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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the quarterly period ended October 2, 2004 or [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from  to Commission File Number 0-9318 SHOPSMITH, INC.  Ohio
(State or other jurisdiction of
incorporation or organization)
    
    31-0811466
(I.R.S. Employer
Identification No.)
 6530 Poe Avenue, Dayton, Ohio
(Address of principal executive offices)
    
    45414
(Zip Code)
 Registrants telephone number, including area code: (937) 898-6070 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. [X] Yes [  ] No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
[  ] Yes [X] No Indicate the number of shares outstanding of each of the issuers classes of
common stock as of the latest practicable date. Common shares, without par value: 2,605,233 shares as of October 25, 2004. Page 1




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SHOPSMITH, INC. AND SUBSIDIARIES INDEX Page No.Part I. Financial Information:Item 1. Financial StatementsConsolidated Balance Sheets -October 2, 2004 and April 3, 2004
    
    
    3-4Consolidated Statements of Operations and Deficit  Three Months and Six Months Ended October 2, 2004 and October 4, 2003
    
    
    5Consolidated
Statements of Cash Flows  Six Months Ended October 2, 2004
and October 4, 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7-8Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    9-11Item 4. Controls and Procedures
    
    
    12Part II. Other InformationItem 3. Defaults Upon Senior Securities
    
    
    13Item 4. Submission of Matters to a Vote of Security Holders
    
    
    13Item 5. Other Information
    
    
    13Item 6. Exhibits
    
    
    13Signatures
    
    
    14Exhibits
    
    
    15-19Exhibit 4.20Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
 Page 2




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Part I  FINANCIAL INFORMATION 
 Item 1. Financial Statements SHOPSMITH, INC. AND SUBSIDIARIES 
  October 2,
    
    April 3,2004
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    700
    
    
    $
    800Accounts receivable:Trade, less allowance for doubtful accounts:$467,528 on October 2, 2004 and $391,871 on April 3, 2004
    
    
    587,616
    
    
    
    1,144,245Inventories:Finished products
    
    
    969,827
    
    
    
    912,318Raw materials and work in process
    
    
    1,281,563
    
    
    
    1,210,122Total inventories
    
    
    2,251,390
    
    
    
    2,122,440Prepaid expenses
    
    
    181,498
    
    
    
    143,569Total current assets
    
    
    3,021,204
    
    
    
    3,411,054Properties:Land, building and improvements
    
    
    3,157,054
    
    
    
    3,157,054Machinery, equipment and tooling
    
    
    6,847,533
    
    
    
    6,806,070Total cost
    
    
    10,004,587
    
    
    
    9,963,124Less, accumulated depreciation and amortization
    
    
    7,446,963
    
    
    
    7,370,470Net properties
    
    
    2,557,624
    
    
    
    2,592,654Long-term portion of accounts receivable
trade, less allowance for doubtful accounts:$302,515 on October 2, 2004 and $278,120 on April 3, 2004
    
    
    845,258
    
    
    
    698,087Other assets
    
    
    2,253
    
    
    
    3,128Total assets
    
    $
    6,426,339
    
    
    $
    6,704,923
 Continued Page 3




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SHOPSMITH, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS October 2,
    
    April 3,2004
    
    2004(Unaudited)LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,179,009
    
    
    $
    1,049,694Revolving line of credit
    
    
    609,055
    
    
    
    Current portion of long-term debt and capital lease obligation
    
    
    98,484
    
    
    
    107,555Customer advances
    
    
    66,156
    
    
    
    74,031Accrued liabilities:Compensation, employee benefits and payroll taxes
    
    
    304,690
    
    
    
    410,603Sales taxes payable
    
    
    76,021
    
    
    
    55,696Accrued recourse liability
    
    
    266,768
    
    
    
    311,768Accrued expenses
    
    
    235,477
    
    
    
    249,482Other
    
    
    59,600
    
    
    
    54,118Total current liabilities
    
    
    2,895,260
    
    
    
    2,312,947Long-term debt and capital lease obligation, less current portion
    
    
    1,877,145
    
    
    
    2,266,665Total liabilities
    
    
    4,772,405
    
    
    
    4,579,612Shareholders equity:Preferred shares- without par value;
authorized 500,000; none issuedCommon shares- without par value;
authorized 5,000,000; issued and outstanding 2,605,233
    
