product liability and expenses withrespect to Maytag appliances sold by the Company.

 

In December 2001, the Company announced that it will be purchasingappliances from Frigidaire.  There areno minimum purchase requirements.

 

TheCompany operated nine retail stores at both the end of 2002 and 2001.  During the first quarter of 2001, theCompany opened a 24,000-square-foot store in the Minneapolis/Saint Paul marketand a 42,000-square-foot store in the Dayton, Ohio, market.  In the second quarter of 2001, the Companyclosed a smaller store and opened a 32,000-square-foot store in the Columbus,Ohio, market.  In the fourth quarter of2001, the Company opened a 49,000-square-foot store in the Minneapolis/SaintPaul market.  In March 2002, theCompany opened a 30,000-square-foot store in the Columbus, Ohio, market.  In December 2002, the Company closed anunderperforming store in the Dayton, Ohio, market.

 

Recyclingrevenues decreased to $14,625,000 in 2002 from $20,506,000 in 2001.  The decrease was primarily due to an overalldecrease in total recycling volumes from all the various recycling contracts inCalifornia of approximately $6,000,000. Edison accounted for approximately 13% of the Company’s total revenuesfor 2002 and 29% for 2001.  In the firstquarter of 2002, the Company recycled appliances for Edison under an extensionof Edison’s 2001 Residential Appliance Recycling Program.  In July 2002, the Company signed acontract in support of California’s Statewide Residential Appliance RecyclingProgram for 2002 to be administered by Edison. This contract was effective April 1, 2002 and endedDecember 31, 2002.  Recyclingservices for this statewide program included customers of Edison, PG&E andSDG&E.  The Company was responsiblefor advertising in the PG&E and SDG&E service territories only; Edisonwas responsible for advertising in the Edison area.

 

In June 2001, the Company signed a contract (the Appliance EarlyRetirement and Recycling Program) with the CPUC to operate arefrigerator/freezer/room air conditioner recycling program in San Diego andsurrounding areas; a six-county region in California’s Central Valley,including the cities of Fresno and Stockton; and the seven-county Bay Area,including the city of San Francisco. The Company started taking customer orders for the Appliance EarlyRetirement and Recycling Program in San Diego in June 2001.  The CPUC budgeted $14 million to fund therecycling program.  The budgetallocation included $50 incentive payments to participants for refrigeratorsand freezers and $25 incentive payments for room air conditioners.  The program was completed August 31,2002.  The CPUC accounted forapproximately 12% of the Company’s total revenues in 2002 and 9% in 2001.

 

Byproduct revenues decreased to $1,202,000 in 2002 from $1,267,000 in2001.  The decrease was primarily due toa decrease in the volume and price of CFCs of approximately $200,000 offset byan increase in scrap metal revenues of approximately $140,000.

 

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**GROSS PROFIT**

 

TheCompany’s overall gross profit decreased to 27.2% in 2003 from 34.5% in2002.  The decrease was primarily due tolower recycling revenues and volumes related to the recycling programs and adecrease in gross margin in sales of special-buy appliances.  Gross profit as a percentage of totalrevenues for future periods can be affected favorably or unfavorably bynumerous factors, including the mix of retail products sold, the prices atwhich product is purchased from the four manufacturers, the volume ofappliances recycled from the 2004-2005 Edison contract and 2004 SDG&Econtract and the price and volume of byproduct revenues.  The Company expects gross profit percentagesto remain about the same for future periods.

 

The Company’s overall gross profit decreased to 34.5% in 2002 from39.6% in 2001.  The decrease wasprimarily due to lower recycling revenues and volumes related to the recyclingprograms, offset by slightly improved gross margins in sales of special-buyappliances.

 

**SELLING, GENERAL ANDADMINISTRATIVE EXPENSES**

 

Selling, general and administrative expenses were31.3% of total revenues in 2003 compared to 30.7% in 2002.  Selling, general and administrative expensesdecreased to $13,655,000 in 2003 from $14,032,000 in 2002, a 2.7%decrease.  Selling expenses increased to$8,210,000 in 2003 from $8,007,000 in 2002, a 2.5% increase.  The increase in selling expenses wasprimarily due to the expense of opening and operating two new stores during2003, offset by closing one smaller store and one underperforming store in 2003compared to 2002.  General andadministrative expenses decreased to $5,445,000 in 2003 from $6,025,000 in2002, a 9.6% decrease.  The decrease wasprimarily due to a decrease in administration costs as a result of an overalldecrease in recycling volumes.

 

Selling, general and administrative expenses were30.7% of total revenues in 2002 compared to 28.7% in 2001.  Selling, general and administrative expensesincreased to $14,032,000 in 2002 from $12,580,000 in 2001, an 11.5%increase.  Selling expenses increased to$8,007,000 in 2002 from $5,959,000 in 2001. The increase was primarily due to the expenses of opening an additionalretail store during 2002 and operating three additional stores in 2002 comparedto the previous year, which also increased advertising by $273,000 andcommissions by $201,000.  General andadministrative expenses decreased to $6,025,000 in 2002 from $6,621,000 in2001.  The decrease was primarily due toa decrease in administrative costs as a result of an overall decrease inrecycling volumes and a decrease in bad debt expense.

 

**INTEREST EXPENSE**

 

Interest expense decreased to $748,000 in 2003 from $1,236,000 in2002.  The decrease was due to a lowereffective rate on outstanding debt in 2003 as compared to 2002 as a result ofrefinancing the debt in 2002 on the two company-owned buildings, offset by aminimum interest amount on the line of credit.

 

Interest expense increased to $1,236,000 in 2002 from $1,074,000 in2001.  The increase was primarily due toa one-time write-off of deferred financing fees and debt discount related to apay down of long-term debt and a higher effective interest rate as a result ofa higher minimum interest amount on the line of credit, offset by a loweraverage borrowed amount.

 

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**INCOMETAXES AND NET OPERATING LOSSES**

** **

The Company recorded a benefit for income taxes of $976,000 for 2003compared to a provision for income taxes of $221,000 in 2002.  The change was due to both a pretax lossversus pretax income and a slightly lower effective tax rate resulting from nobenefit being attributable to 2003 state tax losses.

 

The Company had net operating loss carryovers and credit carryforwardsof approximately $7 million at January 3, 2004, which may be available toreduce taxable income and therefore income taxes payable in future years.  However, future utilization of these lossand credit carryforwards is subject to certain significant limitations underprovisions of the Internal Revenue Code including limitations subject toSection 382, which relate to a 50 percent change in control over athree-year period, and are further dependent upon the Company maintainingprofitable operations.  The Companybelieves that the issuance of Common Stock during 1999 resulted in an“ownership change” under Section 382. Accordingly, the Company’s ability to use net operating losscarryforwards generated prior to February 1999 may be limited toapproximately $56,000 per year, or less than $1 million through 2018.

 

As of its 2003 and 2002 year-ends, the Company had recorded cumulativevaluation allowances of $3,072,000 and $2,998,000 against its net deferred taxassets due to the uncertainty of their realization.  The realization of deferred tax assets is dependent upon sufficientfuture taxable income during the periods when deductible temporary differencesand carryforwards are expected to be available to reduce taxable income.  At January 3, 2004, the remainingvaluation allowance is principally due to the Section 382 limitation ofits net operating losses (NOLs) and tax credits.

 

**LIQUIDITY AND CAPITALRESOURCES**

 

AtJanuary 3, 2004, the Company had working capital of $3,446,000 compared to$5,003,000 at December 28, 2002. Cash and cash equivalents decreased to $1,196,000 at January 3,2004 from $2,802,000 at December 28, 2002.  Net cash used in operating activities was $2,391,000 in 2003compared to net cash provided by operating activities of $3,307,000 in 2002.  The cash used in operating activities wasprimarily due to the net loss plus an increase in receivables and inventories,offset by an increase in accounts payable. During 2003, inventories increased by $1,022,000 principally due to moreand larger stores and increased retail sales and receivables increased $758,000principally due to the timing of receivables related to recycling contracts.

 

Net cash used in investing activities was $558,000 in 2003 compared to$498,000 in 2002.  The 2003 capitalexpenditures were primarily related to continued software development andbuilding improvements.  The cash used ininvesting activities in 2002 was primarily related to leasehold improvementsfor new stores, offset by the proceeds of disposal of certain equipment.  The Company did not have any materialpurchase commitments for assets as of January 3, 2004.

 

Net cash provided by financing activities was $1,343,000 in 2003compared to net cash used in financing activities of $513,000 in 2002.  The cash provided by financing activitieswas primarily due to increased borrowings under the line of credit in 2003.

 

As of January 3, 2004, the Company had a $10,000,000 line ofcredit with a lender.  The interest rateas of January 3, 2004 was 5.50%. The amount of borrowings available under the line of credit is based ona formula using receivables and inventories. The line of credit has a stated maturity date of August 30, 2004,if not renewed, and provides that the lender may demand payment in full of theentire outstanding balance of the loan at any time.  The line of credit is secured by substantially all the Company’sassets and requires minimum monthly interest payments of $37,500, regardless ofthe outstanding principal balance.

 

20

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The lender is also secured by an inventory repurchase agreement withWhirlpool Corporation for purchases from Whirlpool only.  The line requires that the Company meetcertain financial covenants, provides payment penalties for noncompliance andprepayment, limits the amount of other debt the Company can incur, limits theamount of spending on fixed assets, and limits payments of dividends.  The Company’s unused borrowing capacity was$355,000 at January 3, 2004.

 

A summary of the Company’s contractual cash obligations atJanuary 3, 2004 is as follows:

 
| **Contractual  Cash  Obligations** |      | **Cash  payments due by period** |       |
|------------------------------------|-----------|----------------------------------|------------|
|                               |      |                             |       |   |   |   |   |   |   |   |   |   | **2009 and  Thereafter** |   |
|                               | **Total** |                             | **2004**   |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   |   |
| Long-term debt, including interest |      | $                                | 7,640,000  |   | $ | 506,000 |   | $ | 546,000 |   | $ | 454,000 |   | $ | 448,000 |   | $ | 448,000 |   | $ | 5,238,000 |   |
| Operating leases                   |      | $                                | 6,086,000  |   | $ | 1,959,000 |   | $ | 1,812,000 |   | $ | 1,131,000 |   | $ | 742,000 |   | $ | 416,000 |   | $ | 26,000 |   |
| Total contractual cash obligations |      | $                                | 13,726,000 |   | $ | 2,465,000 |   | $ | 2,358,000 |   | $ | 1,585,000 |   | $ | 1,190,000 |   | $ | 864,000 |   | $ | 5,264,000 |   |

 

The Company also has a commercial commitment as described below:

 
| **Other Commercial  Commitment** |   | **Total  Amount  Committed** |       | **Outstanding  at 01/03/04** |   | **Date of  Expiration** |   |
|----------------------------------|--------|------------------------------|------------|------------------------------|--------|-------------------------|--------|
| Line of credit                   |   | $                            | 10,000,000 |                         | $      | 5,089,000               |   | August 30, 2004 |   |
|                                  |        |                              |            |                              |        |                         |        |  |  |

 

The Company believes that its cash balance, availability under theCompany’s line of credit, if needed, and anticipated cash flows from operationswill be adequate to fund cash requirements for fiscal 2004.

