APPLIANCE RECYCLING CENTERS OF AMERICA INC /MN - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended January 2, 1999
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

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 (I.R.S. Employer
incorporation or organization) Identification No.)

7400 EXCELSIOR BOULEVARD, MINNEAPOLIS, MINNESOTA 55426-4517
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: 612-930-9000

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 reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes _X_ No ___

Indicate by check mark if disclosure of delinquent filers pursuant to Item 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 statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

As of March 12, 1999, the aggregate market value of the voting stock held by
nonaffiliates of the registrant, computed by reference to the average of the
high and low prices on such date as reported by the OTC Bulletin Board, was
$1,416,715.

As of March 12, 1999, there were outstanding 2,266,744 shares of the
registrant's Common Stock, without par value.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive proxy statement dated March 23, 1999,
are incorporated by reference into Part III hereof.

TABLE OF CONTENTS

PART I

Item 1. Business
General
Industry Background
Company Background
Customers and Source of Supply
Company Operations
Principal Product and Services
Sales and Marketing
Seasonality
Competition
Government Regulation
Employees
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders

PART II

Item 5. Market for the Company's Common Equity and Related Shareholder
Matters
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 7A. Quantitative and Qualitative Disclosure about Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

PART III

Item 10. Directors and Executive Officers of the Company
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K

SIGNATURES
INDEX TO EXHIBITS

PART I

ITEM 1. BUSINESS

GENERAL

Appliance Recycling Centers of America, Inc., together with its
operating subsidiaries ("ARCA" or the "Company"), provides a comprehensive range
of services for the large-scale resale and recycling of major household
appliances in an environmentally sound manner. The Company provides its
customers with integrated processes and programs addressing the solid waste
management, environmental and energy conservation issues involved with appliance
disposal and recycling. The Company generates revenues from the sale of
reconditioned and distressed appliances through a chain of Company-owned retail
stores called Encore(R) Recycled Appliances ("Encore") and Appliance$mart(R),
fees charged for the disposal of appliances, and the sale of materials generated
from processed appliances (byproduct revenues).

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

INDUSTRY BACKGROUND

There are more than 500 million major household appliances, such as
refrigerators, freezers, ranges, dishwashers, microwaves, washers, dryers, room
air conditioners, water heaters and dehumidifiers, currently in use in the
United States. It is estimated by the Steel Recycling Institute that in 1995, 42
million major household appliances were taken out of use in the United States.
Industry sources estimate that 50 to 55 million major household appliances will
be disposed of each year between the years 1997 and 2000. The disposal of these
appliances has become a serious problem as a result of a number of factors
including: (i) decreasing landfill capacity in many parts of the country; (ii)
the inability of incinerators, composting facilities and other landfill
alternatives to process appliances; and (iii) the presence in appliances of
certain hazardous and other environmentally harmful materials that require
special processing.

Legislation affecting appliance disposal has been adopted in more
than 30 states. This legislation includes landfill restrictions, disposal bans,
advance disposal fees and other types of restrictions. As a result, appliances
must be dealt with outside the ordinary municipal solid waste stream.

Landfill restrictions arise in part because some appliance
components contain certain hazardous and other environmentally harmful
materials, including polychlorinated biphenyls (PCBs), mercury, refrigerants
such as chlorofluorocarbons (CFCs) and sulfur dioxide, and oils. PCBs are
suspected as carcinogens, are resistant to degradation when deposited in
landfills and can cause groundwater contamination. The production of PCBs was
banned by the EPA in 1979, although businesses were allowed to continue using
remaining inventories of components that contained PCBs. Mercury is toxic to
humans and can enter the body through inhalation, skin absorption or ingestion,
and it vaporizes at high temperatures forming extremely toxic fumes. CFCs are
believed to cause long-term damage to the earth's stratospheric ozone layer and
may contribute to global warming when released into the atmosphere. The 1990
Amendments to the Clean Air Act prohibit the venting of CFCs and since July 1,

1992 have required the recovery of CFC refrigerants during the service, repair
and disposal of appliances. See Business - Government Regulation.

In addition to these solid waste management and environmental
issues, utility companies, motivated by economic and environmental factors to
control energy consumption, sponsor various programs to encourage and assist
residential consumers to conserve energy, including programs for turning in
surplus, energy-inefficient appliances. Many residential consumers own and
operate room air conditioners, freezers or more than one refrigerator,
contributing significantly to residential energy use and peak energy demand. In
addition, many of the refrigerators manufactured in the 1960s and early 1970s
consume up to 1,750 kilowatt-hours of electricity each year. The National
Appliance Energy Conservation Act requires that a typical 18-cubic-foot
refrigerator manufactured after 1992 have an energy consumption rate not
exceeding 700 kilowatt-hours per year. As new, more efficient appliances become
available, utility companies have begun to encourage the use of newer models and
the disposal of older, less efficient models.

The Federal Energy Policy Act of 1992 gives individual states the
option of deregulating their electric utility industry. The potential of
deregulation has caused uncertainty about the future and form of energy
conservation programs sponsored by electric utilities. Some electric utility
companies are delaying new energy conservation programs, including the Company's
refrigerator recycling program. The Company believes, however, that energy
conservation and efficiency programs will remain a long-term component of the
nation's electric utility industry. See Business - Government Regulation.

A developing market for the Company is handling distressed
appliances for new appliance manufacturers ("manufacturers"). Manufacturers
generate distressed product in a variety of ways: discontinued models, customer
returns, freight damaged units and warranty exchanges. Historically,
manufacturers disposed of the majority of their distressed product through their
small dealer network. The manufacturer normally discounts the product and
provides warranties and financing. Large retailers do not want to handle
distressed appliances because the majority of the merchandise is out of carton,
requires special handling and pricing, and may require some repair. As small
dealers are having an increasingly more difficult time competing with large
chains (the top 10 chains have 80% of the appliance sales market), manufacturers
are seeing their traditional distribution channel for distressed appliances
shrink. Manufacturers also anticipate that small appliance retailers will be
negatively impacted as manufacturers begin selling directly to the consumer over
the Internet.

COMPANY BACKGROUND

The Company began business in 1976 as a retailer of reconditioned
appliances. Initially, the Company contracted with national and regional
retailers of appliances such as Sears, Roebuck & Company, Inc. ("Sears") and
Montgomery Ward & Co. ("Montgomery Ward") to collect major appliances in
Minneapolis/Saint Paul and two other metropolitan areas. As part of their new
appliance sales efforts, these customers arrange for the removal of old
appliances from consumers' residences. The Company collects old appliances on
behalf of its customers, reconditions and sells suitable used appliances through
its own retail stores and sells the remaining appliances to scrap metal
processors.

In the late 1980s, in response to stricter environmental protection
laws, the Company developed and marketed programs to process and dispose of
appliances in an environmentally sound manner. These programs are offered to new
appliance manufacturers and retailers, waste management companies and the
general public. See Business - Customers and Source of Supply.

In 1989, the Company expanded its appliance recycling concept to the
utility industry when it established an appliance processing center in
Milwaukee, Wisconsin, pursuant to a contract with a utility company. From 1989
to 1994 the Company focused its resources on the expansion of its business with
electric utility companies. During this time period the Company opened nine
centers throughout the U.S. and Canada, primarily serving seventeen electric
utility customers. The Company's electric utility business has been negatively
impacted by the potential of electric utility industry deregulation. The
potential of deregulation has caused electric utilities to decrease their
sponsorship of energy conservation programs like the one the Company offers.
Currently, the Company expects to have only one major contract with an electric
utility customer.

During fiscal year 1998, that customer, Southern California Edison
Company ("Edison"), accounted for approximately 29% or $3.5 million of the
Company's total revenues. The Company is anticipating that it will have a
program with Edison for 1999. Edison recently received budget approval from the
California Public Utilities Commission ("CPUC") for a 1999 program. The Company
is currently in final contract negotiations with Edison. Edison has continued
its appliance recycling program through the first quarter of 1999 while waiting
for CPUC approval and final contract negotiations with the Company.

In February 1999, the Company entered into an 18-month refrigerator
recycling contract with the Los Angeles Department of Water and Power ("DWP").
Under this program, the Company will recycle, from low income housing units in
Los Angeles, refrigerators that have been replaced with new energy-efficient
models. The DWP program contains no minimum guarantees and is expected to start
at relatively low levels in this year's second quarter.

In response to the decrease in demand for services from electric
utilities, the Company has increased its marketing of services to appliance
manufacturers and retailers, waste management companies and property management
companies. The Company also has increased its focus on the sale of reconditioned
appliances. In 1995, under the name Encore(R) Recycled Appliances, the Company
began operating a chain of Company-owned retail stores. In 1998, the Company
began using the name Appliance$mart(R) for its retail stores. The retail stores
offer reconditioned and manufacturers' distressed appliances to value-conscious
individuals and property managers.

During 1996 the Company continued to expand its focus on its Encore
retail stores and had more than 30 retail stores open at one point during the
year. Due to substantial losses in certain markets, the Company closed centers
and stores in three markets in the fourth quarter of 1996. Write-offs and other
significant expenses related to these closings caused the Company to report a
significant loss for the year.

In 1997, the Company entered into pilot program agreements with
Whirlpool Corporation, the nation's largest manufacturer of major household
appliances, to develop a program for handling distressed appliances for
Whirlpool. In 1998, the Company entered into a contract with Whirlpool to
acquire its distressed appliances (including "scratch and dent" units with only
cosmetic imperfections) from distribution centers serving the Midwest and
certain western states. Under the contract, the Company purchases distressed
appliances from Whirlpool, reconditions suitable units and sells them through
ARCA's network of Encore and Appliance$mart retail stores. With increased supply
of product, the Company began opening larger stores and closing its smaller
ones. Appliances that cannot be reconditioned are recycled in accordance with
all applicable environmental regulations. The Company recently scaled back its
agreement with Whirlpool to a level consistent with its current financial
resources. The Company will now buy inventory mainly from Whirlpool's Ohio
distribution

center. The Company believes that this contract will provide an adequate
quantity of high quality appliances that can be sold through its retail stores.