    
    2,806,482
    
    
    
    2,806,482Deficit
    
    
    (1,152,548
    )
    
    
    (681,171
    )Total shareholders equity
    
    
    1,653,934
    
    
    
    2,125,311Total liabilities and shareholders equity
    
    $
    6,426,339
    
    
    $
    6,704,923
 See notes to consolidated financial statements. Page 4




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SHOPSMITH, INC. AND SUBSIDIARIES 
  Three Months Ended
    
    Six Months EndedOctober 2,
    
    October 4,
    
    October 2,
    
    October 4,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Net sales
    
    $
    3,025,730
    
    
    $
    3,174,334
    
    
    $
    5,813,166
    
    
    $
    6,286,838Cost of products sold
    
    
    1,392,670
    
    
    
    1,513,085
    
    
    
    2,788,110
    
    
    
    3,094,994Gross margin
    
    
    1,633,060
    
    
    
    1,661,249
    
    
    
    3,025,056
    
    
    
    3,191,844Selling expenses
    
    
    1,283,912
    
    
    
    1,097,947
    
    
    
    2,668,180
    
    
    
    2,285,274Administrative expenses
    
    
    374,763
    
    
    
    419,824
    
    
    
    830,741
    
    
    
    864,230Total operating expenses
    
    
    1,658,675
    
    
    
    1,517,771
    
    
    
    3,498,921
    
    
    
    3,149,504Income (loss) before
other income and expense
    
    
    (25,615
    )
    
    
    143,478
    
    
    
    (473,865
    )
    
    
    42,340Interest income
    
    
    43,523
    
    
    
    43,518
    
    
    
    88,061
    
    
    
    87,161Interest expense
    
    
    (33,657
    )
    
    
    (64,913
    )
    
    
    (87,355
    )
    
    
    (133,019
    )Other income, net
    
    
    887
    
    
    
    1,305
    
    
    
    1,782
    
    
    
    2,829Income (loss) before income taxes
    
    
    (14,862
    )
    
    
    123,388
    
    
    
    (471,377
    )
    
    
    (689
    )Income tax expense
    
    
    
    
    
    
    4,881
    
    
    
    
    
    
    
    4,881Net income (loss)
    
    
    (14,862
    )
    
    
    118,507
    
    
    
    (471,377
    )
    
    
    (5,570
    )Deficit:Beginning
    
    
    (1,137,686
    )
    
    
    (934,848
    )
    
    
    (681,171
    )
    
    
    (810,771
    )Ending
    
    $
    (1,152,548
    )
    
    $
    (816,341
    )
    
    $
    (1,152,548
    )
    
    $
    (816,341
    )Net income (loss) per common share
(Note 3)Basic
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.18
    )
    
    $
    (0.00
    )Diluted
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.18
    )
    
    $
    (0.00
    )
 See notes to consolidated financial statements. Page 5




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SHOPSMITH, INC. AND SUBSIDIARIES 
  Six Months EndedOctober 2,
    
    October 4,2004
    
    2003(Unaudited)
    
    (Unaudited)Cash flows from operating activities:Net loss
    
    $
    (471,377
    )
    
    $
    (5,570
    )Adjustments to reconcile net loss to
cash provided from (used in) operating activitiesDepreciation and amortization
    
    
    76,493
    
    
    
    79,376Provision for doubtful accounts
    
    
    102,311
    
    
    
    145,929Changes in operating assets and liabilities:Accounts receivable
    
    
    307,147
    
    
    
    360,002Inventories
    
    
    (128,950
    )
    
    
    (188,996
    )Prepaid expenses
    
    
    (37,054
    )
    
    
    (37,254
    )Accounts payable and customer advances
    
    
    121,440
    
    
    
    56,771Other current liabilities
    
    
    (139,111
    )
    
    
    (172,675
    )Cash provided from (used in) operating activities
    
    
    (169,101
    )
    
    
    237,583Cash flows from investing activities:Property additions
    
    
    (41,463
    )
    
    
    (33,488
    )Cash flows from financing activities:Payments on note payable
    
    
    
    
    
    
    (400,000
    )Net borrowings on revolving line of credit
    
    
    609,055
    
    
    
    Payments on long-term debt and capital lease obligation
    
    
    (398,591
    )
    
    
    (53,611
    )Cash provided from (used in) financing activities
    
    
    210,464
    
    
    
    (453,611
    )Net decrease in cash
    
    
    (100
    )
    
    
    (249,516
    )Cash and cash equivalents:At beginning of period
    
    
    800
    
    
    
    250,316At end of period
    
    $
    700
    
    
    $
    800
 See notes to consolidated financial statements. Page 6




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SHOPSMITH, INC. AND SUBSIDIARIES 
   1.
    