 

In June 2001, theCompany signed a contract (the Appliance Early Retirement and RecyclingProgram) with the CPUC to operate a refrigerator/freezer/room air conditionerrecycling program in San Diego and surrounding areas; a six-county region inCalifornia’s Central Valley, including the cities of Fresno and Stockton; andthe seven-county Bay Area, including the city of San Francisco.  The Company started taking customer ordersfor the Appliance Early Retirement and Recycling Program in San Diego inJune.  The CPUC budgeted $14 million tofund the recycling program.  The budgetallocation included $50 incentive payments to participants for refrigeratorsand freezers and $25 incentive payments for room air conditioners.  The program was completed August 31,2002.

 

InJuly 2002, the Company signed a contract in support of California’sStatewide Residential Appliance Recycling Program to be administered byEdison.  This contract was effectiveApril 1, 2002 and continued until December 31, 2002.  Recycling services for this statewideprogram included customers of Edison, PG&E and SDG&E.  The Company was responsible for advertisingin the PG&E and SDG&E service territories only; Edison was responsiblefor advertising in the Edison area.

 

In September 2002, the Company refinanced its building in St.Louis Park, Minnesota, and used the proceeds to pay down long-term debt.  The new long-term debt was for$3,470,000.  The terms include a

 

21

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20-year amortization, a 10-year balloon and a variable interest ratebased on the 30-day LIBOR rate.  Theinterest rate as of January 3, 2004 was 3.8214% and as ofDecember 28, 2002 was 4.5191%.

 

In December 2002, the Company refinanced its building in Compton,California.  The proceeds were includedin cash.  The new long-term debt was for$2,000,000.  The terms include a 20-yearamortization, a 10-year balloon and an interest rate of 6.85%.

 

In September 2003, the Company signed a contract with Edison tosupport the 2003 Statewide Residential Appliance Recycling Program in theterritories served by Edison and SDG&E. Since January 2003, the Company had handled appliance recyclingoperations for this energy conservation initiative under an extension of the2002 program.  The 2003 program ranthrough December 31, 2003.

 

In January 2004, the Company signed a contract with Edison tohandle appliance recycling operations in Edison’s service territory for 2004and 2005.

 

In March 2004, the Company signed a contract with SDG&E tohandle appliance recycling operations in SDG&E’s service territory for2004.

 

The Company believes, based on the anticipatedrevenues from the 2004-2005 Statewide Residential Appliance Recycling Programcontract with Edison, the 2004 Statewide Appliance Recycling Program withSDG&E, the anticipated sales per retail store and its anticipated grossprofit, that its cash balance, anticipated funds generated from operations andits current line of credit, if renewed, will be sufficient to finance itsoperations and capital expenditures through December 2004.  The Company’s total capital requirements for2004 will depend upon, among other things as discussed below, the recyclingvolumes generated from the Statewide Residential Appliance Recycling Programsin 2004 and the number and size of retail stores operating during the fiscalyear.  Currently, the Company has threecenters and nine stores in operation. If revenues are lower than anticipated or expenses are higher thananticipated, the Company may require additional capital to finance operations.  Sources of additional financing, if neededin the future, may include further debt financing or the sale of equity (commonor preferred stock) or other securities. There can be no assurance that such additional sources of financing willbe available on terms satisfactory to the Company or permitted by the Company’scurrent lender.

 

**FORWARD-LOOKINGSTATEMENTS**

 

Statements contained in this annual report regarding the Company’sfuture operations, performance and results, and anticipated liquidity discussedherein are forward-looking and therefore are subject to certain risks anduncertainties, including, but not limited to, those discussed herein.  Any forward-looking information regardingthe operations of the Company will be affected primarily by the Company’s continuedability to purchase product from Whirlpool, Maytag, Frigidaire and GE atacceptable prices, the ability and timing of Edison to deliver units under its2004-2005 Statewide Residential Appliance Recycling Program contract, and theability and timing of SDG&E to deliver units under its 2004 StatewideAppliance Recycling Program contract, with the Company.  In addition, any forward-looking informationwill also be affected by the ability of individual retail stores to meetplanned revenue levels, the rate of sustainable growth in the number of retailstores, the speed at which individual retail stores reach profitability, costsand expenses being realized at higher than expected levels, the Company’sability to secure an adequate supply of special-buy appliances for resale, andthe continued availability of the Company’s current line of credit.

 

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**ITEM 7A.****                    QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

**MARKET RISK AND IMPACT OFINFLATION**

** **

The Company does notbelieve there is any significant risk related to interest rate fluctuations onthe long-term fixed rate debt.  However,there are interest rate risks on the line of credit, since its interest ratefloats with prime, and on approximately $3,300,000 in long-term debt enteredinto in September 2002, since its interest rate is based on the 30-dayLIBOR rate.  Also, the Company believesthat inflation has not had a material impact on the results of operations foreach of the fiscal years in the three-year period ended January 3,2004.  However, there can be noassurance that future inflation will not have an adverse impact on theCompany’s operating results and financial conditions.

 

**ITEM 8.****                             FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 
| **Description**                                                                                      |   |
|------------------------------------------------------------------------------------------------------|--------|
|                                                                                                 |   |
| Independent Auditor’s  Report                                                                   |   |
| Consolidated Balance Sheet  as of January 3, 2004 and December 28, 2002                    |   |
| Consolidated  Statement of Operations for the three years ended January 3, 2004                 |   |
| Consolidated  Statement of Shareholders’ Equity for the three years ended January 3,  2004 |   |
| Consolidated  Statement of Cash Flows for the three years ended January 3, 2004                 |   |
| Notes to  Consolidated Financial Statements                                                          |   |

 

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INDEPENDENT AUDITOR’SREPORT

 

To the Board of Directorsand Shareholders

Appliance RecyclingCenters of America, Inc.

Minneapolis, Minnesota

 

We have audited theaccompanying consolidated balance sheet of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries as of January 3, 2004 and December 28,2002, and the related consolidated statements of operations, shareholders’equity, and cash flows for each of the years in the three year period endedJanuary 3, 2004.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America.  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries as of January 3, 2004 and December 28,2002, and the results of their operations and their cash flows for each of theyears in the three year period ended January 3, 2004, in conformity withaccounting principles generally accepted in the United States of America.

 

 

McGLADREY & PULLEN,LLP

 

 

Minneapolis, Minnesota

February 17, 2004

 

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**APPLIANCE RECYCLING CENTERS OFAMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEET**

 
|                                                                                                                            |   | **January 3,  2004** |           | **December 28,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------|----------------|-----------------------------|--------|
| **ASSETS (Note 3)**                                                                                                             |   |                      |           |                        |   |
|                                                                                                                            |   |                      |           |                        |   |
| **Current Assets**                                                                                                              |   |                      | ** **     |                        |   |
| Cash                                                                                                                            |   | **$**                     | **1,196,000**  | ** **                  | $      | 2,802,000 |   |
| Accounts  receivable, net of allowance of $117,000 and $26,000,respectively (Note 9)                                            |   | **1,887,000**             | ** **     | 1,129,000                   |   |
| Inventories,  net of reserves of $324,000 and $548,000, respectively                                                            |   | **9,338,000**             | ** **     | 8,316,000                   |   |
| Refundable  income taxes                                                                                                        |   | **904,000**               | ** **     | 523,000                     |   |
| Deferred  income taxes (Note 7)                                                                                                 |   | **566,000**               | ** **     | 490,000                     |   |
| Other  current assets                                                                                                           |   | **521,000**               | ** **     | 448,000                     |   |
| Total  current assets                                                                                                           |   | **14,412,000**            | ** **     | 13,708,000                  |   |
| **Property and Equipment,** at cost (Notes 2  and 4)                                                                            |   |                      | ** **     |                        |   |
| Land                                                                                                                            |   | **2,050,000**             | ** **     | 2,050,000                   |   |
| Buildings  and improvements                                                                                                     |   | **4,090,000**             | ** **     | 3,945,000                   |   |
| Equipment                                                                                                                       |   | **5,359,000**             | ** **     | 4,979,000                   |   |
|                                                                                                                            |   | **11,499,000**            |           | 10,974,000                  |   |
| Less  accumulated depreciation                                                                                                  |   | **5,321,000**             | ** **     | 4,763,000                   |   |
| Net  property and equipment                                                                                                     |   | **6,178,000**             | ** **     | 6,211,000                   |   |
| **Other Assets**                                                                                                                |   | **243,000**               | ** **     | 320,000                     |   |
| Total  assets                                                                                                                   |   | **$**                     | **20,833,000** | ** **                  | $      | 20,239,000 |   |
|                                                                                                                            |   |                      |           |                        |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                   |   |                      | ** **     |                        |   |
|                                                                                                                            |   |                      |           |                        |   |
| **Current Liabilities**                                                                                                         |   |                      | ** **     |                        |   |
| Line  of credit (Note 3)                                                                                                        |   | **$**                     | **5,089,000**  | ** **                  | $      | 3,515,000 |   |
| Current  maturities of long-term obligations                                                                                    |   | **240,000**               | ** **     | 259,000                     |   |
| Accounts  payable                                                                                                               |   | **2,958,000**             | ** **     | 2,929,000                   |   |
| Accrued  expenses (Note 5)                                                                                                      |   | **2,019,000**             | ** **     | 1,273,000                   |   |
| Income  taxes payable                                                                                                           |   | **660,000**               | ** **     | 729,000                     |   |
| Total  current liabilities                                                                                                      |   | **10,966,000**            | ** **     | 8,705,000                   |   |
| **Long-Term Obligations,** less current  maturities (Note 4)                                                                    |   | **5,209,000**             | ** **     | 5,424,000                   |   |
| **Deferred  Income Tax Liabilities** (Note 7)                                                                                   |   | **449,000**               | ** **     | 373,000                     |   |
| Total  liabilities                                                                                                              |   | **16,624,000**            | ** **     | 14,502,000                  |   |
| **Commitments** (Note 6)                                                                                                        |   |                      | ** **     |                        |   |
| **Shareholders’ Equity** (Note 8)                                                                                          |   |                      | ** **     |                        |   |
| Common  Stock, no par value; authorized 10,000,000 shares; issued  and outstanding 2,364,000 and 2,324,000 shares, respectively |   | **11,381,000**            | ** **     | 11,368,000                  |   |
| Accumulated  deficit                                                                                                            |   | **(7,172,000**            | **)**          | (5,631,000                  | )      |
| Total  shareholders’ equity                                                                                                |   | **4,209,000**             | ** **     | 5,737,000                   |   |
| Total  liabilities and shareholders’ equity                                                                                |   | **$**                     | **20,833,000** | ** **                  | $      | 20,239,000 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

