**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**FORM 10-K**

 
| **(Mark One)** |
|----------------|
|           |
| ý         | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |
|           | **For the Fiscal year ended: May 31, 2003** |
|           |   |
| **or**         |
|           |   |
| **o**          | **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:  0-23996**

 

| **SCHMITT  INDUSTRIES, INC.**                                   |
|-----------------------------------------------------------------|
| (Exact name of registrant as specified in its charter)          |
|                                                            |
| **Oregon**                                                      |   | **91-1151989** |
| (State or other jurisdiction of  incorporation or organization) |   | (IRS Employer Identification Number) |
|                                                            |   |   |
| **2765 N.W. Nicolai Street  Portland, Oregon 97210**            |
| (Address of principal executive offices) (Zip Code)             |
|                                                            |   |   |
| **(503) 227-7908**                                              |
| (Registrant’s telephone number, including area code)       |

 

Securities registered pursuantto Section 12(b) of the Act:

 
| **Title of  each class** |   | **Name of  each exchange on which registered** |
|--------------------------|--------|------------------------------------------------|
| None                     |   | None                                           |

 

Securities registered pursuantto Section 12(g) of the Act:

 

| Common Stock - no par value |
|-----------------------------|
| (Title of each class)       |

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý         No o

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendmentto this Form 10-K.  ý

 

As of August1, 2003, the aggregate market value of the registrant’s Common Stock held bynonaffiliates of the registrant was $2,451,975 based on the closing sales priceof the registrant’s Common Stock on the Nasdaq SmallCap Market.  On that date, there were2,478,924 shares of Common Stock outstanding.

 

Portions ofthe registrant’s definitive Proxy Statement for its 2003 Annual Meeting ofShareholders are incorporated by reference into Part III hereof.

 

 

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**PART I**

 

**Item 1. Business**

 

***Introduction***

 

The Company (an Oregoncorporation) designs, assembles and markets computer-controlled balancingequipment primarily to the machine tool industry.  Through its wholly owned subsidiaries, Schmitt MeasurementSystems, Inc. (“SMS”), an Oregon corporation and Acuity Research Incorporated(“ARI”), a California corporation, the Company designs, manufactures andmarkets precision laser measurement systems. The Company also sells and marketsits products in Europe through its wholly owned subsidiaries, Schmitt EuropeLtd. (“SEL”), located in the United Kingdom and Schmitt Europa GmbH (“SEG”),located in Germany.  The Company’sexecutive offices are located at 2765 N.W. Nicolai Street, Portland,Oregon 97210, and its telephone number is (503) 227-7908.

* *

***Balancing Products***

 

The Company’s principal productis the Schmitt Dynamic Balance System (the “SBS System”), consisting of acomputer control unit, sensor, spindle-mounting adapter, and balance head.  It is designed to be an inexpensive, yethighly accurate, permanent installation on grinding machines. The Companyacquired its original balancing equipment technology pursuant to a series ofagreements from 1987 through 1991 and substantially enhanced and advanced thepatented technology since that time. Since inception the targeted customer base has been operators ofgrinding machines.

 

The SBS System is fullyautomated, eliminating the need to pre-balance such devices as grindingwheels.  This reduces machine setup timeand ensures a smoother and more efficient operation.  Operating on a principle of mass compensation for wheelimbalance, the balance head contains two movable eccentric weights, each drivenby electric motors through a precision gear train.  These weights are repositioned to offset any imbalance in a grindingwheel or other application.  Imbalanceor vibration is picked up by the sensor that feeds a signal to a controllerthat filters the signal by revolutions per minute.  The controller then drives the balance head weights in adirection that reduces the amplitude of the vibration signal. The balance cycleis complete when the weights are positioned to achieve the lowest vibrationlevel.

 

Notable features of the SBSSystem include its ability to fit almost all machines, ease of installation,compact and modular construction, ability to balance a wheel while on amachine, virtual elimination of wheel vibration, automatic monitoring ofbalancing, display in both English and metric systems, instrument gradecalibration, short balance process, measurement of both displacement and/orvelocity and minimal user maintenance.