    In the opinion of management, all adjustments (consisting of only normal
and recurring adjustments) have been made as of October 2, 2004 and
October 4, 2003 to present the financial statements fairly. However, the
results of operations for the six months then ended are not necessarily
indicative of results for the full fiscal year. The financial statements
and notes are presented as permitted by Form 10-Q, and do not contain
certain information included in the annual financial statements. The
financial statements accompanying this report should be read in
conjunction with the financial statements and notes thereto included in
the Annual Report to Shareholders for the year ended April 3, 2004.  2.
    
    There was no tax benefit during the three and six-month periods ended
October 2, 2004 or the six months ended October 4, 2003, as the tax
benefits were offset by changes in a valuation allowance.3.
    
    Basic income (loss) per share is computed by dividing net income (loss)
by the weighted average number of common shares outstanding during the
period. Diluted income (loss) per share reflects per share amounts that
would have resulted if dilutive stock options had been converted into
common stock. The following reconciles amounts reported in the financial
statements: Three Months Ended
    
    Six Months EndedOctober 2,
    
    October 4,
    
    October 2,
    
    October 4,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    (14,862
    )
    
    $
    118,507
    
    
    $
    (471,377
    )
    
    $
    (5,570
    )Weighted average shares
    
    
    2,605,233
    
    
    
    2,605,233
    
    
    
    2,605,233
    
    
    
    2,605,233Additional dilutive shares
    
    
    
    
    
    
    375
    
    
    
    
    
    
    
    188Total dilutive shares
    
    
    2,605,233
    
    
    
    2,605,608
    
    
    
    2,605,233
    
    
    
    2,605,421Basic income (loss) per share
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.18
    )
    
    $
    (0.00
    )Diluted income (loss) per share
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.18
    )
    
    $
    (0.00
    )
  There were no additional dilutive shares included in the computation for the
three and six-month periods ended October 2, 2004 because the effect of stock
options were anti-dilutive.  4.
    
    On December 31, 2002, the Company entered into a Loan Agreement (the
Revolving Credit Agreement) with Provident Bank. The Revolving Credit
Agreement was amended by Amendments dated July 17, 2003 and September 24,
2004. The Promissory Note issued pursuant to the Revolving Credit
Agreement was amended by Amendment dated June 29, 2004. Under the loan
documents as amended, the Company may borrow the lesser of (i) $1,000,000
or (ii) the sum of (x) 80% of accounts receivable due from Lowes
Companies, plus (y) 50% of other trade accounts receivable (with the
maximum amount being advanced in respect of such other trade accounts
receivable being $250,000), plus (z) 50% of finished goods inventory (with
the maximum amount being advanced in respect of such inventory being
$500,000). Interest on the Revolving Credit Agreement is charged at one
and one-half percent over the Banks prime rate. The maturity date on the
agreement is June 30, 2005. All loans under the Revolving Credit Agreement
are at the discretion of the Bank. At October 2, 2004, $609,000 was
outstanding under the Revolving Credit Agreement.  At July 3, 2004, the Company was not in compliance with the financial
covenants under the Revolving Credit Agreement as then amended. By Second
Amendment dated September 24, 2004, the financial covenants were further
amended as follows: (a) Debt Service Coverage Ratio. Beginning with the Companys third
fiscal quarter (which began October 3, 2004 and ends January 1, 2005), the
Company must maintain a Debt Service Coverage ratio of 1:10 to 1:00,
tested quarterly. Debt Service Coverage is defined as (i) EBITDA minus
cash taxes and dividends, divided by (ii) cash interest expense plus
quarterly current maturities of long-term debt. Page 7