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**APPLIANCE RECYCLING CENTERS OFAMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF OPERATIONS**

 
|                                                       |   | **For the  fiscal year ended** |           |
|------------------------------------------------------------|--------|--------------------------------|----------------|
|                                                       |   | **January 3,  2004**      |           | **December 28,  2002** |   | **December 29,  2001** |   |
| **Revenues**  (Note 9)                                     |   |                           | ** **     |   |   |   |   |
| Retail                                                     |   | **$**                          | **34,805,000** | ** ** | $ | 29,893,000 |   | $ | 22,037,000 |   |
| Recycling                                                  |   | **8,014,000**                  | ** **     | 14,625,000 |   | 20,506,000 |   |
| Byproduct                                                  |   | **790,000**                    | ** **     | 1,202,000 |   | 1,267,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| Total  revenues                                            |   | **43,609,000**                 | ** **     | 45,720,000 |   | 43,810,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Cost  of Revenues**(Note 9)                              |   | **31,730,000**                 | ** **     | 29,946,000 |   | 26,481,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| Gross  profit                                              |   | **11,879,000**                 | ** **     | 15,774,000 |   | 17,329,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Selling,  General and Administrative Expenses** (Note 2) |   | **13,655,000**                 | ** **     | 14,032,000 |   | 12,580,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| Operating  income (loss)                                   |   | **(1,776,000**                 | **)**          | 1,742,000 |   | 4,749,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Other  Income (Expense)**                                |   |                           | ** **     |   |   |   |   |
| Other  income (expense)                                    |   | **(5,000**                     | **)**          | 47,000 |   | 88,000 |   |
| Interest  income                                           |   | **12,000**                     | ** **     | **—** | ** ** | **—** | ** ** |
| Interest  expense                                          |   | **(748,000**                   | **)**          | (1,236,000 | ) | (1,074,000 | ) |
|                                                       |   |                           |           |   |   |   |   |
| Income  (loss) before provision (benefit) for income taxes |   | **(2,517,000**                 | **)**          | 553,000 |   | 3,763,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Provision  (Benefit) for Income Taxes** (Note 7)         |   | **(976,000**                   | **)**          | 221,000 |   | 1,117,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| Net  income (loss)                                         |   | **$**                          | **(1,541,000** | **)** | $ | 332,000 |   | $ | 2,646,000 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Basic  Earnings (Loss) per Common Share**                |   | **$**                          | **(0.66**      | **)** | $ | 0.14 |   | $ | 1.15 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Diluted  Earnings (Loss) per Common Share**              |   | **$**                          | **(0.66**      | **)** | $ | 0.11 |   | $ | 0.86 |   |
|                                                       |   |                           |           |   |   |   |   |
| **Weighted  Average Number of Common Shares Outstanding:** |   |                           | ** **     |   |   |   |   |
| Basic                                                      |   | **2,343,000**                  | ** **     | 2,320,000 |   | 2,291,000 |   |
| Diluted                                                    |   | **2,343,000**                  | ** **     | 3,025,000 |   | 3,068,000 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ EQUITY**

 
|                                |   | **Common  Stock** |       | **Accumulated  Deficit** |   | **Total**  |   |
|-------------------------------------|--------|-------------------|------------|--------------------------|--------|------------|--------|
|                                |   |              |       |                     |   |       |   |
| **Balance, December 30, 2000** |   | $                 | 11,360,000 |                     | $      | (8,609,000 | )      | $ | 2,751,000 |   |
| Net  income                         |   | —            |       | 2,646,000                |   | 2,646,000  |   |
|                                |   |              |       |                     |   |       |   |
| **Balance, December 29, 2001** |   | 11,360,000        |       | (5,963,000               | )      | 5,397,000  |   |
| Exercise  of stock options (Note 8) |   | 8,000             |       | —                   |   | 8,000      |   |
| Net  income                         |   | —            |       | 332,000                  |   | 332,000    |   |
|                                |   |              |       |                     |   |       |   |
| **Balance, December 28, 2002** |   | 11,368,000        |       | (5,631,000               | )      | 5,737,000  |   |
| Exercise  of warrants (Note 8)      |   | 13,000            |       | —                   |   | 13,000     |   |
| Net  loss                           |   | —            |       | (1,541,000               | )      | (1,541,000 | )      |
|                                |   |              |       |                     |   |       |   |
| **Balance,  January 3, 2004**  |   | $                 | 11,381,000 |                     | $      | (7,172,000 | )      | $ | 4,209,000 |   |

 

See Notes to Consolidated Financial Statements.

 

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

 
|                                                                                                 |   | **For the  fiscal year ended** |           |
|------------------------------------------------------------------------------------------------------|--------|--------------------------------|----------------|
|                                                                                                 |   | **January 3,  2004**      |           | **December 28,  2002** |   | **December 29,  2001** |   |
| **Cash  Flows from Operating Activities**                                                            |   |                           | ** **     |   |   |   |   |
| Net  income (loss)                                                                                   |   | **$**                          | **(1,541,000** | **)** | $ | 332,000 |   | $ | 2,646,000 |   |
| Adjustments  to reconcile net income (loss) to net cash  provided by (used in) operating activities: |   |                           | ** **     |   |   |   |   |
| Depreciation  and amortization                                                                       |   | **611,000**                    | ** **     | 507,000 |   | 483,000 |   |
| Write-off  of deferred financing fees and debt discount                                              |   | —                         | ** **     | 258,000 |   | — |   |
| (Gain)  loss on sale of property and equipment                                                       |   | **5,000**                      | ** **     | 7,000 |   | (60,000 | ) |
| Accretion  of long-term debt discount                                                                |   | —                         | ** **     | 46,000 |   | 43,000 |   |
| Deferred  income taxes                                                                               |   | —                         | ** **     | 391,000 |   | (400,000 | ) |
| Change  in assets and liabilities:                                                                   |   |                           | ** **     |   |   |   |   |
| Receivables                                                                                          |   | **(758,000**                   | **)**          | 3,246,000 |   | (2,644,000 | ) |
| Inventories                                                                                          |   | **(1,022,000**                 | **)**          | (1,568,000 | ) | (2,515,000 | ) |
| Other  assets                                                                                        |   | **(11,000**                    | **)**          | (238,000 | ) | (27,000 | ) |
| Accounts  payable and accrued expenses                                                               |   | **775,000**                    | ** **     | 877,000 |   | 1,110,000 |   |
| Income  taxes refundable or payable                                                                  |   | **(450,000**                   | **)**          | (551,000 | ) | 240,000 |   |
| Net  cash provided by (used in) operating activities                                                 |   | **(2,391,000**                 | **)**          | 3,307,000 |   | (1,124,000 | ) |
|                                                                                                 |   |                           |           |   |   |   |   |
| **Cash Flows from Investing Activities**                                                             |   |                           | ** **     |   | ** ** |   | ** ** |
| Purchases  of property and equipment                                                                 |   | **(558,000**                   | **)**          | (598,000 | ) | (910,000 | ) |
| Proceeds  from disposals of property and equipment                                                   |   | —                         | ** **     | 100,000 |   | — |   |
| Net  cash used in investing activities                                                               |   | **(558,000**                   | **)**          | (498,000 | ) | (910,000 | ) |
|                                                                                                 |   |                           |           |   |   |   |   |
| **Cash Flows from Financing Activities**                                                             |   |                           | ** **     |   | ** ** |   | ** ** |
| Net  borrowings (payments) under line of credit                                                      |   | **1,574,000**                  | ** **     | (1,193,000 | ) | 2,306,000 |   |
| Payments  on long-term obligations                                                                   |   | **(244,000**                   | **)**          | (4,648,000 | ) | (350,000 | ) |
| Proceeds  from long-term obligations                                                                 |   | —                         | ** **     | 5,470,000 |   | 282,000 |   |
| Payments  of deferred financing fees                                                                 |   | —                         | ** **     | (150,000 | ) | — |   |
| Proceeds  from issuance of Common Stock                                                              |   | **13,000**                     | ** **     | 8,000 |   | — |   |
| Net  cash provided by (used in) financing activities                                                 |   | **1,343,000**                  | ** **     | (513,000 | ) | 2,238,000 |   |
|                                                                                                 |   |                           |           |   |   |   |   |
| Increase  (decrease) in cash and cash equivalents                                                    |   | **(1,606,000**                 | **)**          | 2,296,000 |   | 204,000 |   |
|                                                                                                 |   |                           |           |   |   |   |   |
| **Cash  and Cash Equivalents**                                                                       |   |                           | ** **     |   |   |   |   |
| Beginning                                                                                            |   | **2,802,000**                  | ** **     | 506,000 |   | 302,000 |   |
| Ending                                                                                               |   | **$**                          | **1,196,000**  | ** ** | $ | 2,802,000 |   | $ | 506,000 |   |
|                                                                                                 |   |                           |           |   |   |   |   |
| **Supplemental  Disclosures of Cash Flow Information**                                               |   |                           | ** **     |   |   |   |   |
| Cash  payments (receipts) relative to:                                                               |   |                           | ** **     |   |   |   |   |
| Interest                                                                                             |   | **$**                          | **748,000**    | ** ** | $ | 1,056,000 |   | $ | 1,031,000 |   |
| Income  taxes, net                                                                                   |   | **(527,000**                   | **)**          | 439,000 |   | 279,000 |   |
|                                                                                                 |   |                           |           |   |   |   |   |
| Equipment  acquired under capital lease                                                              |   | **$**                          | **10,000**     | ** ** | $ | — |   | $ | — |   |

 

See Notes to Consolidated Financial Statements.