In late 1998, the Company decided to close its St. Louis, Missouri
operations and close one store in the Minneapolis/St. Paul market. The Company
currently has three recycling centers located in Columbus, Ohio, Minneapolis,
Minnesota and Los Angeles, California. Also, the Company currently has eight
retail stores: four in Minneapolis/St. Paul, two in California and two in
Columbus, Ohio.

CUSTOMERS AND SOURCE OF SUPPLY

The Company offers its services to entities that, as part of their
operations, become responsible for disposing of large quantities of used and
distressed appliances. These entities include new appliance manufacturers and
retailers, waste management companies, property management companies and utility
companies.

NEW APPLIANCE MANUFACTURERS AND RETAILERS. The Company began its
business by offering appliance recycling programs to Sears, Montgomery Ward and
other new appliance retailers to collect appliances from either the retailers'
facilities or from their consumers. Recently the Company has focused its
marketing efforts to new appliance manufacturers, including Whirlpool
Corporation, a primary source of product that can be reconditioned and sold in
the Company's stores.

WASTE MANAGEMENT COMPANIES. The Company provides services to waste
management companies and the general public for the collection and recycling of
appliances for specified fees.

PROPERTY MANAGEMENT COMPANIES. The Company provides comprehensive
appliance exchange and recycling services to property managers of apartment
complexes as well as local housing authorities.

UTILITY COMPANIES. The Company contracts with utility companies to
provide comprehensive appliance recycling services tailored to the needs of the
particular utility. The contracts historically have had terms of one to four
years, with provisions for renewal at the option of the utility company. Under
some contracts, the utility retains the Company to manage all aspects of its
appliance recycling program, while under other contracts, the Company provides
only specified services. Pricing for the Company's services is on a
per-appliance basis and depends upon several factors, including the total number
of appliances processed, the length of the contract term and the specific
services selected by the utility. Contracts with electric utility customers
require that the Company does not recondition for resale appliances received
from utility company energy conservation programs. Currently, the Company
expects to have only one major contract with an electric utility customer.

The Company believes its sources are adequate to supply the current
number of retail stores and allow the Company to grow its retail sales.

COMPANY OPERATIONS

The Company provides an integrated range of collection, reuse and
recycling services. Appliances are collected from a variety of sources,
including new appliance retailers and manufacturers, solid waste management
companies, property managers, local governments and electric utilities. Some
appliances are reconditioned and sold through the Company's retail network of
Encore and Appliance$mart stores. The remaining appliances are disposed of in an
environmentally responsible manner at the Company's recycling centers.
Environmentally harmful substances---including CFCs,

PCBs and mercury---are removed and properly managed. After all appliance
processing is completed, scrap materials are sold for recycling.

The Company believes 10 to 15% of all used appliances collected can
be reconditioned. Appliances identified for resale are thoroughly inspected for
wear-and-tear and broken or damaged parts. Worn parts are replaced and
appliances are tested to ensure they are fully operational and function safely
under proper conditions. Appliances are professionally cleaned and touched-up or
repainted. Reconditioned appliances are then sold in the Company's chain of
retail stores. Each appliance has a 90-day or one year warranty, with an
additional extended warranty available for purchase. The Company offers a
money-back guarantee and provides delivery and repair services on products that
it sells.

Appliances that don't meet the Company's standards are processed and
recycled in an environmentally sound manner. Appliances identified to be
recycled are processed per federal, state and local environmental regulations.
They are inspected and categorized according to the types of hazardous materials
they may contain. After the appliances are moved to the processing area, the
Company's processing technicians remove electrical capacitors and fluorescent
light ballasts that may contain PCB dielectric fluid, and components that may
contain mercury. The Company's processing technicians are trained to locate and
remove such components from all makes and models of appliances.

When processing at the Company's centers has been completed and the
appliances are free of environmentally hazardous components and materials, they
are delivered to qualified metals processing facilities for shredding. Shredded
materials from the processed appliances are sold to steel mini-mills or other
metal recovery facilities for appropriate reuse.

Management believes that the uncertainties in the electric utility
industry regarding deregulation will persist at least through 1999. The reaction
to deregulation among states and utilities has been varied. The Company
believes, however, that energy conservation and efficiency programs will remain
a long-term component of the nation's electric utility industry.

The Company does not expect to expand its retail business into new
geographic markets at this time. The Company plans to close three to four of its
smaller stores while opening 1 to 2 larger stores in its existing markets. The
Company believes that the growth of its business in the near future will likely
occur primarily through the expansion of revenues from the Company's current
retail stores and the generation of revenues from the expected contract with
Edison.

PRINCIPAL PRODUCT AND SERVICES

The Company generates revenues from three sources: recycling fees,
appliance sales and byproduct sales. The following table reflects the percentage
of total revenues from each source.

1998 1997 1996
---- ---- ----
Retail revenues 57.6% 34.6% 36.7%
Recycling revenues 35.6% 52.4% 48.4%
Byproduct revenues 6.8% 13.0% 14.9%
100.0% 100.0% 100.0%

SALES AND MARKETING

The Company uses various means to promote awareness of its services
and the need for environmentally sound recycling of appliances and believes it
is recognized as a leader in the appliance recycling industry.

The Company's strategy for its retail stores is to present a large
warehouse image in convenient, high-traffic locations. Store interiors are
bright and clean. In every market, the Company actively promotes its stores
through various forms of print advertising, including daily classified ads in
major newspapers, telephone yellow pages ads and direct mail. In addition, the
Company uses radio and television advertisements in some markets, in addition to
other types of promotions.

SEASONALITY

The Company experiences seasonal fluctuations in operating results,
with revenues generally higher during the second and third calendar quarters
than in the first and fourth calendar quarters. The lower levels in the first
and fourth quarters reflect consumer purchasing cycles, which result in lower
sales of major household appliances during such quarters and corresponding
reductions in the demand for appliance recycling services. Furthermore, utility
companies that sponsor appliance turn-in programs generally reduce their
promotional efforts for such programs during the first and fourth calendar
quarters. The Company expects that it will continue to experience lower revenues
in the first and fourth quarters of future years as compared to the second and
third quarters of such years.

COMPETITION

Competition for the Company's retail stores comes from new appliance
manufacturers and retailers and other reconditioned and used appliance
retailers. Each retail location will compete not only with local and national
chains of new appliance retailers, many of whom have been in business longer
than the Company and who may have significantly greater assets than the Company,
but will also be required to compete with numerous independently owned retailers
of used and reconditioned appliances.

Many factors, including existing and proposed governmental
regulation, may affect competition in the waste management and environmental
services industry. The Company generally competes with two or three other
companies which are based in the geographic area to be served under the contract
and which generally offer only some of the services provided by the Company.

The Company expects its primary competition for contracts with
existing or new customers to come from entrepreneurs entering the appliance
recycling business, energy management consultants, current recycling companies,
major waste hauling companies, scrap metal processors and used appliance
dealers. In addition, customers such as utility companies and local governments
may operate appliance recycling programs internally rather than contracting with
the Company or other third parties. There can be no assurance that the Company
will be able to compete profitably in any of its chosen markets.

GOVERNMENT REGULATION

The business of recycling major appliances is subject to certain
governmental laws and regulations and is becoming increasingly regulated. These
laws and regulations include landfill disposal restrictions, hazardous waste
management requirements and air quality standards, as well as special 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 various
federal, state and local laws, regulations and licensing requirements relating
to the collection, processing and recycling of household appliances.
Requirements for registrations, permits and licenses vary among the Company's
market areas. The Company's centers are registered with the EPA as hazardous
waste generators and are licensed, where required, by appropriate state and
local authorities. The Company has agreements with approved and licensed
hazardous waste companies for transportation and disposal of PCBs from its
centers.

The 1990 Amendments to the Clean Air Act provide for the phaseout of
the production of CFCs over a period of years. Effective July 1, 1992, the Act
prohibited the venting of CFCs in the course of maintaining, servicing,
repairing or disposing of an appliance. The Act also requires the recovery of
CFC refrigerants from appliances prior to their disposal or delivery for
recycling. In 1995, the venting of CFC substitute refrigerants was also
prohibited.

In 1992, Congress adopted the Energy Policy Act of 1992 to encourage
energy efficiency. Requirements under this act establish, among other things,
mandatory energy performance standards that affect the manufacture and sale of
major household appliances. Another component of this act allows for
deregulation of the nation's energy providers, including the electric utility
industry. The ultimate impact of deregulation on the electric utility industry
is yet unknown; therefore, there can be no assurance that the Company will be
able to continue certain of its current operations in a deregulated environment.

Company management believes that further government regulation of
the appliance recycling industry could have a positive effect on the Company's
business; however, there can be no assurance what course future regulation could
have. Under some circumstances, further regulation could materially increase the
costs of the Company's operations and have an adverse effect on the Company's
business. In addition, as is the case with all companies handling hazardous
materials, under some circumstances, the Company may be subject to contingent
liability.

EMPLOYEES

At March 1, 1999, the Company had 118 full-time employees, of whom
approximately 60 percent were involved in the collection, transportation and
processing of appliances at the Company's centers and approximately 40 percent
were in sales, administration and management. The Company has not experienced
any work stoppages and believes its employee relations are good.

ITEM 2. PROPERTIES

The Company's executive offices are located in Minneapolis,
Minnesota, in a Company owned facility which includes approximately 11 acres of
land. The building contains approximately 122,000 square feet, including 27,000
square feet of office space and 95,000 square feet of operations and processing
space. The Southern California center building, which also is owned by the
Company, is located in Compton, California, and consists of 44,000 square feet:
6,000 square feet of office space and 38,000 square feet of warehouse space. In
addition, the Company owns a 14,000-square-foot facility in Saint Paul,
Minnesota, which contains a retail store at which it sells reconditioned and
distressed appliances. All properties and equipment owned by the Company
currently secure outstanding loans of the Company.

The Company generally leases the other facilities it operates. The
Company usually attempts to negotiate lease terms that correspond to the term of
the principal contract or contracts in connection with which the center is to be
operated. The Company's recycling centers typically range in size from 12,000

to 40,000 square feet. The Company's retail stores have been typically 2,500 to
5,000 square feet. With the move toward larger retail stores, future stores are
anticipated to be 30,000 to 40,000 square feet.