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(b) Consolidated Tangible Net Worth. From July 1, 2004 through March
31, 2005, the Company must maintain consolidated tangible net worth in
excess of $1,450,000. From and after April 1, 2005, consolidated tangible
net worth must be in excess of $1,800,000. (c) Limitation on Capital Expenditures. The Company may not make
capital expenditures in excess of $50,000 during any fiscal year without
Bank approval.  As of October 2, 2004, the Company was in compliance with the foregoing
financial covenants. The Company expects to remain in compliance with its
amended covenants through the remainder of fiscal 2005.In connection with the Revolving Credit Agreement, Mr. John R. Folkerth,
Chairman and Chief Executive Officer of the Company, delivered to Provident
Bank a Continuing Unconditional Guaranty pursuant to which Mr. Folkerth
guaranteed repayment of $200,000 of the indebtedness then or thereafter owing
by the Company to the Bank. In consideration of that Guaranty, the Company
has agreed to pay to Mr. Folkerth an annual fee of $3,000 (being 1.5% of the
guaranteed amount).On June 29, 2004, the Company refinanced a mortgage note on its building with
a balance of $2,356,000 with a mortgage note from Provident Bank in the
amount of $2,000,000 with interest at one-quarter percent over the banks
prime rate. The note requires monthly payments of interest and from $8,000 to
$10,000 of the principal. In August 2009, the remaining balance of
approximately $1,477,000 will become due.Under the terms of the new mortgage loan, default under the Revolving Credit
Agreement can trigger default under the new mortgage loan. In the event of
default, the Bank may declare the new mortgage loan immediately due and
payable.The new mortgage loan and the revolving credit loans are secured by a
mortgage on, or security interest in, substantially all assets of the
Company.At October 2, 2004, there was $1,975,629 and $609,055 outstanding under the
building mortgage agreement and line of credit agreement, respectively.5.
    
    A major retailer represented 32% and 24% of net sales for the quarters
ended October 2, 2004 and October 4, 2003, respectively. This retailer
also represented 18% and 41% of trade accounts receivable at October 2,
2004 and April 3, 2004, respectively.6.
    
    The Company has adopted the disclosure only provisions of Statement of
Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation, as amended by SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure, and, accordingly,
accounts for its stock option plans using the intrinsic value method of
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees.The following table illustrates the effect on net income (loss) and net
earnings (loss) per share if compensation expense was measured using the fair
value recognition provisions of SFAS No. 123. Three Months Ended
    
    Six Months EndedOctober 2,
    
    October 4,
    
    October 2,
    
    October 4,2004
    
    2003
    
    2004
    
    2003Net income (loss)  as reported
    
    $
    (14,862
    )
    
    $
    118,507
    
    
    $
    (471,377
    )
    
    $
    (5,570
    )Net income (loss)  pro forma
    
    $
    (28,406
    )
    
    $
    117,847
    
    
    $
    (484,921
    )
    
    $
    (6,230
    )Diluted earnings (loss) per share  as reported
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.18
    )
    
    $
    (0.00
    )Diluted earnings (loss) per share  pro forma
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.18
    )
    