 

28

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1.****          Natureof Business and Significant Accounting Policies**

 

**Nature of business: **ApplianceRecycling Centers of America, Inc. and Subsidiaries (Company) are in thebusiness of providing reverse logistics, energy conservation and recyclingservices for major household appliances. The Company sells appliances through a chain of Company-owned factoryoutlet stores under the name ApplianceSmart®.  The Company also provides recycling serviceson a credit basis to appliance retailers, electric utilities, waste managementcompanies and local governments.

 

**A summary of the Company’s significant accounting policies isas follows:**

 

**Principles of consolidation:**  The consolidated financial statementsinclude the accounts of Appliance Recycling Centers of America, Inc. and itssubsidiaries.  All significantintercompany accounts and transactions have been eliminated in consolidation.

 

During the second quarterof 2003, the Company became a majority (60%) owner in North America ApplianceCompany, LLC (NAACO).  NAACO was formedand commenced operations in June 2003 and is a retailer of special-buyappliances in Texas.  Because NAACO hasa net shareholder’s deficit, no minority interest has been recognized on theCompany’s consolidated balance sheet and 100% of NAACO’s operations areincluded in the Company’s consolidated financial statements as ofJanuary 3, 2004.

 

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

 

**Cash equivalents, accounts receivableand accounts payable:** Due to their nature and short-term maturities, the carrying amountsapproximate fair value.

 

**Short- and long-term debt:**  The fair value of short- and long-term debthas been estimated based on discounted cash flows using interest rates beingoffered for similar debt having the same or similar remaining maturities andcollateral requirements.

 

No separate comparison offair values versus carrying values is presented for the aforementionedfinancial instruments since their fair values are not significantly differentthan their balance sheet carrying amounts. In addition, the aggregate fair values of the financial instrumentswould not represent the underlying value of the Company.

 

**Fiscal year:**  The Company uses a 52-53 week fiscal year.  The Company’s 2003 fiscal year (2003) endedJanuary 3, 2004, its 2002 fiscal year (2002) ended December 28, 2002and its 2001 fiscal year (2001) ended December 29, 2001.  The 2003 fiscal year contains 53 weeks.  The 2002 and 2001 fiscal years contain 52weeks.

 

**Revenue recognition:**  The Company recognizes revenue fromappliance sales in the period the appliances are purchased and paid for by theconsumer.  Revenue from appliancerecycling is recognized when a unit is collected and processed.  Byproduct revenue is recognized uponshipment.

 

The Company defersrevenue under certain appliance extended warranty arrangements it services andrecognizes the revenue over the related terms of the warranty contracts.  On extended warranty arrangements sold bythe Company but serviced by others for a fixed portion of the warranty salesprice, the Company recognizes revenue for the net amount retained at the timeof sale of the extended warranty to the consumer.

 

Shipping and handlingcharges to customers are included in revenues. Shipping and handling costs incurred by the Company are included in costof revenues.

 

**Product warranty:**  The Company provides a warranty for the replacement or repair ofcertain defective units.  The Company’sstandard warranty policy requires the Company to repair or replace certaindefective units at no cost to its customers. The Company estimates the costs that may be incurred under its warrantyand records a liability reserve in the amount of such costs at the time productrevenue is recognized.  Factors thataffect the Company’s warranty liability reserve for covered units include thenumber of units sold, historical and anticipated rates of warranty claims onthese units, and the cost of such claims. The Company periodically assesses the adequacy of its recorded warrantyliability reserve and adjusts the amounts as necessary.

 

29

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Changes in the Company’swarranty liability reserve are as follows:

 
|                                  |   | **2003**     |       | **2002**   |   | **2001** |   |
|---------------------------------------|--------|--------------|------------|------------|--------|----------|--------|
| Balance,  beginning                   |   | **$**        | **82,000** | ** ** | $      | 187,000  |   | $ | 106,000 |   |
|                                  |   |         | ** ** |       |   |     |   |
| Standard  accrual based on units sold |   | **164,000**  | ** ** | 203,000    |   | 301,000  |   |
| Actual  costs incurred                |   | **(133,000** | **)**      | (134,000   | )      | (253,000 | )      |
| Periodic  accrual adjustments         |   | **(59,000**  | **)**      | (174,000   | )      | 33,000   |   |
| Balance,  ending                      |   | **$**        | **54,000** | ** ** | $      | 82,000   |   | $ | 187,000 |   |

 

**Trade receivables: **Tradereceivables are carried at original invoice amount less an estimate made fordoubtful receivables based on a review of all outstanding amounts on a monthlybasis.  Management determines theallowance for doubtful accounts by regularly evaluating individual customerreceivables and considering a customer’s financial condition, credit history,and current economic conditions.  Tradereceivables are written off when deemed uncollectible. Recoveries of tradereceivables previously written off are recorded when received.  A trade receivable is considered to be pastdue if any portion of the receivable balance is outstanding for more than 90days.  The reserve for doubtful accountsof $117,000 is considered by management to be adequate to cover any exposure toloss in the Company’s January 3, 2004 accounts receivable.

 

**Cash:** The Company maintains its cash in bank deposit and money-market accountswhich, at times, exceed federally insured limits.  The Company has not experienced any losses in such accounts.

 

**Inventories:**  Inventories, consisting principally of appliances, are stated atthe lower of cost, first-in, first-out (FIFO), or market and consist of:

 
|                                  |   | **2003**     |          | **2002**   |   |
|---------------------------------------|--------|--------------|---------------|------------|--------|
| Finished  goods                       |   | **$**        | **9,662,000** | ** ** | $      | 8,596,000 |   |
| Work-in-process-  unrefurbished units |   | **—**   | ** **    | 268,000    |   |
| Less  reserves                        |   | **(324,000** | **)**         | (548,000   | )      |
|                                  |   | **$**        | **9,338,000** |       | $      | 8,316,000 |   |

 

The Company providesestimated reserves for the realizability of its appliance inventories,including adjustments to market, based on various factors including the age ofsuch inventory and management’s assessment of the need for suchallowances.  Management looks athistorical inventory agings and margin analysis in determining its reserveestimate.  The Company believes thereserve of $324,000 as of January 3, 2004 is adequate.  Because of a decrease in volume and a changein business, unrefurbished units are no longer valued in inventory.

 

**Property and equipment:**  Depreciation is computed using straight-lineand accelerated methods over the following estimated useful lives:

 
|                        |   | **Years** |   |
|-----------------------------|--------|-----------|--------|
| Buildings  and improvements |   | 18 - 30   |   |
| Equipment                   |   | 3 - 8     |   |

 

**Softwaredevelopment costs:** The Company capitalizes software developed for internal use inaccordance with Statement of Position 98-1 and is amortizing such costs overtheir estimated useful life of five years. Costs capitalized were $255,000, $221,000, and $225,000 for the fiscalyears of 2003, 2002 and 2001, respectively. Amortization expense on software development costs was $164,000,$119,000 and $78,000 for the fiscal years of 2003, 2002 and 2001,respectively.  Estimated amortizationexpenses are $216,000, $240,000, $207,000, $159,000 and $113,000 for the fiscalyears 2004, 2005, 2006, 2007 and 2008, respectively.

 

**Accounting for long-lived assets: **Long-lived assets such as property andequipment are evaluated for impairment whenever events or changes incircumstances indicate the carrying value of an asset may not be recoverable inaccordance with SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*.  TheCompany assesses the fair value of the assets based on the estimated future netundiscounted cash flows expected to result from the use of the assets,including cash flows from disposition. Should the sum of the expected future net cash flows be less than thecarrying value, the Company recognizes an impairment loss at that time.  An impairment loss is measured by comparingthe amount by which the carrying value exceeds the fair value (estimateddiscounted future cash flows or appraisal of assets) of the long-livedassets.  The Company wrote offapproximately $26,000 of leasehold improvements due to the closing of a retail storein the fiscal year ending January 3, 2004.  Also see Note 2.

 

**Deferredfinancing fees:** Deferred financing fees are presented in the consolidated balance sheetas a component of other assets and are reported net of accumulatedamortization.  Amortization expense isdetermined on a straight-line basis over the term of the underlying debt.

 

**Advertising expense: **Advertisingis expensed as incurred, and was $1,545,000, $1,823,000 and $1,487,000 for the2003, 2002 and 2001 fiscal years, respectively.

 

**Income taxes:**  Deferred taxes are provided on an asset and liability methodwhereby deferred tax assets are recognized for deductible temporary differencesand operating loss and tax credit carryforwards, and deferred tax liabilitiesare recognized for taxable temporary differences.  Temporary differences are the differences between the reportedamounts of assets and liabilities and their tax basis.  Deferred tax

 

30

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assets are reduced by avaluation allowance when, in the opinion of management, it is more likely thannot that some portion or all of the deferred tax assets will not berealized.  Deferred tax assets andliabilities are adjusted for the effects of changes in tax laws and rates onthe date of enactment.  Realization ofdeferred tax assets is dependent upon sufficient future taxable income duringthe periods when deductible temporary differences and carryforwards areexpected to be available to reduce taxable income.  At January 3, 2004 a valuation allowance of $3,072,000 hasbeen recorded against deferred tax assets principally relating to net operatingloss and tax credit carryforwards, the use of which is limited underSection 382 of the Internal Revenue Code.

 

**Basic and diluted net earnings per share:**  Basic per-share amounts are computed,generally, by dividing net income or loss by the weighted-average number ofcommon shares outstanding.  Dilutedper-share amounts assume the conversion, exercise or issuance of all potentialcommon stock instruments unless their effect is antidilutive, thereby reducingthe loss or increasing the income per common share.

 

In arriving at dilutedweighted-average shares and per-share amounts, options and warrants (see Note8) with exercise prices below average market prices, for the respective fiscalquarters in which they were dilutive, were included using the treasury stockmethod.  The number of additional shareswas calculated by assuming the outstanding stock options and warrants wereexercised and that the proceeds from such exercises were used to acquire CommonStock at the average market price during the year.  The dilutive effect of these additional shares for the fiscalyears of 2002 and 2001 was to increase the weighted average shares outstandingby 705,000 and 777,000, respectively. Because the effect of options and warrants on 2003 is antidilutive, theywere not included in the computation of per-share amounts.

 

**Stock-based compensation:**  The Company regularly grants options to itsemployees under various plans as described in Note 8.  As permitted under accounting principles generally accepted inthe United States of America, these grants are accounted for following APBOpinion No. 25 and related interpretations. Accordingly, compensation cost would be recognized for those grantswhere the exercise price is less than the fair market value of the stock on thedate of grant.  There was nocompensation expense recorded for employee grants for fiscal years 2003, 2002and 2001.