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

ITEM 3. LEGAL PROCEEDINGS

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

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

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

PART II

ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS

MARKET FOR COMMON STOCK

The Company's Common Stock began trading on the OTC Bulletin Board September 8,
1998. Prior to that time, the Common Stock traded as follows: on the Nasdaq
SmallCap Market from February 26, 1997 to September 7, 1998; on the Nasdaq
National Market from January 8, 1993 to February 25, 1997; on the Nasdaq
SmallCap Market from January 7, 1991 to January 7, 1993; and on the local
over-the-counter market prior thereto. The following table sets forth, for the
periods indicated, the high and low closing bid quotations for the Common Stock,
as reported by the Nasdaq SmallCap Market and the OTC Bulletin Board, as
applicable. The table gives effect to the one-for-four reverse stock split
effective February 21, 1997.

HIGH LOW
---- ---
1997

First Quarter....................... $ 4 $ 2
Second Quarter...................... 3 3/8 2 3/8
Third Quarter....................... 3 1/4 2 1/2
Fourth Quarter...................... 4 1/4 2 1/8

1998

First Quarter....................... $ 2 3/4 $ 1 1/2
Second Quarter...................... 4 2
Third Quarter....................... 3 3/4
Fourth Quarter...................... 1 1/8 1/2

On March 12, 1999, the last reported sale price of the Common Stock
was $0.63 per share. As of March 12, 1999, there were approximately 1,775
beneficial holders of the Company's Common Stock.

The Common Stock trades under the symbol "ARCI."

During 1998, the Company issued 100,000 unregistered shares and
893,750 warrants to purchase shares.

During February 1999, the Company issued 1,030,000 unregistered
shares, and 83,000 warrants to purchase shares.

In May 1998, the Company sold in a private placement 100,000 shares
of Common Stock at a price of $2.00 per share. The sale, which represented
approximately 8% of the Common Stock outstanding after such sale, was made to an
institutional investor. The proceeds were used for additional working capital.

In July 1998, the Company issued 12% subordinated promissory notes
in the principal amount of $275,000, plus an aggregate of 68,750 warrants to
purchase the Company's Common Stock at $2.25 per share, subject to adjustment.
The notes were repaid in September 1998.

In September 1998, the Company entered into a loan agreement with a
lender resulting in gross proceeds of $3.5 million. The loan also provides for
non-voting attendance at board meetings. The Company issued to the lender, in
connection with the loan, a warrant to purchase 700,000 shares of Common Stock
at $2.50 per share, which price was adjustable under certain circumstances,
including the issuance of stock at or below $2.00 per share As a result of the
February 1999 stock issuance described below, the current exercise price of this
warrant is $0.60 per share. If exercised in full, this warrant would represent
approximately 24% of the Common Stock after such exercise. The Company also
issued to an investment banker associated with this transaction a warrant to
purchase 125,000 shares of Common Stock at $2.50 per share, subject to
adjustment. The portion of the gross loan proceeds ascribed to the
aforementioned warrants in conjunction with debt was $307,000.

In February 1999, the Company sold in a private placement 1,030,000
shares of Common Stock at a price of $0.50 per share. The sale represented
approximately 45% of Common Stock outstanding after such sale. The Company paid
$31,500 of the proceeds and issued warrants to purchase 83,000 shares of Common
Stock at $0.50 per share, subject to adjustment, to an investment banker as a
placement fee. The remaining proceeds were used to repay certain indebtedness,
to purchase inventory and for other general corporate purposes.

ITEM 6. SELECTED FINANCIAL DATA

The selected financial information set forth below should be read in
conjunction with "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Item 8. Financial Statements and
Supplementary Data."

Fiscal Years Ended 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------
(In thousands, except
per share data)

STATEMENT OF OPERATIONS
Total revenues $ 13,612 $ 11,979 $ 14,030 $ 16,241 $ 20,327
- -------------------------------------------------------------------------------------------------
Gross profit $ 3,981 $ 4,990 $ 2,744 $ 5,630 $ 8,360
- -------------------------------------------------------------------------------------------------
Operating income (loss) $ (2,744) $ (489) $ (6,899) $ (1,538) $ 1,753
- -------------------------------------------------------------------------------------------------
Net income (loss) $ (3,056) $ (748) $ (7,269) $ (943) $ 877
- -------------------------------------------------------------------------------------------------
Basic and diluted income
(loss) per common share $ (2.55) $ (0.66) $ (6.53) $ (0.90) $ 0.82
- -------------------------------------------------------------------------------------------------
Weighted average number
of common shares outstanding 1,200 1,137 1,114 1,052 1,071
- -------------------------------------------------------------------------------------------------

BALANCE SHEET
Working capital (deficit) $ (471) $ (1,959) $ (1,671) $ 3,503 $ 4,700
- -------------------------------------------------------------------------------------------------
Total assets $ 8,843 $ 8,569 $ 9,992 $ 15,890 $ 16,912
- -------------------------------------------------------------------------------------------------
Long-term liabilities $ 4,965 $ 1,633 $ 1,711 $ 2,084 $ 2,741
- -------------------------------------------------------------------------------------------------
Shareholders' equity $ 816 $ 3,365 $ 4,113 $ 10,188 $ 10,932
- -------------------------------------------------------------------------------------------------

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS FOR THE FISCAL YEARS 1998, 1997 AND 1996

OVERVIEW

The Company's 1998 fiscal year (1998) ended January 2, 1999, its
1997 fiscal year (1997) ended January 3, 1998 and its 1996 fiscal year (1996)
ended December 26, 1996.

The Company generates revenues from three sources: retail revenues,
recycling revenues and byproduct revenues. Retail revenues are sales of
appliances, extended warranty sales and delivery fees. Recycling revenues are
fees charged for the disposal of appliances. Byproduct revenues are sales of
materials generated from processed appliances. The Company experiences seasonal
fluctuations in operating results, with revenues generally higher during the
second and third calendar quarters than in the first and fourth quarters. The
lower levels in the first and fourth quarters reflect consumer purchasing
cycles, which result in lower demand for appliances and recycling services.

In 1998, the Company focused on increasing its sales of Whirlpool
products in its retail stores. The increase in total revenues was due to an
increase in retail sales offset by decreases in both recycling revenues and
byproduct revenues. In 1998, same-store sales for its reconditioned and
distressed appliance business increased by 108%. Retail revenues accounted for
57.6% of total revenues in 1998.

REVENUES

The Company's total revenues for 1998 were $13,612,000 compared to
$11,979,000 in 1997.

Retail revenues increased to $7,835,000 in 1998 from $4,149,000 in
1997. The increase was primarily due to increased sales of Whirlpool product.
Same-store retail sales for 1998 increased 108% (a sales comparison of 10 stores
open for full years in both 1998 and 1997). The Company operated 11 stores
throughout 1998. In December 1998, the Company decided to withdraw from a market
and close one center and two retail stores in 1999. Also, the Company decided to
close a retail store in another market as of December 31, 1998.

In 1998, the Company entered into a contract with Whirlpool
Corporation to acquire its distressed appliances (including "scratch and dent"
units with only cosmetic imperfections) from distribution centers serving the
Midwest and certain western states.

Recycling revenues decreased to $4,842,000 in 1998 from $6,274,000
in 1997. The decrease was primarily due to lower volume of appliances related to
the contract with Southern California Edison Company ("Edison"). Edison
accounted for approximately 29% of the Company's total revenues for 1998 and 38%
for 1997. The Company is anticipating that it will have a program with Edison
for 1999. Edison recently received budget approval from the California Public
Utilities Commission for a 1999 program. The Company is currently in final
contract negotiations with Edison and believes its 1999 recycling revenues level
is dependent on such an agreement and the resulting volume of appliances from
such arrangement.

Byproduct revenues decreased to $935,000 in 1998 from $1,556,000 in
1997. The decrease was primarily due to lower sales of reclaimed
chlorofluorocarbons due to fewer refrigerators being recycled and lower scrap
revenue due to a decrease in scrap prices.

The Company's total revenues for 1997 were $11,979,000 compared to
$14,030,000 in 1996.

Retail revenues decreased to $4,149,000 in 1997 from $5,148,000 in
1996. The decrease was primarily due to a reduction in the number of the
Company's retail stores to 13 in 1997 from 26 in the fourth quarter of 1996. Due
to substantial losses in 1996, the Company withdrew from three markets during
the fourth quarter of 1996, closing 12 retail locations and three recycling
centers. The Company operated 13 stores throughout 1997. Same-store sales (for
six stores open for the full years 1997 and 1996) increased 19% in 1997.

Recycling revenues decreased to $6,274,000 in 1997 from $6,785,000
in 1996. The decrease was primarily due to the Company's closing four recycling
centers in late 1996 and early 1997, partially offset by increased recycling
revenues from the Company's Edison contract.

Byproduct revenues decreased to $1,556,000 in 1997 from $2,097,000
in 1996. The decrease was primarily due to fewer appliances recycled in 1997
compared to 1996, which resulted from the closing of three recycling centers in
the fourth quarter of 1996.

In 1997, the Company entered into pilot program agreements with
Whirlpool Corporation to purchase Whirlpool's distressed, discontinued and
returned products.

GROSS PROFIT

The Company's overall gross profit decreased to 29.2% in 1998 from
41.7% in 1997. The decrease was primarily due to retail revenues, which have a
lower gross profit than recycling revenues, being a higher percentage of total
revenues and a decrease in recycling revenues related to the Edison contract.
Gross profit as a percentage of total revenues for future periods can be
affected favorably or unfavorably by numerous factors, including the volume of
appliances recycled from the expected Edison contract, the volume of Whirlpool
products sold during the period and the price and volume of byproduct revenues.
The Company expects gross profit percentages to continue to decline as retail
revenues become a higher percentage of total revenues.