    $
    (0.00
    )
 Page 8




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Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Shopsmith manufactures and sells woodworking products. Our core product, the
Mark V, is sold directly to consumers through demonstration sales events and
indirectly to consumers through distributors (primarily Lowes where Shopsmith
also conducts sales demonstrations) along with smaller amounts through other
efforts. Mark V sales demonstrations are performed in shopping malls, at home
shows, and at state fairs. Other woodworking products and accessories are sold
through mail and internet channels. Shopsmith recognizes revenue for these
orders at the time of product shipment. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The financial condition and results of operations for Shopsmith presented in
the Consolidated Financial Statements, accompanying notes , and managements
discussion and analysis are dependent upon the Companys accounting policies.
The selection and application of these accounting policies involve judgments,
estimates, and uncertainties that are susceptible to change. The Companys
significant accounting policies are discussed in Note 2 of the notes to the
Consolidated Financial Statements included in the Companys annual report to
shareholders for the year ended April 3, 2004. In managements opinion, the
Companys critical accounting policies include the allowance for doubtful
accounts, accrued recourse liability and deferred tax valuation allowance. Allowance For Doubtful Accounts The Company maintains an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments.
Customer accounts are stratified by type of account, original credit rating,
and recent payment history. Estimated loss rates are then applied to these
groups. Deterioration of our customers ability to make payments could require
additions to the allowance. Accounts repurchased under the recourse provision, discussed below, are carried
in trade accounts receivable, net of an allowance for doubtful accounts, while
the Company attempts to collect them. Accrued Recourse Liability Certain retail installment contracts sold to financial institutions through the
fiscal year ended March 31, 2001 included a recourse provision. Under this
recourse provision, Shopsmith is obligated to purchase the installment contract
if the customer defaults on their obligation to the financial institution. The
Companys liability for future recourse obligations has been estimated using
factors based on the value and rate of change of the value of the outstanding
accounts, the rate and changes in the rate of repurchases required under the
recourse provision, as well as estimates of amounts collectable after the
accounts are repurchased. If these factors would deteriorate, additional
accruals would be necessary and would affect future operating results. The
Company will be required to adopt Statement of Position 03-03 in April 2005.
At that time, purchases of loans under a recourse provision will be recorded at
fair value at repurchase date, instead of gross less an allowance for doubtful
accounts. Deferred Tax Valuation Allowance The Company has recorded a full valuation allowance against its net deferred
tax assets based on its evaluation of the realizability of the future tax
benefits of deferred tax assets. The effect of the allowance is to reduce to
zero the carrying value of the potential tax benefit arising from the
possibility of offsetting the Companys cumulative operating losses against
future taxable income. Page 9




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Results of Operations Fiscal 2005 second quarter sales decreased to $3,026,000, or 4.7%, from
$3,174,000 during the same period a year ago. The decrease in the second
quarter occurred primarily in our mail and internet accessory sales. Fiscal
2005 year-to-date sales decreased to $5,813,000, or 7.5%, from $6,287,000 last
year. Gross margin rates for the fiscal 2005 second quarter increased by 1.6
percentage points compared to the same period last year. On a year-to-date
basis, gross margin rates increased by 1.3 percentage points. Operating
expenses increased by $141,000 to $1,659,000 in the fiscal 2005 second quarter
from $1,518,000 in last years second quarter. For fiscal 2005 year-to-date,
operating costs increased by $349,000 to $3,499,000 from $3,150,000 in the
prior year. The most significant factors in the increase in operating expenses
were an increase in the number of Mark V sales demonstration events, as well as
expenditures on sales representative training costs. Provisions for recoverable federal income taxes are based on estimated annual
effective rates, less a valuation allowance. No tax benefit is reported for the
periods ended October 2, 2004 and October 4, 2003, as it was offset by a change
in valuation allowance. With the reduction in sales and increased operating expenses, the Company
recorded a net loss of $15,000, or $.01 per diluted share, in the quarter ended
October 2, 2004, compared to net income of $119,000, or $.05 per diluted share,
for the same period of last year. For fiscal 2005 year-to-date, a net loss of
$471,000, or $.18 per diluted share, was incurred, compared to a net loss of
$6,000, or $.00 per diluted share, for the same period last year. Liquidity and Financial Position Cash used in operations totaled $169,000 for the six months ended October 2,
2004, compared with $238,000 provided from operations for the same period of
the preceding year. The Companys net loss of $471,000 was the primary reason
for the change from last year. On December 31, 2002, the Company entered into a Loan Agreement (the Revolving
Credit Agreement) with Provident Bank. The Revolving Credit Agreement was
amended by Amendments dated July 17, 2003 and September 24, 2004. The
Promissory Note issued pursuant to the Revolving Credit Agreement was amended
by Amendment dated June 29, 2004. Under the loan documents as amended, the
Company may borrow the lesser of (i) $1,000,000 or (ii) the sum of (x) 80% of
accounts receivable due from Lowes Companies, plus (y) 50% of other trade
accounts receivable (with the maximum amount being advanced in respect of such
other trade accounts receivable being $250,000), plus (z) 50% of finished goods
inventory (with the maximum amount being advanced in respect of such inventory
being $500,000). Interest on the Revolving Credit Agreement is charged at one
and one-half percent over the Banks prime rate. The maturity date on the
agreement is June 30, 2005. All loans under the Revolving Credit Agreement are
at the discretion of the Bank. At October 2, 2004, $609,000 was outstanding
under the Revolving Credit Agreement. The maximum amount available
under the credit line at October 2, 2004 was $822,000. At July 3, 2004, the Company was not in compliance with the financial covenants
under the Revolving Credit Agreement as then amended. By Second Amendment
dated September 24, 2004, the financial covenants were further amended as
follows: (a) Debt Service Coverage Ratio. Beginning with the Companys third
fiscal quarter (which began October 3, 2004 and ends January 1, 2005), the
Company must maintain a Debt Service Coverage ratio of 1:10 to 1:00,
tested quarterly. Debt Service Coverage is defined as (i) EBITDA minus
cash taxes and dividends, divided by (ii) cash interest expense plus
quarterly current maturities of long-term debt. (b) Consolidated Tangible Net Worth. From July 1, 2004 through March
31, 2005, the Company must maintain consolidated tangible net worth in
excess of $1,450,000. From and after April 1, 2005, consolidated tangible
net worth must be in excess of $1,800,000. (c) Limitation on Capital Expenditures. The Company may not make
capital expenditures in excess of $50,000 during any fiscal year without
Bank approval. As of October 2, 2004, the Company was in compliance with the foregoing
financial covenants. Page 10