 

The Company also grantsoptions and warrants to nonemployees for goods and services and in conjunctionwith certain agreements.  These grantsare accounted for under SFAS No. 123, *Accounting for Stock-Based Compensation*,based on the grant date fair values.

 

Had compensation cost forall of the employee stock-based compensation grants and warrants issued beendetermined based on the fair values at the grant date consistent with theprovisions of SFAS No. 123, the Company’s net income  (loss) and net income (loss) per basic and diluted common sharewould have been as indicated below.

 
|                                       |   | **2003**    |           | **2002** |   | **2001** |   |
|--------------------------------------------|--------|-------------|----------------|----------|--------|----------|--------|
| Net  income (loss):                        |   |        |           |     |   |     |   |
| As  reported                               |   | **$**       | **(1,541,000** | **)**    | $      | 332,000  |   | $ | 2,646,000 |   |
| Deduct  pro forma stock-based compensation |   | **(52,000** | **)**          | (80,000  | )      | (58,000  | )      |
| Pro  forma                                 |   | **$**       | **(1,593,000** | **)**    | $      | 252,000  |   | $ | 2,588,000 |   |
| Basic  earnings (loss) per share:          |   |        | ** **     |     |   |     |   |
| As  reported                               |   | **$**       | **(0.66**      | **)**    | $      | 0.14     |   | $ | 1.15 |   |
| Pro  forma                                 |   | **$**       | **(0.68**      | **)**    | $      | 0.11     |   | $ | 1.13 |   |
| Diluted  earnings (loss) per share:        |   |        | ** **     |     |   |     |   |
| As  reported                               |   | **$**       | **(0.66**      | **)**    | $      | 0.11     |   | $ | 0.86 |   |
| Pro  forma                                 |   | **$**       | **(0.68**      | **)**    | $      | 0.08     |   | $ | 0.84 |   |

 

The above pro formaeffects on net income (loss) and net income (loss) per basic and diluted commonshare are not likely to be representative of the effects on reported net income(loss) or net income (loss) per common share for future years because optionsvest over several years and additional awards generally are made each year.

 

**Comprehensive income: **Comprehensive income is equivalent to net income inthe statement of operations.

 

**Segment information: **TheCompany has one operating segment. Although certain separate financial information by retail store, orretail store and recycling center, is available to management, the Company ismanaged as a unit.  Specifically, theCompany does not measure profit or loss or maintain assets separately for itsproducts or revenue sources (retail appliance sales, appliance recyclingincluding recycling services for utilities, and byproduct sales).

 

**Estimates:** The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ from those estimates.

 

31

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**Recentlyissued accounting pronouncements: **Thefollowing items represent accounting standards that have been recently issued.

 

In January 2003, theFASB issued SFAS No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure*.  Thisstatement provided alternative methods of transition for a voluntary change tothe fair value-based method of accounting for stock-based employeecompensation.  In addition, thisstatement also amended the disclosure requirements of SFAS No. 123 to requiremore prominent and frequent disclosures in the financial statements about theeffects of stock-based compensation. The Company began applying disclosure provisions of this statement inits December 28, 2002 consolidated financial statements.  Because the Company continues to account foremployee stock-based compensation under APB Opinion No. 25, SFAS No. 148 had noeffect on the Company’s consolidated financial statements.

 

In January 2003, theFASB issued Interpretation No. 45 (FIN 45),*Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others*.  FIN 45**clarifiesthat a guarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing certainguarantees.  It also**elaborates on the disclosures in SFAS No.5, *Accounting for Contingencies,*which are to be made by a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it has issued,even when the likelihood of making any payments under the guarantees is remote.The January 3, 2004 consolidated financial statements have incorporatedthe enhanced disclosure requirements of FIN 45, as presented in Note 1 to thefinancial statements under the caption “Product warranty.”

 

In 2003, the FASB issuedInterpretation No. 46 (FIN 46), *Consolidationof Variable Interest Entities*and its amendment (FIN 46R)*. *This interpretationestablishes standards for identifying a variable interest entity and fordetermining under what circumstances a variable interest entity should beconsolidated with its primary beneficiary. Until now, a company generally has included another entity in itsconsolidated financial statements only if it controlled the entity throughvoting interests.  FIN 46 changes thatby requiring a variable interest entity to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the variable interestentity’s activities or is entitled to receive a majority of the entity’sresidual returns or both.  FIN 46applies to the Company’s consolidated financial statements for the year ended January 3, 2004.  The adoption of this pronouncement did nothave a significant effect on the Company’s consolidated financial statements.

 

The FASB has issued SFASNo. 150, *Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*.  SFAS No. 150requires that certain freestanding financial instruments be reported asliabilities in the balance sheet. Depending on the type of financial instrument, it will be accounted forat either fair value or the present value of future cash flows determined ateach balance sheet date with the change in that value reported as interestexpense in the statement of operations. Prior to the application of SFAS No. 150, either those financialinstruments were not required to be recognized, or if recognized were reportedin the balance sheet as equity and changes in the value of those instrumentswere normally not recognized in net income. The Company adopted SFAS No. 150 for the year ended January 3, 2004and it had no effect on reported results for that year.  The Company does not expect the applicationof SFAS No. 150 to have a material effect on its future consolidated financialstatements.

 

**Note 2.****          MarketClosings and Loss on Impaired Assets**

 

In December 2002,the Company closed a retail store in the Dayton, Ohio, market and incurredexpenses of $108,000 for the remaining lease payments and write-off ofleasehold improvements.

 

In February 2003,the Company closed a retail store in the Minneapolis market that resulted in noclosing costs.

 

In March 2003, theCompany closed a retail store in the Dayton, Ohio, market and wrote offleasehold improvements of approximately $26,000.

 

**Note 3.****          Lineof Credit**

 

At January 3, 2004, theCompany had a $10 million line of credit with a lender.  The interest rate as of January 3, 2004was 5.50%.  The amount of borrowingsavailable under the line of credit is based on a formula using receivables andinventories.  The line of credit has a statedmaturity date of August 30, 2004, if not renewed, and provides that thelender may demand payment in full of the entire outstanding balance of the loanat any time.  The line of credit issecured by substantially all the Company’s assets and requires minimum monthlyinterest payments of $37,500, regardless of the outstanding principalbalance.  The lender is also secured byan inventory repurchase agreement with Whirlpool Corporation for purchases fromWhirlpool only.  The loan requires thatthe Company meet certain financial covenants, provides payment penalties fornoncompliance and prepayment, limits the amount of other debt the Company canincur, limits the amount of spending on fixed assets, and limits payments ofdividends.  At January 3, 2004 theCompany’s unused borrowing capacity under this line was $355,000.

 

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**Note 4.****          Long-Term Obligations**

 

Long-term obligationsconsisted of the following:

 
|                                                                                                                                                                                                                                                                     |   | **2003**      |          | **2002**   |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------|---------------|------------|--------|
| 13.00%  note payable, due in monthly interest payments of $541 with balance due  September 2005, secured by equipment                                                                                                                                               |   | **$**         | **50,000**    | ** ** | $      | 50,000 |   |
| Adjustable  rate mortgage based on the 30-day LIBOR rate (1.12% as of January 3,  2004) plus 2.7%, adjusted yearly, monthly payments include interest and principal,  and are based on a 20-year amortization, due October 2012, secured by  land and building |   | **3,340,000** | ** **    | 3,452,000  |   |
| 6.85%  mortgage, due in monthly installments of $15,326, including interest, due  January 2013, secured by land and building                                                                                                                                        |   | **1,956,000** | ** **    | 2,000,000  |   |
| Other                                                                                                                                                                                                                                                                    |   | **103,000**   | ** **    | 181,000    |   |
|                                                                                                                                                                                                                                                                     |   | **5,449,000** |          | 5,683,000  |   |
| Less  current maturities                                                                                                                                                                                                                                                 |   | **240,000**   | ** **    | 259,000    |   |
|                                                                                                                                                                                                                                                                     |   | **$**         | **5,209,000** |       | $      | 5,424,000 |   |

 

The future annualmaturities of long-term obligations are as follows:

 
| **Fiscal year**      |   |              |    |
|----------------------|--------|-------------------|---------|
| 2004                 |   | $                 | 240,000 |   |
| 2005                 |   | 206,000           |    |
| 2006                 |   | 238,000           |    |
| 2007                 |   | 196,000           |    |
| 2008                 |   | 183,000           |    |
| 2009  and thereafter |   | 4,386,000         |    |
|                 |   |  $ 5,449,000 |    |
|                      |        |                   |         |  |

 

**Note 5.****          Accrued Expenses**

 

Accrued expenses were asfollows:

 
|                       |   | **2003**    |          | **2002**   |   |
|----------------------------|--------|-------------|---------------|------------|--------|
| Compensation  and benefits |   | **$**       | **930,000**   | ** ** | $      | 813,000 |   |
| Warranty  expense          |   | **54,000**  | ** **    | 82,000     |   |
| Accrued  incentives        |   | **686,000** | ** **    | —     |   |
| Other                      |   | **349,000** | ** **    | 378,000    |   |
|                       |   | **$**       | **2,019,000** |       | $      | 1,273,000 |   |

 

**Note 6.****          Commitments**

 

**Operating leases: **TheCompany leases certain of its retail stores and recycling center facilities andequipment under noncancelable operating leases.  The leases require the payment of taxes, maintenance, utilitiesand insurance.

 

Minimum future rentalcommitments under noncancelable operating leases as of January 3, 2004 areas follows:

 
| **Fiscal Year**      |   |      |      |
|----------------------|--------|-----------|-----------|
| 2004                 |   | $         | 1,959,000 |   |
| 2005                 |   | 1,812,000 |      |
| 2006                 |   | 1,131,000 |      |
| 2007                 |   | 742,000   |      |
| 2008                 |   | 416,000   |      |
| 2009  and thereafter |   | 26,000    |      |
|                 |   | $         | 6,086,000 |   |

 

Rent expense for fiscalyears 2003, 2002 and 2001 was $1,686,000, $1,973,000 and $1,519,000,respectively.

 

**Contracts:**  The Company has entered into contracts withfour of its appliance vendors.  Underthe agreements there are no minimum purchase commitments; however, the Companyhas agreed to indemnify the vendors for certain claims, allegations or losseswith respect to appliances sold by the Company.  Also see Note 9.