The Company's overall gross profit rate increased to 41.7% in 1997
from 19.6% in 1996. The increase was primarily due to the closing of
under-performing recycling centers and retail stores in the fourth quarter of
1996 and increased operating efficiencies in the remaining centers.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses were 45.2% of sales in
1998 compared to 45.7% and 68.7% in 1997 and 1996, respectively. Selling,
general and administrative expenses increased to $6,152,000 in 1998 from
$5,479,000 in 1997, a 12.3% increase. Selling expenses increased to $2,028,000
in 1998 from $1,498,000 in 1997. The increase in selling expenses was primarily
due to an increase in sales commissions and advertising and costs associated
with opening an additional retail store in 1998. General and administrative
expenses increased to $4,124,000 in 1998 from $3,981,000 in 1997. The increase
in general and administrative expenses was primarily due to increased expenses
related to temporary personnel costs.

Selling, general and administrative expenses decreased to $5,479,000
in 1997 from $9,643,000 in 1996, a 43.2% decrease. Selling expenses decreased to
$1,498,000 in 1997 from $3,275,000 in 1996. The decrease in selling expenses was
primarily due to operating fewer retail stores in 1997 compared to 1996. General
and administrative expenses decreased to $3,981,000 in 1997 from $6,368,000 in
1996. The decrease was primarily due to operating fewer recycling centers in
1997 compared to 1996 and incurring lower costs associated with the closed
markets.

In June 1998, the Company took a one-time charge of $518,000 related
to a loss on impaired equipment associated with the Company's decision to
curtail the appliance shredding operation of its recycling business located
primarily at the Company's Minneapolis center. Also, in December 1998, the
Company took a one-time charge of $55,000 related to a loss on impaired assets
associated with the Company's decision to withdraw from a market and close one
center and two retail stores in 1999.

INTEREST EXPENSE

Interest expense increased to $601,000 in 1998 from $347,000 in
1997. The increase was primarily due to a higher average borrowed amount
outstanding in 1998 compared to 1997.

Interest expense increased slightly in 1997 compared to 1996 due to
a higher average borrowed amount outstanding in 1997 than 1996.

INCOME TAXES AND NET OPERATING LOSSES

As of its 1998 and 1997 year-ends, the Company recorded a valuation
allowance of $4,190,000 and $2,952,000, respectively, against its net deferred
tax assets due to the uncertainty of their realization. The realization of
deferred tax assets is dependent upon sufficient future taxable income during
the periods when deductible temporary differences and carryforwards are expected
to be available to reduce taxable income.

The Company has net operating losses of approximately $8,114,000 at
January 2, 1999, which are available to reduce taxable income and in turn income
taxes payable in future years. These carryforwards may be subject to certain
limitations under the provisions of the Internal Revenue Code, Section 382,
which relate to a 50 percent change in control over a three-year period. In
addition, any future changes of control may result in the expiration of a
portion of the carryforwards before they can be used and are also dependent upon
the Company attaining profitable operations in the future. To the extent the
Company is able to generate taxable income in a period in which this net
operating loss carryforward is available, the Company's cash requirements for
the payment of income taxes would be reduced.

MINORITY INTEREST IN NET INCOME OF SUBSIDIARY

The Company was an 80% shareholder in its California subsidiary, and
accordingly, recorded the minority shareholder's interest in the subsidiary's
net income during 1997. No minority interest was recorded in 1996 since the
subsidiary had an accumulated net loss. During the fourth quarter of 1997, the
Company purchased all the minority shareholder's stock in the California
subsidiary.

LIQUIDITY AND CAPITAL RESOURCES

At January 2, 1999, the Company had a working capital deficit of
$471,000 compared to a working capital deficit of $1,959,000 at January 3, 1998.
Cash and cash equivalents increased to $14,000 at January 2, 1999 from $13,000
at January 3, 1998. Net cash used in operating activities was $3,078,000 in 1998
compared to net cash provided by operating activities of $308,000 in 1997. The
increase in cash used in operating activities was primarily due to an increase
in the Company's net loss net of a one-time non-cash expense for impaired
assets, plus an increase in inventories.

Net cash used in investing activities was $18,000 in 1998 compared
to $467,000 in 1997. The decrease in net cash used in investing activities in
1998 from 1997 was due to higher proceeds from selling excess equipment in 1998
and cash used for the purchase of the minority interest in the California
subsidiary in 1997.

Net cash provided by financing activities was $3,097,000 compared to
net cash used in financing activities of $108,000 in 1997. The increase in cash
provided by financing activities was primarily due to net proceeds from
long-term obligations received in 1998 offset by a decrease in net borrowings
under the line of credit and increased payments on long-term obligations. In
September 1998, the Company entered into a loan agreement with a lender
resulting in gross proceeds of $3.5 million.

The Company's capital expenditures were approximately $289,000 in
1998 and $299,000 in 1997. The 1998 and 1997 capital expenditures were primarily
related to building improvements. The Company did not have any material purchase
commitments for assets as of January 2, 1999.

As of January 2, 1999, the Company had a $2.0 million line of credit
with a lender. The interest rate as of January 2, 1999 was 12.75%. The amount of
borrowings available under the line of

credit is based on a formula using receivables and inventories. The line of
credit has a stated maturity date of August 30, 1999, if not renewed, and
provides that the lender may demand payment in full of the entire outstanding
balance of the loan at any time. The line of credit is secured by substantially
all the Company's assets, is guaranteed by the President of the Company and
requires minimum monthly interest payments of $5,625 regardless of the
outstanding principal balance. The Lender is also secured by an inventory
repurchase agreement with Whirlpool Corporation. The loan also requires that the
Company meet certain financial covenants, provides payment penalties for
noncompliance, limits the amount of other debt the Company can incur, limits the
amount of spending on fixed assets and limits payments of dividends. At January
2, 1999, the Company's unused borrowing capacity was $65,000 and at March 1,
1999 was $335,000.

In May 1998, the Company sold 100,000 shares of its Common Stock in
a private placement at a price of $2.00 per share. The sale was made to an
institutional investor. The proceeds were used for additional working capital.

In June 1998, the Company entered into a ten-year, 9.88% mortgage
loan with a bank for $250,000. The proceeds from the mortgage loan were used to
remodel one of its retail stores.

In July 1998, the Company issued 12% subordinated promissory notes
plus 68,750 warrants to purchase the Company's Common Stock at $2.25 per share
for $275,000. The loan proceeds were used to purchase inventory and provide
additional working capital. The notes were repaid in September 1998 with part of
the proceeds of the September 1998 loan (as defined below).

In September 1998, the Company entered into a loan agreement with a
lender resulting in gross proceeds of $3.5 million ("September 1998 Loan"). The
maturity date for the loan is September 30, 2005 and the annual interest rate is
13%. The loan is secured by all the Company's personal property and all of its
real estate, and provides for non-voting attendance at board meetings. The
Company issued to the lender, in connection with the loan, a warrant to purchase
700,000 shares of Common Stock at $2.50 per share, which price was adjustable
under certain circumstances, including the issuance of stock at or below $2.00
per share. As a result of the February 1999 stock issuance described below, the
current price of this warrant is $0.60 per share. The Company also issued to an
investment banker, in connection with the September 1998 Loan, a warrant to
purchase 125,000 shares of Common Stock at $2.50 per share and paid a placement
fee of $180,000. The Company used the proceeds to repay certain indebtedness
(including approximately $1,500,000 of outstanding indebtedness), to finance
inventory and for other general corporate purposes. The portion of the gross
loan proceeds ascribed to the aforementioned warrants in conjunction with debt
was $307,000.

In February 1999, the Company sold in a private placement 1,030,000
shares of Common Stock at a price of $0.50 per share. The Company paid $31,500
of the proceeds and issued warrants to purchase 83,000 shares of Common Stock at
$0.50 per share, subject to adjustment, to an investment banker as a placement
fee. The remaining proceeds were used to repay certain indebtedness, to purchase
inventory and for other general corporate purposes.

The Company believes, based on anticipated revenues from the
expected Edison contract, the anticipated sales per retail store and the
anticipated gross profit, that its cash balance, anticipated funds generated
from operations, its current line of credit if renewed in August 1999, and the
proceeds from the sale of its Common Stock in February 1999 will be sufficient
to finance its operations and capital expenditures through December 1999. The
Company's total capital requirements will depend, among other things as
discussed below, on the number of recycling centers operating and the number and
size of retail stores operating during the fiscal year. Currently, the Company
has three centers and eight

stores in operation. If revenues are lower than anticipated or expenses are
higher than anticipated or the line of credit cannot be maintained, the Company
may require additional capital to finance operations. Sources of additional
financing, if needed in the future, may include further debt financing or the
sale of equity (common or preferred stock) or other securities. There can be no
assurance that such additional sources of financing will be available or
available on terms satisfactory to the Company or permitted by the Company's
current lenders.

YEAR 2000

Based on a recent assessment of the Year 2000 Issue, the Company
determined that it will be required to modify or replace significant portions of
its software so that its computer systems will properly utilize dates beyond
December 31, 1999. The Company believes that with modifications to existing
software and conversions to new software, the Year 2000 Issue will not have a
material adverse impact on the Company's operations. However, if such
modifications and conversions are not made, or are not completed in a timely
manner, the Year 2000 Issue could have a material impact on the operations of
the Company. The Company has determined it has no exposure to contingencies
related to the Year 2000 Issue for products it has sold.

The Company will utilize both internal and external resources to
replace and test the software for Year 2000 modifications. The Company plans to
complete the Year 2000 Project no later than September 30, 1999. The costs of
the project are expected to be funded through operating cash flows. A portion of
the costs will be used to purchase new software, which will be capitalized. The
remaining portion of the costs will be expensed as incurred over the course of
the project. The overall cost of the project is expected to be approximately
$250,000 in 1999. To date, the Company has incurred and expensed approximately
$10,000 related to the assessment of, and preliminary efforts in connection
with, its Year 2000 Project and development of a remediation plan. The Company's
cost and estimates to complete the Year 2000 Project include the estimated costs
and time associated with accessing the impact of a third party's Year 2000
Issue, and are based on presently available information.