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In connection with the Revolving Credit Agreement, Mr. John R. Folkerth,
Chairman and Chief Executive Officer of the Company, delivered to Provident
Bank a Continuing Unconditional Guaranty pursuant to which Mr. Folkerth
guaranteed repayment of $200,000 of the indebtedness then or thereafter owing
by the Company to the Bank. In consideration of that Guaranty, the Company has
agreed to pay to Mr. Folkerth an annual fee of $3,000 (being 1.5% of the
guaranteed amount). On June 29, 2004, the Company refinanced a mortgage on its office and
manufacturing facility. At the time of the refinancing, the mortgage balance
was $2,356,000. The mortgage was refinanced with a mortgage loan from
Provident Bank in the amount of $2,000,000 (the New Mortgage Loan). In order
to facilitate the New Mortgage Loan, the Company drew $356,000 under the
Revolving Credit Agreement to reduce the prior mortgage balance immediately
before the refinancing. Interest on the New Mortgage Loan is at one-quarter
percent over the Banks prime rate. The loan documents require monthly payment
of interest and monthly payments of principal from $8,000 to $10,000. In
August 2009, the remaining balance of approximately $1,477,000 will become due. Under the terms of the New Mortgage Loan, default under the Revolving Credit
Agreement can trigger default under the New Mortgage Loan. In the event of
default, the Bank may declare the New Mortgage Loan immediately due and
payable. The New Mortgage Loan and the revolving credit loans are secured by a mortgage
on, or security interest in, substantially all assets of the Company. Borrowings under the Revolving Credit Agreement totaled $609,000 during the
first six months of fiscal 2005. As stated above, $356,000 of such borrowings
was used to reduce the balance of the previous mortgage loan prior to the
refinancing. The Company is dependent upon the Revolving Credit Agreement to fund operations
during periods of negative cash flow. Termination of the Revolving Credit
Agreement, without establishment of a substitute credit facility, would create
significant liquidity issues for the Company. The Companys current ratio was 1.04 to 1 at October 2, 2004 and 1.47 to 1 at
April 3, 2004. The debt to equity ratio increased to 2.89 to 1 at October 2,
2004 from 2.15 to 1 at April 3, 2004. Losses during the six
months ended October 2, 2004 have contributed to a tightening of
liquidity which in turn has caused the Company to defer payments to
vendors beyond the Companys customary payment practice. The Company believes that profitability is critical to ensuring adequate
liquidity in both the current and future fiscal years. Contractual Obligations Payments due by periodLess than
    
    
    
    
    
    
    
    
    
    More thanContractual Obligations
    
    Total
    
    1 Year
    
    1-3 Years
    
    3-5 Years
    
    5 YearsRevolving Line of Credit
    
    $
    609,055
    
    
    $
    609,055
    
    
    $
    
    
    
    $
    
    
    
    $
    Long-Term Debt
    
    
    1,975,629
    
    
    
    98,484
    
    
    
    209,958
    
    
    
    1,667,187
    
    
    
    Operating Leases
    
    
    176,531
    
    
    