 

**Note 7.****          Income Taxes**

 

The provision (benefit)for income taxes consisted of the following:

 
|     |   | **2003**   |         | **2002** |   | **2001** |   |
|----------|--------|------------|--------------|----------|--------|----------|--------|
| Current: |   |       | ** **   |     |   |     |   |
| Federal  |   | **$**      | **(976,000** | **)**    | $      | (170,000 | )      | $ | 1,289,000 |   |
| State    |   | **—** | ** **   | —   |   | 228,000  |   |
| Deferred |   | **—** | ** **   | 391,000  |   | (400,000 | )      |
|     |   | **$**      | **(976,000** | **)**    | $      | 221,000  |   | $ | 1,117,000 |   |

 

A reconciliation of theCompany’s income tax expense with the federal statutory tax rate is shownbelow:

 
|                                                                               |   | **2003**     |         | **2002** |   | **2001** |   |
|------------------------------------------------------------------------------------|--------|--------------|--------------|----------|--------|----------|--------|
| Income  tax expense (benefit) at statutory rate                                    |   | **$**        | **(856,000** | **)**    | $      | 188,000  |   | $ | 1,278,000 |   |
| State  taxes net of federal tax effect                                             |   | **(152,000** | **)**        | 25,000   |   | 189,000  |   |
| Permanent  differences and other                                                   |   | **(42,000**  | **)**        | 8,000    |   | 20,000   |   |
| Change  in valuation allowance (net of effect of NOL attribute  reduction in 2001) |   | **74,000**   | ** **   | —   |   | (370,000 | )      |
|                                                                               |   | **$**        | **(976,000** | **)**    | $      | 221,000  |   | $ | 1,117,000 |   |

 

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The components of netdeferred tax assets are as follows:

 
|                              |   | **2003**       |          | **2002**   |   |
|-----------------------------------|--------|----------------|---------------|------------|--------|
| Deferred  tax assets:             |   |           |          |       |   |
| Net  operating loss carryforwards |   | **$**          | **3,002,000** | ** ** | $      | 2,834,000 |   |
| Federal  and state tax credits    |   | **269,000**    | ** **    | 199,000    |   |
| Reserves                          |   | **322,000**    | ** **    | 362,000    |   |
| Accrued  expenses                 |   | **134,000**    | ** **    | 93,000     |   |
| Prepaid  expenses                 |   | **(106,000**   | **)**         | —     |   |
| Other                             |   | **17,000**     | ** **    | —     |   |
| Net  deferred tax assets          |   | **$**          | **3,638,000** | ** ** | $      | 3,488,000 |   |
| Valuation  allowance              |   | **(3,072,000** | **)**         | (2,998,000 | )      |
|                              |   | **$**          | **566,000**   |       | $      | 490,000 |   |
|                              |   |           | ** **    |       |   |
| Deferred  tax liabilities:        |   |           | ** **    |       |   |
| Property  and equipment           |   | **$**          | **449,000**   | ** ** | $      | 373,000 |   |

 

At January 3, 2004,the Company had a valuation allowance against deferred tax assets to reduce thetotal to an amount management believes is appropriate.  Realization of deferred tax assets isdependent upon sufficient future taxable income during the periods whendeductible temporary differences and carryforwards are expected to be availableto reduce taxable income.  The reductionin the valuation allowance during 2001 was due to the determination thatcertain deferred tax assets are more likely than not to be realized and to theeffect of an NOL attribute reduction.

 

At January 3, 2004,the Company had NOL carryforwards expiring as follows:

 
| **Expiration** |   | **Amount** |      |
|----------------|--------|------------|-----------|
| 2011           |   | $          | 3,185,000 |   |
| 2012           |   | $          | 1,144,000 |   |
| 2018           |   | $          | 2,645,000 |   |

 

Future utilization of NOLand tax credit carryforwards is subject to certain limitations under provisionsof Section 382 of the Internal Revenue Code.  This section relates to a 50 percent change in control overa three-year period.  The Companybelieves that the issuance of Common Stock during 1999 resulted in an“ownership change” under Section 382. Accordingly, the Company’s ability to use NOL and tax creditcarryforwards generated prior to February 1999 may be limited toapproximately $56,000 per year.

 

**Note 8.****          Shareholders’ Equity**

 

**Stock options:**  The Company has two stock option plans (Plans) that permit thegranting of “incentive stock options” meeting the requirements ofSection 422 of the Internal Revenue Code of 1986, as amended, andnonqualified options that do not meet the requirements ofSection 422.  The Plans have150,000 and 600,000 shares, respectively, available for grant.  The options that have been granted under thePlans are exercisable for a period of five to ten years from the date of grantand vest over a period of six months to five years from the date of grant.

 

The pro forma fair valueof each option grant as presented in Note 1 to the financial statements isestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted-average assumptions:

 
|                              |   | **2003**   |       | **2002** |   | **2001** |   |
|-----------------------------------|--------|------------|------------|----------|--------|----------|--------|
| Expected  dividend yield          |   | **—** | ** ** | —   |   | —   |   |
| Expected  stock price volatility  |   | **79.5**   | **%**      | 79.7     | %      | 82.3     | %      |
| Risk-free  interest rate          |   | **0.9**    | **%**      | 1.4      | %      | 6.2      | %      |
| Expected  life of options (years) |   | **2**      | ** ** | 2        |   | 2        |   |

 

Additional informationrelating to all outstanding options is as follows:

 
|                                   |   | **Shares** |   | **Weighted  Average  Exercise Price** |   |
|----------------------------------------|--------|------------|--------|---------------------------------------|--------|
| Outstanding  at December 30, 2000 |   | 373,000    |   | $                                     | 2.59   |   |
| Granted                                |   | 56,000     |   | $                                     | 1.82   |   |
| Cancelled                              |   | (21,000    | )      | $                                     | 17.52  |   |
| Outstanding  at December 29, 2001 |   | 408,000    |   | $                                     | 1.98   |   |
| Granted                                |   | 57,000     |   | $                                     | 3.77   |   |
| Exercised                              |   | (8,000     | )      | $                                     | 0.96   |   |
| Cancelled                              |   | (20,000    | )      | $                                     | 3.60   |   |
| Outstanding  at December 28, 2002 |   | 437,000    |   | $                                     | 2.16   |   |
| Granted                                |   | 15,000     |   | $                                     | 1.60   |   |
| Cancelled                              |   | (44,000    | )      | $                                     | 3.06   |   |
| Outstanding  at January 3, 2004   |   | 408,000    |   | $                                     | 2.04   |   |

 

The weighted average fairvalue per option of options granted during fiscal years 2003, 2002 and 2001 was$0.69, $1.65 and $0.86, respectively.

 

The following tablessummarize information about stock options outstanding as of January 3,2004:

 

OPTIONSOUTSTANDING

 
| **Range of  Exercise  Prices** |   | **Number of  Options  Outstanding** |   | **Weighted  Average  Remaining  Contractual  Life in  Years** |   | **Weighted  Average  Exercise  Price** |   |
|--------------------------------|--------|-------------------------------------|--------|---------------------------------------------------------------|--------|----------------------------------------|--------|
| $4.05 to $4.30                 |   | 38,000                              |   | 7.0                                                           |   | $                                      | 4.15   |   |
| $2.38 to $3.50                 |   | 46,000                              |   | 3.3                                                           |   | $                                      | 2.55   |   |
| $0.75 to $2.20                 |   | 249,000                             |   | 3.1                                                           |   | $                                      | 1.95   |   |
| $0.59 to $0.65                 |   | 75,000                              |   | 3.2                                                           |   | $                                      | 0.63   |   |
|                           |   | 408,000                             |   |                                                          |   | $                                      | 2.04   |   |

 

34

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OPTIONSEXERCISABLE

 
| **Range of  Exercise  Prices** |   | **Number of  Options  Exercisable** |   | **Weighted  Average  Exercise  Price** |   |
|--------------------------------|--------|-------------------------------------|--------|----------------------------------------|--------|
| $4.05  to $4.30                |   | 30,000                              |   | $                                      | 4.11   |   |
| $2.38  to $3.50                |   | 46,000                              |   | $                                      | 2.55   |   |
| $0.75  to $2.20                |   | 185,000                             |   | $                                      | 1.86   |   |
| $0.59  to $0.65                |   | 75,000                              |   | $                                      | 0.63   |   |
|                           |   | 336,000                             |   | $                                      | 1.88   |   |

 

The following tablesummarizes options exercisable for stock options outstanding as ofDecember 28, 2002 and December 29, 2001:

 
|                             |   | **December 28,  2002** |   | **December 29,  2001** |   |
|----------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
| Number  of options exercisable   |   | 325,000                     |   | 275,000                     |   |
| Weighted  average exercise price |   | $                           | 2.01   |                        | $      | 1.77 |   |
|                                  |        |                             |        |                             |        |  |  |

 

**Warrants: **The Company has adopted the provisions ofSFAS No. 123 in accounting for its warrants issued for financing orservices.  Accordingly, the expense, ifany, applicable to the value of such warrants is recognized as of the date ofgrant.  Such warrants are generallyissued to non-employees.

 

In September 1998,the Company entered into a loan agreement with a lender resulting in grossproceeds to the Company of $3.5 million. In connection with this loan, the Company issued the lender a warrant topurchase 700,000 shares of Common Stock at an adjustable exercise price, whichis currently $0.60 per share.  TheCompany also issued to an investment banker associated with this transaction awarrant to purchase 125,000 shares of Common Stock at $2.50 per share.  The portion of the gross loan proceedsascribed to the aforementioned warrants issued in conjunction with this debtfinancing was $307,000 as determined using the Black-Scholes method.  During 2002, 32,136 warrants were exercisedresulting in the issuance of 14,872 shares of Common Stock.

 

During 2001, 53,750warrants related to a 1998 financing transaction were exercised resulting inthe issuance of 9,768 shares of Common Stock and 15,000 of warrants from thesame financing transaction expired.

 

In February 1999, inconnection with a private placement, the Company issued warrants to purchase83,000 shares of Common Stock at $0.50 per share, subject to adjustment.  During 2002, 4,000 warrants were exercisedresulting in the issuance of 3,506 shares of Common Stock.  During 2003, 26,000 warrants were exercisedresulting in the issuance of 20,326 shares of Common Stock.  In the first quarter of 2004, the remaining53,000 warrants were exercised resulting in the issuance of 44,061 shares ofCommon Stock.

 

In March 1999, theCompany issued to a board member at that time 5,000 warrants to purchase theCompany’s Common Stock at $0.625 per share, the market value of the Company’sstock at the date of grant.