The Company has initiated communications with all of its significant
suppliers and large customers to determine the extent to which the Company is
vulnerable to those third parties' failure to remediate their own Year 2000
Issue. However, there can be no guarantee that the systems of other companies on
which the Company's systems rely will be timely converted, or that a failure to
convert by another company, or a conversion that is incompatible with the
Company's systems, would not have material adverse effect on the Company.

At this time, the Company believes that its most reasonable likely
worst case scenario is that the Company could experience delays in receipt of
inventory and/or key customers could experience a delay in accounts receivable
payments to the Company. In the event that either of these scenarios occur,
management believes that it would not have a long-term material adverse effect
on the Company's financial condition and results of operations.

The Company does intend to prepare contingency plans so that the
Company's critical business processes can be expected to continue to function on
January 1, 2000 and beyond. The Company's contingency plans are expected to
address modification of the Company's systems and components as well as overall
business operating risks. These plans are intended to mitigate both internal
risks as well as potential risks in the supply chain of the Company's suppliers
and customers, and will likely include identifying and securing alternative
supplies of inventory and sources of financing. The Company intends to begin
working on a contingency plan in early 1999 and to have it substantially
finalized by September 1999.

The costs of the project and the date by which the Company plans to
complete the Year 2000 modifications and contingency plans are based on
management's best estimates, which were derived utilizing numerous assumptions
of future events, including the continued availability of certain resources,
third party modification plans and other factors. However, there can be no
assurances that these estimates will be achieved and actual results could differ
materially from those plans. Specific factors that might cause such material
differences include, but are not limited to, the availability and cost of
personnel trained in this area, the ability to locate and correct all relevant
computer codes, and similar uncertainties.

FORWARD-LOOKING STATEMENTS

Statements contained in this annual report regarding the Company's
future operations, performance and results, and anticipated liquidity discussed
herein are forward-looking and therefore are subject to certain risks and
uncertainties, including those discussed herein. In addition, any
forward-looking information regarding the operations of the Company will be
affected by the ability of individual stores to meet planned revenue levels, the
speed at which individual stores reach profitability, costs and expenses being
realized at higher than expected levels, the continued ability to purchase
product from Whirlpool at acceptable prices, the Company's ability to secure an
adequate supply of used appliances for resale, the continued availability of the
Company's current line of credit, the renewal of the contract with Edison for
1999 and the ability and timing of Edison to deliver units under its expected
contract with the Company.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Not applicable.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Description
-----------

Independent Auditor's Report
Consolidated Balance Sheets as of January 2, 1999
and January 3, 1998
Consolidated Statements of Operations for the three years
ended January 2, 1999
Consolidated Statements of Shareholders' Equity for the three years
ended January 2, 1999
Consolidated Statements of Cash Flows for the three years
ended January 2, 1999
Notes to Consolidated Financial Statements

INDEPENDENT AUDITOR'S REPORT

To the Board of Directors and Shareholders
Appliance Recycling Centers of America, Inc.
Minneapolis, Minnesota

We have audited the accompanying consolidated balance sheets of Appliance
Recycling Centers of America, Inc. and subsidiaries as of January 2, 1999 and
January 3, 1998, and the related consolidated statements of operations,
shareholders' equity, and cash flows for each of the years in the three year
period ended January 2, 1999. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Appliance Recycling
Centers of America, Inc. and subsidiaries as of January 2, 1999 and January 3,
1998, and the results of their operations and their cash flows for each of the
years in the three year period ended January 2, 1999, in conformity with
generally accepted accounting principles.

McGLADREY & PULLEN, LLP

Minneapolis, Minnesota
February 19, 1999

APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

JANUARY 2, January 3,
1999 1998
- --------------------------------------------------------------------------------------------

ASSETS

CURRENT ASSETS
Cash and cash equivalents $ 14,000 $ 13,000
Accounts receivable, net of allowance of
$18,000 and $35,000, respectively
(Notes 4 and 10) 498,000 765,000
Inventories, net of reserves of $40,000
and $20,000, respectively (Note 4) 1,979,000 694,000
Other current assets 100,000 140,000
------------ ------------
Total current assets $ 2,591,000 $ 1,612,000
------------ ------------
PROPERTY AND EQUIPMENT, AT COST (Notes 4, 5 and 11)
Land $ 2,103,000 $ 2,103,000
Buildings and improvements 3,957,000 3,955,000
Equipment 3,597,000 5,461,000
------------ ------------
$ 9,657,000 $ 11,519,000
Less accumulated depreciation 3,876,000 4,807,000
------------ ------------
Net property and equipment $ 5,781,000 $ 6,712,000
------------ ------------
OTHER ASSETS $ 319,000 $ 55,000
GOODWILL, NET OF AMORTIZATION OF $38,000
AS OF JANUARY 2, 1999 152,000 190,000
------------ ------------
Total assets $ 8,843,000 $ 8,569,000
============ ============

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES
Line of credit (Note 4) $ 1,081,000 $ 1,513,000
Current maturities of long-term obligations (Note 5) 79,000 101,000
Accounts payable 1,202,000 1,136,000
Accrued expenses (Note 6) 700,000 821,000
------------ ------------
Total current liabilities $ 3,062,000 $ 3,571,000
LONG-TERM OBLIGATIONS, LESS CURRENT MATURITIES (Note 5) 4,965,000 1,633,000
------------ ------------
Total liabilities $ 8,027,000 $ 5,204,000
------------ ------------
COMMITMENTS (Note 7)
SHAREHOLDERS' EQUITY (Notes 3, 4, and 9)
Common Stock, no par value; authorized 10,000,000
shares; issued and outstanding 1,237,000 shares
and 1,137,000 shares, respectively $ 10,857,000 $ 10,350,000
Accumulated deficit (10,041,000) (6,985,000)
------------ ------------
Total shareholders' equity $ 816,000 $ 3,365,000
------------ ------------
Total liabilities and shareholders' equity $ 8,843,000 $ 8,569,000
============ ============

See Notes to Consolidated Financial Statements.

APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

For the fiscal year ended
- ----------------------------------------------------------------------------------------------------------------
JANUARY 2, January 3, December 28,
1999 1998 1996
-----------------------------------------------------

REVENUES (Note 10)
Retail revenues $ 7,835,000 $ 4,149,000 $ 5,148,000
Recycling revenues 4,842,000 6,274,000 6,785,000
Byproduct revenues 935,000 1,556,000 2,097,000
------------- ------------- -------------

Total revenues $ 13,612,000 $ 11,979,000 $ 14,030,000

COST OF REVENUES 9,631,000 6,989,000 11,286,000
------------- ------------- -------------

Gross profit $ 3,981,000 $ 4,990,000 $ 2,744,000

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (Note 2) 6,152,000 5,479,000 9,643,000

LOSS ON IMPAIRED ASSETS (Note 11) 573,000 -- --
------------- ------------- -------------

Operating loss $ (2,744,000) $ (489,000) $ (6,899,000)

OTHER INCOME (EXPENSE)
Other income 319,000 134,000 122,000
Interest income 1,000 8,000 37,000
Interest expense (601,000) (347,000) (294,000)
------------- ------------- -------------

Loss before provision for (benefit of) income
taxes and minority interest $ (3,025,000) $ (694,000) $ (7,034,000)

PROVISION FOR (BENEFIT OF) INCOME TAXES (Note 8) 31,000 (31,000) 235,000
------------- ------------- -------------

Loss before minority interest $ (3,056,000) $ (663,000) $ (7,269,000)

MINORITY INTEREST IN NET INCOME OF SUBSIDIARY -- 85,000 --
------------- ------------- -------------

Net loss $ (3,056,000) $ (748,000) $ (7,269,000)
============= ============= =============

BASIC AND DILUTED LOSS PER COMMON SHARE $ (2.55) $ (0.66) $ (6.53)
============= ============= =============

WEIGHTED AVERAGE NUMBER OF COMMON SHARES 1,200,000 1,137,000 1,114,000
============= ============= =============

See Notes to Consolidated Financial Statements.

APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

Retained Accumulated
Earnings Other
(Accumulated Comprehensive
Common Stock Deficit) Income (Loss) Total
-------------------- -------- ------------- -----
Shares Amount
------ ------

BALANCE, DECEMBER 30, 1995 1,057,000 $ 9,177,000 $ 1,032,000 $ (21,000) $ 10,188,000
Issuance of Common Stock
(Notes 3 and 9) 73,000 1,118,000 -- -- 1,118,000
Exercise of Common Stock
Options and Warrants (Note 9) 7,000 55,000 -- -- 55,000
Comprehensive loss:
Net loss -- -- (7,269,000) -- --
Other comprehensive income:
Foreign currency translation
adjustment -- -- -- 21,000 --
Comprehensive loss -- -- -- -- (7,248,000)
- --------------------------------------------------------------------------------------------------------------------------

BALANCE, DECEMBER 28, 1996 1,137,000 $ 10,350,000 $ (6,237,000) $ -- $ 4,113,000
Net loss -- -- (748,000) -- (748,000)
- --------------------------------------------------------------------------------------------------------------------------

BALANCE, JANUARY 3, 1998 1,137,000 $ 10,350,000 $ (6,985,000) $ -- $ 3,365,000
Issuance of Common Stock
(Note 9) 100,000 200,000 -- -- 200,000
Proceeds ascribed to warrants issued
in conjunction with long-term debt
(Note 9) -- 307,000 -- -- 307,000
Net loss -- -- (3,056,000) -- (3,056,000)
- --------------------------------------------------------------------------------------------------------------------------

BALANCE, JANUARY 2, 1999 1,237,000 $ 10,857,000 $(10,041,000) $ -- $ 816,000
==========================================================================================================================

See Notes to Consolidated Financial Statements.

APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

For the fiscal year ended
- ---------------------------------------------------------------------------------------------------------------------
JANUARY 2, January 3, December 28,
1999 1998 1996
------------ ------------ ------------

CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (3,056,000) $ (748,000) $ (7,269,000)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Depreciation and amortization 704,000 1,027,000 2,477,000
Minority interest in net income of subsidiary -- 85,000 --
Common Stock issued for services -- -- 30,000
Gain on sale of equipment (266,000) (80,000) (118,000)
Deferred income taxes -- -- 650,000
Loss on impaired assets 573,000 -- --
Change in current assets and liabilities, net of effects
from acquisition of Universal Appliance Company, Inc.,
and Universal Appliance Recycling, Inc. in 1996:
Receivables 238,000 391,000 510,000
Inventories (1,285,000) (250,000) 37,000
Other current assets 40,000 106,000 88,000
Refundable income taxes 29,000 371,000 (294,000)
Accounts payable 66,000 (255,000) (327,000)
Accrued expenses (121,000) (339,000) 87,000
Income taxes payable -- -- (13,000)
------------ ------------ ------------
Net cash provided by (used in)
operating activities $ (3,078,000) $ 308,000 $ (4,142,000)
------------ ------------ ------------

CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment $ (289,000) $ (299,000) $ (1,285,000)
Purchase of minority interest in California subsidiary -- (275,000) --
Cash acquired in 1996 business acquisition -- -- 26,000
Proceeds from disposals of property and equipment 271,000 107,000 415,000
Payments for non-compete agreements -- -- (110,000)
------------ ------------ ------------
Net cash used in investing activities $ (18,000) $ (467,000) $ (954,000)
------------ ------------ ------------

CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) under line of credit $ (432,000) $ 123,000 $ 1,390,000
Payments on long-term obligations (408,000) (231,000) (1,412,000)
Proceeds and tax benefit from stock options exercises -- -- 55,000
Proceeds from long-term obligations 3,718,000 -- 17,000
Proceeds ascribed to warrants issued in conjunction
with long-term debt obligations 307,000 -- --
Deferred financing costs (288,000) -- --
Proceeds from issuance of Common Stock 200,000 -- 700,000
------------ ------------ ------------
Net cash provided by (used in)
financing activities $ 3,097,000 $ (108,000) $ 750,000
------------ ------------ ------------
Effect of foreign currency exchange rate
changes on cash and cash equivalents $ -- $ -- $ 21,000
------------ ------------ ------------
Increase (decrease) in cash and cash equivalents $ 1,000 $ (267,000) $ (4,325,000)

CASH AND CASH EQUIVALENTS
Beginning 13,000 280,000 4,605,000
------------ ------------ ------------
Ending $ 14,000 $ 13,000 $ 280,000
============ ============ ============

APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

For the fiscal year ended
- ---------------------------------------------------------------------------------------------------------------
JANUARY 2, January 3, December 28,
1999 1998 1996
---------- ---------- ------------

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for (receipts of):
Interest $ 562,000 $ 346,000 $ 285,000
Income taxes 2,000 (399,000) (103,000)
========== ========== ==========

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
Long-term obligations incurred on purchase
of equipment $ -- $ 27,000 $ --
========== ========== ==========
Acquisition of Universal Appliance Company, Inc.
and Universal Appliance Recycling, Inc.
Working capital acquired, including cash and
cash equivalents of $26,000 $ -- $ -- $ 118,000
Fair value of other assets acquired, principally
property and equipment and a non-compete
agreement -- -- 176,000
Purchase price assigned to goodwill -- -- 301,000
Long-term debt assumed -- -- (207,000)
---------- ---------- ----------
Total consideration, 21,000 shares of
Common Stock $ -- $ -- $ 388,000
========== ========== ==========

See Notes to Consolidated Financial Statements.

APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESS: Appliance Recycling Centers of America, Inc. and
subsidiaries (the "Company") is in the business of selling reconditioned and
distressed appliances and providing recycling services in an environmentally
sound manner for major household appliances throughout the United States. The
Company sells reconditioned appliances through a chain of Company-owned stores
under the names "Encore(R) Recycled Appliances" and "Appliance$mart(R)." The
Company provides recycling services on a credit basis to utilities, local
governments, appliance retailers and waste management companies.

A SUMMARY OF THE COMPANY'S SIGNIFICANT ACCOUNTING POLICIES IS AS FOLLOWS:

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

FAIR VALUE OF FINANCIAL INSTRUMENTS: The following methods and assumptions are
used to estimate the fair value of each class of financial instrument:

CASH EQUIVALENTS, ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE: Due to
their short-term maturities, the carrying amounts approximate fair
value.

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

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

FISCAL YEAR: The Company's 1998 fiscal year (1998) ended January 2, 1999, its
1997 fiscal year (1997) ended January 3, 1998 and its 1996 fiscal year (1996)
ended December 26, 1996. The fiscal years 1998 and 1996 include 52 weeks. The
fiscal year 1997 includes 53 weeks.

REVENUE RECOGNITION: The Company recognizes revenue from appliance sales in the
period the appliance is sold. Recycling revenue is recognized when a unit is
collected and processed. Byproduct revenue is recognized upon shipment.

The Company provides allowances for uncollectable revenues receivable based on
management's periodic assessment of the need for such allowances. The Company
defers revenue under appliance extended warranty arrangements and recognizes it
over the terms of the warranty contracts. The Company accrues the estimated cost
of initial warranty arrangements at the time of the appliance sale.

CASH AND CASH EQUIVALENTS: For purposes of reporting cash flows, the Company
considers all cash and any treasury bills, commercial paper and money-market
funds with an initial maturity of three months or less to be cash equivalents.
The Company maintains its cash in bank deposits and money-market accounts which,
at times, exceed federally insured limits. The Company has not experienced any
losses in such accounts.

INVENTORIES: Inventories, consisting primarily of reconditioned and distressed
appliances, are stated at the lower of cost, first-in, first-out (FIFO), or
market.

Inventories consisted of the following:

1998 1997
- -------------------------------------------------------------------------------
Finished goods $1,830,000 $605,000
Work-in-process-
unrefurbished units 189,000 109,000
Less reserves (40,000) (20,000)
---------- --------
$1,979,000 $694,000
========== ========

DEFERRED FINANCING COSTS: In connection with financing transactions in 1998
under notes payable arrangements, the Company incurred $288,000 of costs which
have been recorded in other assets and are being amortized using the straight
line method over the terms of the related debt.

GOODWILL: The Company was an 80% shareholder in its California subsidiary, and
accordingly, recorded the minority shareholder's interest in the subsidiary's
net

income. During the fourth quarter of 1997, the Company purchased all of the
minority shareholder's stock in the California subsidiary. This transaction
resulted in the Company recording goodwill of $190,000. Goodwill is being
amortized by the straight-line method over a period of five years.

PROPERTY AND EQUIPMENT: Depreciation is computed using straight-line and
accelerated methods over the following estimated useful lives:

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

ACCOUNTING FOR LONG-LIVED ASSETS: The Company reviews its property, equipment
and goodwill periodically to determine potential impairment by comparing the
carrying value of the long-lived assets with the estimated future net
undiscounted 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 the carrying value, the Company recognizes an impairment loss
at that date. An impairment loss is measured by comparing the amount by which
the carrying value exceeds the fair value (estimated discounted future cash
flows or appraisal of assets) of the long-lived assets. In 1998, the Company
recorded a loss on impairment of certain assets (See Note 11).

ADVERTISING EXPENSE: Advertising is expensed as incurred.

INCOME TAXES: Deferred taxes are provided on an asset and liability method
whereby deferred tax assets are recognized for deductible temporary differences
and operating loss and tax credit carryforwards, and deferred tax liabilities
are recognized for taxable temporary differences. Temporary differences are the
differences between the reported amounts of assets and liabilities and their tax
basis. Deferred tax assets are reduced by a valuation allowance when, in the
opinion of management, it is more likely than not that some portion or all of
the deferred tax assets will not be realized. Deferred tax assets and
liabilities are adjusted for the effects of changes in tax laws and rates on the
date of enactment.

BASIC AND DILUTED NET LOSS PER SHARE: Basic per-share amounts are computed,
generally, by dividing net income or loss by the weighted-average number of
common shares outstanding. Diluted per-share amounts assume the conversion,
exercise or issuance of all potential common stock instruments unless their
effect is antidilutive, thereby reducing the loss or increasing the income per
common share.

As described in Note 9, at January 2, 1999, and January 3, 1998, the Company had
stock options and warrants outstanding to purchase a total of 1,038,000 and
93,000 shares of Common Stock, respectively. However, because the Company has
incurred a loss in all periods presented, the inclusion of those potential
common shares in the calculation of diluted loss per-share would have an
antidilutive effect. Therefore, basic and diluted loss per-share amounts are the
same in each period presented.

REPORTING COMPREHENSIVE INCOME: As of January 1, 1998, the Company adopted
Statement of Financial Accounting Standards (SFAS) No. 130, REPORTING
COMPREHENSIVE INCOME. SFAS No. 130 establishes new rules for the reporting and
display of comprehensive income and its components. SFAS No. 130 requires
unrealized gains or losses, which prior to adoption were reported separately in
shareholders' equity, to be included in other comprehensive income. For the
Company, reporting comprehensive income would be equivalent to reporting
operating results in the statement of operations for the years ended January 2,
1999 and January 3, 1998. Comprehensive income for the year ended December 28,
1996 is presented in the consolidated statements of shareholders' equity.

SEGMENT INFORMATION: Effective January 1, 1998, the Company adopted Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"). SFAS 131 requires that a
company report financial and descriptive information about its reportable
operating segments, defined as those components of an enterprise about which
separate financial information is available and is evaluated regularly by
management in deciding how to allocate resources and in assessing performance.
The adoption of SFAS No. 131 did not affect the Company's results of operations
or financial position. The Company believes that it has one operating segment,
although certain separate financial information by retail store, or retail store
and recycling center, is available to management. The Company is managed as a
unit. Specifically, it does not measure profit or loss or maintain assets
separately for its products/revenue sources (reconditioned appliance sales,
appliance recycling and recycling services for utilities).

ESTIMATES: The preparation of financial statements in conformity with generally
accepted accounting principles

requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.

NOTE 2. MARKET CLOSINGS AND CORPORATE LIQUIDITY

In December 1998, the Company decided to withdraw from the under-performing St.
Louis, Missouri market. The Company closed its recycling center and two retail
stores in February 1999. For the year ended January 2, 1999, the Company
incurred expenses of approximately $130,000 which included the write-off of
leasehold improvements of approximately $55,000 and inventory and the accrual of
remaining lease payments and other costs of approximately $75,000.