    63,191
    
    
    
    82,721
    
    
    
    30,619
    
    
    
    Total
    
    $
    2,761,215
    
    
    $
    770,730
    
    
    $
    292,679
    
    
    $
    1,697,806
    
    
    $
    
 Forward Looking Statements The foregoing discussion and the Companys consolidated financial statements
contain certain forward-looking statements that involve risks and
uncertainties, including but not limited to the following: (i) the operating
cash flows together with currently available working capital may be inadequate
to finance the operating needs of the Company; (ii) cancellation by Lowes of
the in-store sales program; (iii) the Company may fail to meet the amended
financial covenants contained in its Loan Agreement with Provident Bank, in
which event the Bank may declare all amounts owed by the Company to the Bank
under the revolving credit and mortgage loan facilities to be immediately due
and payable; (iv) the Bank may decline to make further advances under the
revolving credit facility; (v) the Company may be unable to extend or refinance
the revolving credit facility when the revolving credit loans mature on June 30, 2005; and (vi) actual losses related to
doubtful accounts and recourse liabilities (discussed under Critical Accounting
Policies and Estimates) may exceed current estimates. Page 11




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##### Table of Contents



Item 4. Controls and Procedures. (a) Evaluation of Disclosure Controls and Procedures The Companys Chairman and Chief Executive Officer, John R. Folkerth,
and the Companys Chief Financial Officer, Mark A. May, have evaluated the
Companys disclosure controls and procedures within 90 days of the filing
of this report. Messrs. Folkerth and May have concluded that the Companys
disclosure controls and procedures are functioning effectively to provide
reasonable assurance that the Company can meet its disclosure obligations.
The reporting process is designed to ensure that information required to
be disclosed by the Company in the reports that it files or submits with
the Commission is recorded, processed, summarized and reported within the
time periods specified in the Commissions rules and forms. (b) Changes in Internal Controls There were no significant changes in the Companys internal controls
over financial reporting that could materially affect these controls
subsequent to the date of the above reference evaluation. Page 12




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##### Table of Contents



PART II. OTHER INFORMATION 
 Item 3. Defaults Upon Senior Securities As discussed in the Liquidity and Financial Position section of the
Managements Discussion and Analysis of Financial Condition and Results of
Operations set forth in Item 2 of this report, at July 3, 2004, the Company was
not in compliance with the financial covenants (relating to fixed charge
coverage and tangible net worth) contained in its Loan Agreement with Provident
Bank. Also as discussed in that section, the Bank has waived the covenant
violations and the financial covenants have been modified. As of October 2,
2004, the Company was in compliance with the covenants as modified. 
 Item 4. Submission of Matters to a Vote of Security Holders The Company held its Annual Meeting of Shareholders on July 28, 2004. At the
meeting, shareholders (a) elected Messrs. John R. Folkerth, J. Michael Herr,
and Edward A. Nicholson as directors of the Company and (b) approved the
appointment of Crowe Chizek and Company LLC as independent public accountants
for the Company. Votes were tabulated as follows: BrokerIssue
    
    For
    
    Against
    
    Withheld
    
    Non votesElection of directors:John R. Folkerth
    
    
    2,070,481
    
    
    
    
    
    
    
    83,646
    
    
    
    J. Michael Herr
    
    
    2,070,878
    
    
    
    
    
    
    
    83,249Edward A. Nicholson
    
    
    2,070,878
    
    
    
    
    
    
    
    83,249
    
    
    
    AppointmentCrowe Chizek and Company LLC
    
    
    2,082,913
    
    
    
    11,437
    
    
    
    59,777
    
    
    
    
 
 Item 5. Other Information  (a)
    
    The Loan Agreement, dated December 31, 2002 and amended July
17, 2003 and September 24, 2004, between the Company and Provident
Bank prohibits the payment of dividends by the Company. 
 Item 6. Exhibits  4.20
    
    Second amendment to loan agreement with The Provident Bank dated September 24, 2004.31.1
    
    Certification of the Chief Executive Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. Page 13




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of
1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized. SHOPS
    
    MITH, INC.By
    
    /s/ Mark A MayMark A. MayVice President of Finance (Principal
Financial and Accounting Officer)
 Date: November 15, 2004 Page 14