 

In April 1999, theCompany issued to a vendor 50,000 warrants to purchase Common Stock at $0.625per share.  In February 2003,20,000 warrants were exercised resulting in the issuance of 20,000 shares of CommonStock.

 

All issued warrants areexercisable and expire as follows: 83,000 in 2004; 700,000 in 2007 and 5,000 in 2009.

 

**Preferred Stock: **The Company’s amended Articles ofIncorporation authorize two million shares of Preferred Stock of the Company(Preferred Stock) which may be issued from time to time in one or more serieshaving such rights, powers, preferences and designations as the Board ofDirectors may determine.  To date nosuch preferred shares have been issued.

 

**Note 9.****          Major Customer andSuppliers**

 

Revenuesfrom the Company’s major recycling customers as a percentage of total revenuesare as follows:

 
|                 |   | **2003**   |       | **2002** |   | **2001** |   |
|----------------------|--------|------------|------------|----------|--------|----------|--------|
| Revenue  percentage: |   |       | ** ** |     |   |     |   |
| Customer  A          |   | **9**      | **%**      | 13       | %      | 29       | %      |
| Customer  B          |   | **—** | ** ** | 12       | %      | 9        | %      |

 

As of January 3,2004, the Company had a receivable from Customer A of $717,000.

 

During the three-yearperiod ended January 3, 2004, the Company purchased a vast majority ofappliances for resale from four suppliers. The Company has and is continuing to secure other vendors from which topurchase appliances.  However, the lossof one of these suppliers or any appliance supplier could adversely affectCompany’s operations.

 

35

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**ITEM 9.****          CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

No changes in ordisagreements with accountants have occurred within the two-year period endedJanuary 3, 2004 that required reporting on Form 8-K.

 

**ITEM 9A.****                    CONTROLSAND PROCEDURES**

 

Underthe supervision and with the participation of the Company’s management,including its principal executive officer and principal financial officer, theCompany has evaluated the effectiveness of the design and operation of itsdisclosure controls and procedures as of the filing date of this annual report,and, based on the evaluation, its principal executive officer and principalfinancial officer have concluded that these controls and procedures areeffective.  There were no significantchanges in the Company’s internal controls or in other factors that could significantlyaffect these controls subsequent to the date of their evaluation.

 

Disclosurecontrols and procedures are the Company’s controls and other procedures thatare designed to ensure that information required to be disclosed by the Companyin the reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include, without limitation,controls and procedures designed to ensure that information required to bedisclosed by the Company in the reports that it files under the Exchange Act isaccumulated and communicated to its management, including its principalexecutive officer and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

 

**PARTIII**

 

**ITEM 10.****                      DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Information regardingdirectors and executive officers of the Company is set forth under the headings“Nominees and Information Concerning Officers Who Are Not Directors” and“Section 16 (a) Beneficial Ownership Reporting Compliance” in theCompany’s Proxy Statement for its 2004 Annual Meeting of Shareholders to beheld April 29, 2004, and is incorporated herein by reference.

 

**ITEM 11.****                      EXECUTIVECOMPENSATION**

 

Information regardingexecutive compensation is set forth under the heading “Executive Compensationand Stock Options Granted and Exercised in Last Fiscal Year” in the Company’sProxy Statement for its 2004 Annual Meeting of Shareholders to be heldApril 29, 2004, and is incorporated herein by reference.

 

**ITEM 12.****       SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

 

Information regardingsecurity ownership of certain beneficial owners and management is set forthunder the heading “Common Stock Ownership” in the Company’s Proxy Statement forits 2004 Annual Meeting of Shareholders to be held April 29, 2004, and isincorporated herein by reference.

 

36

----

 

The following table givesaggregate information under our equity compensation plans as of January 3,2004:

 
|                                                        |   |                                                                                                 |   |                                                                                |   | **(c)**                                                                                                                                     |    |
|-------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                        |   |                                                                                                 |   |                                                                                |   | **Number of  Securities  Available for Future  Issuance Under Equity  Compensation Plans  (Excluding Securities  Reflected in  Column(a))** |    |
|                                                        |   | **(a)**                                                                                              |   | **(b)**                                                                             |   |                                                                                                                                        |
|                                                        |   | **Number of  Securities to  be Issued upon Exercise  of Outstanding  Options,  Warrants and Rights** |   | **Weighted-Average  Exercise Price of  Outstanding  Options,  Warrants and Rights** |   |                                                                                                                                        |
|                                                        |   |                                                                                                 |   |                                                                                |
|                                                        |   |                                                                                                 |   |                                                                                |
|                                                        |   |                                                                                                 |   |                                                                                |
|                                                        |   |                                                                                                 |   |                                                                                |
| Equity  compensation plans approved by stockholders         |   | 408,000                                                                                              |   | $                                                                                   | 1.98   |                                                                                                                                        | 181,750 |   |
| Equity  compensation plans not approved by stockholders (1) |   | 788,000                                                                                              |   | $                                                                                   | 0.59   |                                                                                                                                        | N/A     |   |
| Total                                                       |   | 1,196,000                                                                                            |   | $                                                                                   | 1.07   |                                                                                                                                        | 181,750 |   |

 

----

(1)  SeeNote 8 regarding warrants issued for financing or services.

 

**ITEM 13.****                      CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

Information regardingcertain relationships and related transactions is set forth under the heading“Nominees and Information Concerning Officers and Key Employees Who Are NotDirectors” in the Company’s Proxy Statement for its 2004 Annual Meeting ofShareholders to be held April 29, 2004, and is incorporated herein byreference.

 

**ITEM 14.****                      PRINCIPALACCOUNTANT FEES AND SERVICES**

 

Information regardingprincipal accountant fees and services is set forth under the heading “FeesPaid to Auditors by the Company During the Last Fiscal Year” in the Company’sProxy Statement for its 2004 Annual Meeting of Shareholders to be heldApril 29, 2004, and is incorporated herein by reference.

 

**PARTIV**

 

**ITEM15.****                      EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

 

**(a)****                                  FinancialStatements, Financial Statement Schedules and Exhibits**

 

**1.****                                      FinancialStatements**

 

See Index to FinancialStatements under Item 8 of this report.

 

37

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**2.****                                      FinancialStatement Schedule**

 

To the Board of Directors

Appliance RecyclingCenters of America, Inc.

Minneapolis, Minnesota

 

Our audits were made forthe purpose of forming an opinion on the basic consolidated financialstatements of Appliance Recycling Centers of America, Inc. and Subsidiariestaken as a whole.  The supplementalSchedule II is presented for purposes of complying with the Securities andExchange Commission’s rules and is not a part of the basic consolidatedfinancial statements. This schedule has been subjected to the auditingprocedures applied in our audits of the basic consolidated financial statementsand in our opinion, is fairly stated in all material respects in relation tothe basic consolidated financial statements taken as a whole.

 

McGLADREY & PULLEN,LLP

 

 

Minneapolis, Minnesota

February 17, 2004

 

Schedule II -Valuation and Qualifying Accounts

 
|                               |   | **Accounts  Receivable  Allowance** |        | **Inventory  Allowance** |   |
|------------------------------------|--------|-------------------------------------|-------------|--------------------------|--------|
| Balance,  December 30, 2000   |   | $                                   | 20,000      |                     | $      | 375,000 |   |
| Additional  allowance/adjustments  |   | 578,000                             |        | 359,000                  |   |
| Write-offs                         |   | (498,000                            | )           | (270,000                 | )      |
| Balance, December 29, 2001    |   | $                                   | 100,000     |                     | $      | 464,000 |   |
| Additional  allowance/adjustments  |   | (35,000                             | )           | 265,000                  |   |
| Write-offs                         |   | (39,000                             | )           | (181,000                 | )      |
| Balance,  December 28, 2002   |   | $                                   | 26,000      |                     | $      | 548,000 |   |
| Additional  allowance/adjustments  |   | 100,000                             |        | 148,000                  |   |
| Write-offs                         |   | (9,000                              | )           | (372,000                 | )      |
| **Balance,  January 3, 2004** |   | **$**                               | **117,000** | ** **               | **$**  | **324,000** | ** ** |

 

**3.****                                      Exhibits**

 

See Index to Exhibits onpage 40 of this report.

 

**(b)****                                  Reportson Form 8-K**

 

The Company filed Form8-K on October 29, 2003 announcing its third quarter 2003 results.

 

38

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or Section 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this Report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
| Dated:  March 16, 2004 | APPLIANCE RECYCLING  CENTERS OF |
|----------------------------------|---------------------------------|
|                             | AMERICA, INC.                   |
|                             | (Registrant)                    |
|                             |                            |
|                             |                            |
|                             | By                              | /s/  Edward R. Cameron |   |
|                             |                            | Edward R. Cameron |
|                             |                            | President and Chief  Executive Officer |
|                             |                            |   |
|                             |                            |   |
|                             | By                              | /s/  Linda A. Koenig |   |
|                             |                            | Linda A. Koenig |
|                             |                            | Vice President of  Finance |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this Report has beensigned by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.

 
| **Signature**               |   | **Title**               |                                  | **Date** |
|-----------------------------|--------|-------------------------|---------------------------------------|----------|
|                        |   |                    |                                  |     |
| /s/  Edward R. Cameron |   |                    | Chairman of the Board,  President and |     | March 16, 2004 |
| Edward R. Cameron           |   | Chief Executive Officer |                                  |     |
|                        |   |                    |                                  |     |
|                        |   |                    |                                  |     |
| /s/  Linda A. Koenig   |   |                    | Vice President of  Finance            |     | March 16, 2004 |
| Linda A. Koenig             |   |                    |                                  |     |
|                        |   |                    |                                  |     |
|                        |   |                    |                                  |     |
| /s/  Duane S. Carlson  |   |                    | Director                              |     | March 16, 2004 |
| Duane S. Carlson            |   |                    |                                  |     |
|                        |   |                    |                                  |     |
|                        |   |                    |                                  |     |
| /s/  Harry W. Spell    |   |                    | Director                              |     | March 16, 2004 |
| Harry W. Spell              |   |                    |                                  |     |

 