The Company withdrew from three under-performing markets in the fourth quarter
of 1996. The Company closed three recycling centers and nine retail stores in
Hartford, Connecticut; Washington, D.C./Baltimore, Maryland; and Oakland,
California. In addition, the Company closed its three retail stores in Los
Angeles, California. In connection therewith, the Company incurred charges of
approximately $2.0 million which included the write-off of leasehold
improvements, deferred tax assets, goodwill, and certain non-compete agreements,
receivables and inventories, and the accrual of potential lease contingencies
and other costs.

The Company believes, based on anticipated revenues from an expected Southern
California Edison Company contract, the anticipated sales per retail store and
the anticipated gross profit, that its cash balance, anticipated funds generated
from operations, its current line of credit if renewed, and the proceeds from
the sale of its Common Stock in February 1999 will be sufficient to finance its
operations and capital expenditures through December 1999. The Company's total
capital requirements will depend, among other things as discussed below, on the
number of recycling centers operating and the number and size of retail stores
operating during the fiscal year. Currently, the Company has three recycling
centers and eight stores in operation. If revenues are lower than anticipated or
expenses are higher than anticipated or the line of credit cannot be maintained,
the Company may require additional capital to finance operations. Sources of
additional financing, if needed in the future, may include further debt
financing or the sale of equity or other securities. There can be no assurance
that such additional sources of financing will be available or available at
terms satisfactory to the Company or permitted by the Company's current lenders.

NOTE 3. BUSINESS COMBINATIONS

On January 2, 1996, the Company acquired Universal Appliance Company, Inc. and
Universal Appliance Recycling, Inc., Washington, D.C.-based companies, by
exchanging a total of 21,000 shares of its Common Stock for 100% ownership of
the respective companies. The acquisitions were accounted for under the purchase
method of accounting. Also, the selling shareholders received $110,000 under
non-compete agreements. In December 1996, the Company withdrew from the
Washington D.C./Baltimore, Maryland market and closed the center and three
retail locations. Accordingly, the related goodwill and non-compete agreements
were written off in the fourth quarter of 1996.

NOTE 4. LINE OF CREDIT

At January 2, 1999, the Company had a $2.0 million line of credit with a lender.
The interest rate as of January 2, 1999 was 12.75%. The amount of borrowings
available under the line of credit is based on a formula using receivables and
inventories. The line of credit has a stated maturity date of August 30, 1999
unless renewed and provides that the lender may demand payment in full of the
entire outstanding balance of the loan at any time. The line of credit is
secured by substantially all the Company's assets, is guaranteed by the
President of the Company and requires minimum monthly interest payments of
$5,625 regardless of the outstanding principal balance. The lender is also
secured by an inventory repurchase agreement with Whirlpool Corporation. The
loan also requires that the Company meet certain financial covenants, provides
payment penalties for noncompliance, limits the amount of other debt the Company
can incur, limits the amount of spending on fixed assets and limits payments on
dividends. At January 2, 1999 the Company's unused borrowing capacity under this
line was $65,000.

NOTE 5. LONG-TERM OBLIGATIONS

Long-term obligations consisted of the following:

1998 1997
- --------------------------------------------------------------------------
9.00% mortgage, due in
monthly installments of
$11,411, including
interest, balance due
February 2004,
secured by land
and building $ 911,000 $ 962,000
8.75% mortgage, due
in monthly installments
of $7,027, including
interest, balance due
January 2003, secured
by land and building 678,000 700,000
13.00% note payable,
monthly interest
payments of $37,917
until September 2000,
monthly principal and
interest payments of
$52,259 beginning
September 2000, balance
due September 2005,
secured by equipment,
land and building 3,203,000 --
9.88% mortgage, due in
monthly installments of
$3,286, including interest,
balance due September
2008, secured by land
and building 231,000 --
Other 21,000 72,000
---------- ----------
$5,044,000 $1,734,000
Less current maturities 79,000 101,000
---------- ----------
$4,965,000 $1,633,000
========== ==========

The future annual maturities of long-term obligations are as follows:

Fiscal year
- -----------
1999 $ 79,000
2000 134,000
2001 271,000
2002 305,000
2003 867,000
Thereafter 3,388,000
----------
$5,044,000
==========

NOTE 6. ACCRUED EXPENSES

Accrued expenses were as follows:
1998 1997
- --------------------------------------------------------------------------
Compensation $139,000 $ 167,000
Warranty 157,000 74,000
Lease contingencies
and closing costs 124,000 289,000
Other 280,000 291,000
-------- ------------
$700,000 $ 821,000
======== ============

NOTE 7. COMMITMENTS

OPERATING LEASES: The Company leases certain of its recycling center facilities
and equipment and retail stores under noncancelable operating leases. The leases
require the payment of taxes, maintenance, utilities and insurance.

In the fourth quarter of 1996, the Company withdrew from three under-performing
markets and closed its retail locations in the Los Angeles, California, market.
At January 2, 1999, the Company had $69,000 accrued for the remaining settlement
of these leases.

In December 1998, the Company decided to withdraw from the St. Louis, Missouri
market. The Company accrued approximately $42,000 for the remaining lease
payments on these leases.

Minimum rental commitments under noncancelable operating leases as of January 2,
1999 were as follows:

Fiscal Year
- -----------
1999 $ 510,000
2000 431,000
2001 241,000
2002 199,000
2003 199,000
----------
$1,580,000
==========

Rent expense for the fiscal years ended January 2, 1999, January 3, 1998 and
December 28, 1996 was $482,000, $433,000 and $1,585,000, respectively.

NOTE 8. INCOME TAXES

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

1998 1997 1996
- -------------------------------------------------------------------------------
Current:
Federal $ -- $ -- $(415,000)
State 31,000 (31,000) --
Deferred -- -- 650,000
------- -------- ---------
$31,000 $(31,000) $ 235,000
======= ======== =========

A reconciliation of the Company's income tax expense (benefit) with the federal
statutory tax rate is shown below:

1998 1997 1996
- -------------------------------------------------------------------------------
Income tax
benefit at
statutory rate $ (1,049,000) $ (236,000) $ (2,462,000)
State taxes, net
of federal
tax effect (192,000) (26,000) (208,000)
Permanent
differences 34,000 74,000 110,000
Change in valuation
allowance 257,000 (289,000) 235,000
Effect of NOL
with no current
tax benefit 981,000 446,000 2,560,000
------------ ---------- ------------
$ 31,000 $ (31,000) $ 235,000
============ ========== ============

The tax effects of principal temporary differences are as follows:

1998 1997
- -------------------------------------------------------------------------------
Deferred tax assets:
Net operating loss
carryforwards $ 3,300,000 $ 2,319,000
Loss on asset impairment 658,000 429,000
Federal and state tax credits 250,000 250,000
Accrued expenses 236,000 246,000
----------- ----------
Gross defered tax assets $ 4,444,000 $ 3,244,000
----------- ----------
Deferred tax liability:
Accelerated tax depreciation (254,000) (292,000)
Valuation allowance (4,190,000) (2,952,000)
----------- -----------
Net deferred tax assets $ -- $ --
=========== ===========

At January 2, 1999, the Company recorded a valuation allowance of $4,190,000
against deferred tax assets to reduce the total to an amount management believes
is appropriate. Realization of deferred tax assets is dependent upon sufficient
future taxable income during the periods when deductible temporary differences
and carryforwards are expected to be available to reduce taxable income.

At January 2, 1999, the Company had net operating loss carryforwards consisting
of the following:

Expiration Amount
- ---------- ------
2011 $4,515,000
2012 $1,115,000
2018 $2,484,000

These carryforwards may be subject to certain limitations under the provisions
of the Internal Revenue Code, Section 382, which relate to a 50 percent change
in control over a three-year period. In addition, any future changes of control
may result in the expiration of a portion of the carryforwards before they can
be used and are also dependent upon the Company attaining profitable operations
in the future.

NOTE 9. SHAREHOLDERS' EQUITY

STOCK OPTIONS: The Company has two Stock Option Plans (the "Plans") that permit
the granting of "incentive stock options" meeting the requirements of Section
422 of the Internal Revenue Code of 1986, as amended, and nonqualified options
which do not meet the requirements of Section 422. The Plans have 150,000 and
100,000 shares, respectively, available for grant. The options that have been
granted under the Plans are exercisable for a period of five to ten years from
the date of grant and vest over a period of six months to three years from the
date of grant.

The Company has adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation."
Accordingly, no compensation cost has been recognized for the Plans. Had
compensation cost for the Plans been determined based on the fair value at the
grant date consistent with the provisions of SFAS No. 123, the Company's net
loss and basic and diluted loss per share would have been increased to the pro
forma amounts indicated below:

1998 1997
- --------------------------------------------------------------------------------
Net loss:
As reported $(3,056,000) $(748,000)
Pro forma $(3,136,000) $(847,000)
Basic and diluted loss
per share:
As reported $ (2.55) $ (0.66)
Pro forma $ (2.61) $ (0.75)
- --------------------------------------------------------------------------------

The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions:

1998 1997
- --------------------------------------------------------------------------------
Expected dividend yield -- --
Expected stock price volatility 83.22% 50.43%
Risk-free interest rate 5.50% 6.00%
Expected life of options (years) 3 3
- --------------------------------------------------------------------------------

Additional information relating to all outstanding options is as follows:

Weighted Average
Shares Exercise Price
- --------------------------------------------------------------------------------
Outstanding at
December 30, 1995 64,000 $27.08
Granted 37,000 $12.72
Exercised (9,000) $ 9.60
Cancelled (12,000) $20.72
- --------------------------------------------------------------------------------
Outstanding at
December 28, 1996 80,000 $23.36
Granted 44,000 $ 2.54
Cancelled (31,000) $31.31
- --------------------------------------------------------------------------------
Outstanding at
January 3, 1998 93,000 $10.93
Granted 78,000 $ 1.50
Cancelled (27,000) $13.22
- --------------------------------------------------------------------------------
Outstanding at
January 2, 1999 144,000 $ 5.37
================================================================================

The weighted average fair value per option of options granted during 1998, 1997
and 1996 was $0.85, $0.96 and $4.92 respectively.