39

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**INDEX TO EXHIBITS**

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                   |
|------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.1              |   | Restated Articles of  Incorporation of Appliance Recycling Centers of America, Inc.  [filed as Exhibit 3.1 to the Company’s  Form 10-K for the year ended January 2, 1999 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                                                               |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.2              |   | Amended and Restated  Bylaws of Appliance Recycling Centers of America, Inc. [filed as Exhibit 3.2  to the Company’s Form 10-K for the year ended January 2, 1999 (File No.  0-19621) and incorporated herein by reference].                                                                                                                                                                            |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| *10.1            |   | Amended Appliance  Recycling Centers of America, Inc. Restated 1989 Stock Option Plan [filed as  Exhibit 19.3 to the Company’s Form 10-Q for the quarter ended June 30,  1993 (File No. 0-19621) and incorporated herein by reference].                                                                                                                                                                 |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.2             |   | Line of credit dated  August 30, 1996, between Appliance Recycling Centers of America, Inc.  and Spectrum Commercial Services, a division of Lyons Financial Services,  Inc. [filed as exhibit 10.15 to the Company’s Form 10-Q for the quarter ended  September 28, 1996 (File No. 0-19621) and incorporated herein by  reference].                                                               |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.3             |   | Amended line of credit  dated November 8, 1996, between Appliance Recycling Centers of America,  Inc. and Spectrum Commercial Services, a division of Lyons Financial  Services, Inc. [filed as exhibit 10.16 to the Company’s Form 10-Q for the  quarter ended September 28, 1996 (File No. 0-19621) and incorporated  herein by reference].                                                      |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| *10.4            |   | 1997 Stock Option Plan  and Amendment [filed as Exhibits 28.1 and 28.2 to the Company’s Registration  Statement on Form S-8 (Registration No. 333-28571) and incorporated herein by  reference].                                                                                                                                                                                                             |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.5             |   | Amended line of credit  dated February 12, 1998 between Appliance Recycling Centers of America,  Inc. and Spectrum Commercial Services, a division of Lyons Financial  Services, Inc., Amended Revolving Note and Amended Guarantor Acknowledgments  [filed as Exhibit 10.10 to the Company’s Form 10-K for year ended  January 3, 1998 (File No. 0-19621) and incorporated herein by  reference]. |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| *10.6            |   | Amendment, effective  April 24, 1997, to 1989 Stock Option Plan [filed as Exhibit 28.2 to the  Company’s Post-Effective Amendment No. 1 (June 5, 1997) to Registration  Statement on Form S-8 (Registration No. 33-68890) and incorporated herein by  reference].                                                                                                                                  |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.7             |   | Reverse Logistics  Master Service Agreement between Whirlpool Corporation and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10 to the Company’s Form  10-Q for the quarter ended July 4, 1998 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                              |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.8             |   | Loan Agreement between  Medallion Capital, Inc. and Appliance Recycling Centers of America, Inc.  dated September 10, 1998 [filed as Exhibit 10.1 to the Company’s Form  10-Q for the quarter ended October 3, 1998 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                     |

 

40

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| 10.9   |   | Promissory note of the  Company to Medallion Capital, Inc. in the principal amount of $3,500,000 due  September 30, 2005 [filed as Exhibit 10.2 to the Company’s Form 10-Q for  the quarter ended October 3, 1998 (File No. 0-19621) and incorporated  herein by reference].                                                                                                                                                                                                             |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.10  |   | Security Agreement of  the Company [filed as Exhibit 10.3 to the Company’s Form 10-Q for the quarter  ended October 3, 1998 (File No. 0-19621) and incorporated herein by  reference].                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.11  |   | Warrant of the Company  in favor of Medallion Capital, Inc. for 700,000 shares of the Company’s stock  [corrected copy] [filed as Exhibit 10.14 to the Company’s Form 10-K for the  year ended January 2, 1999 (File No. 0-19621) and incorporated herein by  reference].                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.12  |   | Amendment to the line  of credit dated September 10, 1998 between Appliance Recycling Centers  of America, Inc. and Spectrum Commercial Services, a division of Lyons  Financial Services, Inc., Amendment to General Credit and Security Agreement  and Amended Guarantor Acknowledgement   [filed as Exhibit 10.15 to the Company’s Form 10-K for the year ended  January 2, 1999 (File No. 0-19621) and incorporated herein by  reference].                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.13  |   | Amendment to the line  of credit dated September 17, 1998 between Appliance Recycling Centers  of America, Inc. and Spectrum Commercial Services, a division of Lyons  Financial Services, Inc., Amendment to General Credit and Security Agreement,  Amended Guarantor Acknowledgement and Amended and Restated Revolving  Note  [filed as Exhibit 10.16 to the  Company’s Form 10-K for the year ended January 2, 1999 (File No. 0-19621)  and incorporated herein by reference]. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| *10.14 |   | Amendment effective  April 29, 1999 to 1997 Stock Option Plan [filed as Exhibit 10 to the  Company’s Form 10-Q for the quarter ended July 3, 1999 (File No.  0-19621) and incorporated herein by reference].                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.15  |   | Agreement dated  June 12, 2000 between Southern California Edison Company and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10 to the Company’s Form  10-Q for the quarter ended July 1, 2000 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.16  |   | Agreement dated  August 21, 2000 between Southern California Edison Company and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10.2 to the Company’s  Form 10-Q for the quarter ended September 30, 2000 (File No. 0-19621)  and incorporated herein by reference].                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.17  |   | Amendment to the line  of credit dated August 30, 2000 between Appliance Recycling Centers of  America, Inc. and Spectrum Commercial Services, a division of Lyons Financial  Services, Inc., Amendment to General Credit and Security Agreement and  Amended and Restated Revolving Note [filed as Exhibit 10.1 to the Company’s  Form 10-Q for the quarter ended September 30, 2000 (File No. 0-19621)  and incorporated herein by reference].                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.18  |   | Updated contract dated  January 1, 2001 between Southern California Edison Company and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10.1 to the Company’s  Form 10-Q for the quarter ended March 31, 2001 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| *10.19 |   | Amendment effective April 26,  2001 to 1997 Stock Option Plan [filed as Exhibit 10.2 to the Company’s Form  10-Q for the quarter ended March 31, 2001 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                                                                                                                                                                         |

 

41

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| 10.20  |   | Agreement dated  June 12, 2001 between the California Public Utilities Commission and  Appliance Recycling Centers of America, Inc. [filed as Exhibit 10.1 to the  Company Form 10-Q for the quarter ended June 30, 2001 (File No. 0-19621)  and incorporated herein by reference].                                                                                                                     |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.21  |   | Agreement dated  June 18, 2001 between Spectrum Commercial Services Company and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10.2 to the Company’s  Form 10-Q for the quarter ended June 30, 2001 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.22  |   | Agreement dated  July 26, 2001 between Spectrum Commercial Services Company and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10.3 to the Company’s  Form 10-Q for the quarter ended June 30, 2001 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.23  |   | Amendment to the line  of credit dated August 24, 2001 between Appliance Recycling Centers of  America, Inc. and Spectrum Commercial Services, Amendment to General Credit  and Security Agreement and Amended and Restated Revolving Note [files as  Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended  September 29, 2001 (File No. 0-19621) and incorporated herein by  reference]. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.24  |   | Retail Dealer Sales  Agreement dated October 12, 2001 between Appliance Recycling Centers of  America, Inc. and Maytag Corporation [filed as Exhibit 10.2 to the Company’s  Form 10-Q for the quarter ended September 29, 2001 (File No. 0-19621)  and incorporated herein by reference].                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.25  |   | Amendment dated March 7,  2002 to the agreement between the California Public Utilities Commission and  Appliance Recycling Centers of America, Inc. [filed as Exhibit 10.29 to the  Company’s Form 10-K for the year ended December 20, 2001 (File No.  0-19621) and incorporated herein by reference].                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.26  |   | Amendment to the line  of credit dated April 11, 2002 between Appliance Recycling Centers of  America, Inc. and Spectrum Commercial Services, Amendment to General Credit  and Security Agreement and Amended Guarantor Acknowledgement [filed as  Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended March 30,  2002 (File No. 0-19621) and incorporated herein by reference].         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| *10.27 |   | Amendment effective  April 25, 2002 to 1997 Stock Option Plan [filed as Exhibit 10.2 to the  Company’s Form 10-Q for the quarter ended March 30, 2002 (File No.  0-19621) and incorporated herein by reference].                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.28  |   | Agreement dated  June 18, 2002 between Southern California Edison Company and Appliance  Recycling Centers of America, Inc. [filed as Exhibit 10.1 to the Company’s  Form 10-Q for the quarter ended June 29, 2002 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.29  |   | Loan agreement dated  September 19, 2002 between Appliance Recycling Centers of America, Inc.  and General Electric Capital Business Asset Funding Corp. [filed as Exhibit  10.1 to the Company’s Form 10-Q for the quarter ended September 28, 2002  (File No. 0-19621) and incorporated herein by reference].                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.30  |   | Agreements dated  September 24, 2002 between Appliance Recycling Centers of America, Inc.  and the Department of Water and Power of the City of Los Angeles [filed as  Exhibit 10.32 to the Company’s Form 10-K for the year ended December 28,  2002 (File No. 0-19621) and incorporated herein by reference].                                                                                    |

 

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| 10.31  |   | Loan agreement dated  December 28, 2002 between Appliance Recycling Centers of America, Inc.  and General Electric Capital Business Asset Funding Corp.  [filed as Exhibit 10.33 to the Company’s  Form 10-K for the year ended December 28, 2002 (File No. 0-19621) and  incorporated herein by reference].                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| 10.32  |   | Amendment to the line  of credit dated January 23, 2003 between Appliance Recycling Centers of  America, Inc. and Spectrum Commercial Services, Amendment to General Credit  and Security Agreements [filed as Exhibit 10.34 to the Company’s Form 10-K  for the year ended December 28, 2002 (File No. 0-19621) and incorporated  herein by reference]. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| 10.33  |   | Agreement dated  September 2, 2003 between Southern California Edison Company and  Appliance Recycling Centers of America, Inc. [filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarter ended September 27, 2003 (File No.  0-19621) and incorporated herein by reference].                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +10.34 |   | Agreement dated January 1,  2004 between Southern California Edison Company and Appliance Recycling  Centers of America, Inc.                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +10.35 |   | Agreement dated  March 1, 2004 between San Diego Gas & Electric and Appliance  Recycling Centers of America, Inc.                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +21.1  |   | Subsidiaries of Appliance Recycling Centers of America, Inc.                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +23.1  |   | Consent of McGladrey  & Pullen, LLP, Independent Public Accountants.                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +31.1  |   | Certifications pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +31.2  |   | Certifications pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                    |
| +32    |   | Certifications pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                    |

 

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| * | Items that are  management contracts or compensatory plans or arrangements required to be  filed as an exhibit pursuant to Item 14(a)3 of this Form 10-K. |
|---|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| + | Filed herewith.                                                                                                                                           |

 

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