The following tables summarize information about stock options outstanding as of
January 2, 1999:

OPTIONS OUTSTANDING
Weighted
Average Weighted
Range of Number Remaining Average
Exercise Options Contractual Exercise
Prices Outstanding Life in Years Price
- --------------------------------------------------------------------------------
$45.52 2,000 1.9 $ 45.52
$17.50 22,000 2.6 $ 17.50
$10.52 to $12.76 10,000 4.5 $ 10.58
$2.38 to $3.00 32,000 5.8 $ 2.60
$0.75 to $2.06 78,000 6.9 $ 1.50
-------
144,000
=======

OPTIONS EXERCISABLE
Range of Number Weighted
Exercise Options Average
Prices Exercisable Exercise Price
- --------------------------------------------------------------------------------
$45.52 2,000 $45.52
$17.50 21,000 $17.50
$10.52 to $12.76 10,000 $10.58
$2.38 to $3.00 16,000 $2.60
------
49,000 $12.37
======

The following table summarizes options exercisable for stock options outstanding
as of January 2, 1998 and December 26, 1996:

1997 1996
- --------------------------------------------------------------------------------
Number of options
exercisable 40,000 45,000
Weighted average
exercise price $19.44 $31.77

WARRANTS: In July 1998, the Company issued 12% subordinated promissory notes in
the principal amount of $275,000, plus an aggregate of 68,750 warrants to
purchase the Company's Common Stock at $2.25 per share.

In September 1998, the Company entered into a loan agreement with a lender
resulting in gross proceeds to the Company of $3.5 million. In connection with
this loan, the Company issued the lender a warrant to purchase 700,000 shares of
Common Stock at an adjustable exercise price, which is currently $0.60 per
share. The Company also issued to an investment banker associated with this
transaction, a warrant to purchase 125,000 shares of Common Stock at $2.50 per
share.

The portion of the gross loan proceeds ascribed to the aforementioned warrants
issued in conjunction with debt was $307,000 as determined using the
Black-Scholes method.

PREFERRED STOCK: In April 1998, the Company's shareholders approved an amendment
to the Company's Articles of Incorporation authorizing two million shares of
Preferred Stock of the Company ("Preferred Stock") which may be issued from time
to time in one or more series having such rights, powers, preferences and
designations as the Board of Directors may determine.

PRIVATE PLACEMENT: In May 1998, the Company sold in a private placement, 100,000
shares of Common Stock at a price of $2.00 per share. The sale, which
represented approximately 8% of the Common Stock outstanding

after such sale, was made to an institutional investor. The proceeds were used
for additional working capital.

In May 1996, $700,000 was raised in a private placement of Common Stock to an
institutional investor by selling 50,000 shares at $14.00 per share.

NOTE 10. MAJOR CUSTOMERS AND SUPPLIERS

MAJOR CUSTOMER:

Net revenues include sales to one major customer as follows:
1998 1997 1996
- --------------------------------------------------------------------------------
REVENUE PERCENTAGE:
Customer 28.8% 37.8% 22.1%

As of January 2, 1999, the receivable from this customer on the Company's
balance sheet was $208,000.

MAJOR SUPPLIER:

The Company purchases substantially all of its scratch and dent (distressed)
appliances from one original equipment manufacturer under a contractual
arrangement. Management believes that should this arrangement be terminated
other original equipment manufacturers would be available for alternate sources
of supply.

NOTE 11. LOSS ON IMPAIRED ASSETS

In June 1998, the Company elected to curtail its appliance shredding operation
and intensify its strategic focus on appliance retailing. As a result, the
Company recorded a $518,000 loss on impaired equipment. In addition, as
discussed in Note 2, the Company also recorded an impairment loss of $55,000 in
December 1998 related to withdrawing from an under-performing market.

NOTE 12. SUBSEQUENT EVENT

In February 1999, the Company sold in a private placement 1,030,000 shares of
Common Stock at a price of $0.50 per share. The Company paid $31,500 of the
proceeds and issued warrants to purchase 83,000 shares of Common Stock at $0.50
per share, subject to adjustment, to an investment banker as a placement fee.
The remaining proceeds were used to repay certain indebtedness, to purchase
inventory and for other general corporate purposes.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

No changes in or disagreements with accountants have occurred within
the two-year period ended January 2, 1999, which required reporting on Form 8-K.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

Information regarding directors and executive officers of the
Company is set forth under Information Concerning Directors, Nominees and
Executive Officers and under Beneficial Ownership Reporting Compliance in the
Company's definitive Proxy Statement for its 1999 Annual Meeting of Shareholders
to be held April 29, 1999, and is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

Information regarding Executive Compensation set forth under
Executive Compensation in the Company's definitive Proxy Statement for its 1999
Annual Meeting of Shareholders to be held April 29, 1999, other than the
subsections captioned Report of the 1998 Compensation and Benefits Committee and
Performance Graph, is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information regarding security ownership of certain beneficial
owners and management is set forth under Beneficial Ownership of Common Stock in
the Company's definitive Proxy Statement for its 1999 Annual Meeting of
Shareholders to be held April 29, 1999, and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information regarding certain relationships and related transactions
is set forth under Information Concerning Directors, Nominees and Executive
Officers in the Company's definitive Proxy Statement for its 1999 Annual Meeting
of Shareholders to be held April 29, 1999, and is incorporated herein by
reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS

1. FINANCIAL STATEMENTS

See Index to Financial Statements under Item 8 of this report.

2. FINANCIAL STATEMENT SCHEDULES

To the Board of Directors
Appliance Recycling Centers of America, Inc.
Minneapolis, Minnesota

Our report on the consolidated financial statements of Appliance
Recycling Centers of America, Inc. and subsidiaries is included
in this Form 10-K. In connection with our audits of such
financial statements, we have also audited the related financial
statement schedule listed immediately following. This financial
schedule is the responsibility of the Company's management. Our
responsibility is to express an opinion based on our audit.

In our opinion, the financial statement schedule referred to
above, when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material
respects, the information required to be included therein.

McGLADREY & PULLEN, LLP

Minneapolis, Minnesota
February 19, 1999

Schedule II - Valuation and qualifying accounts

Accounts Receivable Inventory
Allowance Allowance
---------------------------------------------------------------
Balance, December 30, 1995 $ -- $ --
Additional allowance 90,000 --
Write-off of accounts receivable (6,000) --
---------------------------------------------------------------
Balance, December 28, 1996 $ 84,000 $ --
Additional allowance 60,000 20,000
Write-off of accounts receivable (109,000) --
---------------------------------------------------------------
Balance, January 3, 1998 $ 35,000 $ 20,000
Additional allowance 50,000 20,000
Write-off of accounts receivable (67,000) --
---------------------------------------------------------------
BALANCE, JANUARY 2, 1999 $ 18,000 $ 40,000
---------------------------------------------------------------

3. EXHIBITS

See Index to Exhibits in this report.

(b) REPORTS ON FORM 8-K

No reports on Form 8-K were filed during the last quarter of the
fiscal year covered by this report.

SIGNATURES

Pursuant to the requirements of Section 13 or Section 15(d) of the
Securities Exchange Act of 1934, the Registrant has duly caused this Report to
be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: March 22, 1999 APPLIANCE RECYCLING CENTERS OF
AMERICA, INC.
(Registrant)

By /s/ Edward R. Cameron
-------------------------------------
Edward R. Cameron
President and Chief Executive Officer

By /s/ Kent S. McCoy
-------------------------------------
Kent S. McCoy
Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed by the following persons on behalf of the Registrant
and in the capacities and on the dates indicated.

SIGNATURE TITLE DATE
- --------- ----- ----

/s/ Edward R. Cameron Chairman of the Board, President and March 22, 1999
- ------------------------ Chief Executive Officer
Edward R. Cameron

/s/ Kent S. McCoy Chief Financial Officer March 22, 1999
- ------------------------ (Principal Accounting Officer)
Kent S. McCoy

/s/ George B. Bonniwell Director March 22, 1999
- ------------------------
George B. Bonniwell

/s/ Duane S. Carlson Director March 22, 1999
- ------------------------
Duane S. Carlson

/s/ Harry W. Spell Director March 22, 1999
- ------------------------
Harry W. Spell

/s/ Marvin Goldstein Director March 22, 1999
Marvin Goldstein

INDEX TO EXHIBITS

Exhibit
No. Description

+3.1 Restated Articles of Incorporation of Appliance Recycling Centers of
America, Inc.

+3.2 Amended and Restated Bylaws of Appliance Recycling Centers of
America, Inc.

*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 Agreement dated December 17, 1992, between Appliance Recycling
Centers of America, Inc. and TCF Savings Bank [filed with the
Company's Form 8-K, dated December 17, 1992 (File No. 0-19621) and
incorporated herein by reference].

10.3 Agreement dated January 19, 1994, between Appliance Recycling
Centers of America, Inc. and Standard Insurance Corporation [filed
as Exhibit 10.29 to the Company's Form 10-K for the year ended
December 31, 1993 (File No.0-19621) and incorporated herein by
reference].

10.4 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].

10.5 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].

*10.6 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].

10.7 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 Acknowledgements [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].

10.8 Agreement dated February 13, 1998 between Western Bank and Appliance
Recycling Centers of America, Inc. [filed as Exhibit 10.11 to the
Company's Form 10-K for the year ended January 3, 1998 (File No
0-19621) and incorporated herein by reference].

*10.9 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].

10.10 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].

10.11 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].

10.12 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].

10.13 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].

+10.14 Warrant of the Company in favor of Medallion Capital, Inc. for
700,000 shares of the Company's Stock [corrected copy].

+10.15 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.

+10.16 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.

+ 21.1 Subsidiaries of Appliance Recycling Centers of America, Inc.

+ 23.1 Consent of McGladrey & Pullen, LLP, Independent Public Accountants.

+ 27.0 Financial Data Schedule.

- ------------------
* 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.