 

Benefits to the system userinclude improved quality of finished parts, ease of product adaptation, minimaldowntime, complete and ready installation, elimination of static balancing,longer life of the grinding wheel, diamond dressings and spindle bearings, theability to balance within 0.02 microns and its adaptability to all types ofmachines.

 

Precision grinding is necessaryin all major manufacturing areas including the automotive industry (camshafts,crankshafts, valves), bearings (roller and tapered types), ceramics (precisionshaping), electric motors (shafts), pumps (shafts and turbines), aircraft(engine parts), and general manufacturing. Precision grinding has anestablished worldwide presence in all industrialized countries and is expandingas a method of material removal and processing.  Therefore, the Company believes there may be an increase inmarket growth and the need for automatic balancing. Within the industry thereare three major market segments:

* *

***Machine ToolBuilders****-*Thesecompanies design and manufacture a variety of cylindrical, surface andspecialty application grinding machines. SBS Systems are distributed to a variety of world markets through OEM(original equipment manufacturer) accounts, where a special pricing (20%discount) is offered to the machine builder incorporating the SBS System intoits machine.

 

Examples ofsome well-known worldwide machine tool builders who have offered and/orinstalled the SBS System include ANCA (Australia), Blohm Incorporated (U.S.),Blohm GmbH (Germany),

 

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CapcoMachinery (U.S.), Cincinnati Milacron (U.S.), Ecotech/SMTW (China/U.S.),Gleason Works (U.S.), Litton IAS/Landis Grinding (U.S.), Micron MachineryLimited (Japan/U.S.), Normac Incorporated (U.S.), NTC Toyama America(U.S./Japan), Okomoto (Japan), Okuma Machine (Japan), Shigiya Machine (Japan),Sumitomo Heavy Industry (Japan), CETOS Hostivar (Czech Republic), TOS Holice(Czech Republic), Toyoda Machine (Japan) and Weldon Machine Tool (U.S.).  The Company currently sells its productsdirectly to most of the major machine rebuilders in the U.S. and WesternEurope.

* *

***Machine ToolRebuilders –*** These customers, found in allindustrial nations, develop their business by offering to completely update andrefurbish older machine tools. These rebuilders typically tear the old machineapart and install new components, such as the SBS System.  The Company currently sells its productsdirectly to major machine rebuilders in the U.S. and Western Europe.

* *

***Grinding MachineUsers****-* These end users become aware of theSBS System through trade shows, trade magazine advertising, distributors, fieldrepresentatives, referrals and new machine suppliers.  The Company’s business is conducted worldwide with some betterknown customers including: Black & Decker, Briggs and Stratton,Caterpillar Inc., Daewoo International Corp., Eaton Corporation, Ford MotorCompany, General Electric Corp., General Motors, Ingersoll Rand, Sumitomo HeavyIndustries, Texas Instruments, The Timken Company, Torrington, TRW AutomotiveComponents and Westinghouse Electric Corp.

 

The acquisition of SEG addedthe internal spindle, ring and water balancer designs to the Company’s productline.  These proven designs allowSchmitt to provide products to a broad range of machine applications.

 

In Fiscal 2003, 2002 and 2001,net sales of the Company’s balancing products totaled $5,481,010, $5,275,556and $6,030,030 respectively.  Net salesof balancing products accounted for 74% of the Company’s revenue inFiscal 2003, 77% in Fiscal 2002 and 80% in Fiscal 2001.  See Note 9 to Consolidated FinancialStatements.

* *

***Competition*:**

 

Management believes the SBSSystem is one of few fully automatic balancing systems marketed in theworld.  Most competitive productsrequire special setup and training or calibration to the specific machine. TheCompany believes the SBS System is currently the only balancing product thatfits all machines with wheel sizes from 6 to 48 inches in diameter and aspindle rpm of 500 through 7,500.

 

Competitive products come fromEuropean companies located in Switzerland, Germany, Spain and Italy.  These competitors produce electromechanicalbalancers similar to the SBS System and water balancers similar to the SEGsystem.  The Company considers thesecompanies, with their established European base, to be the majorcompetitors.  These balancers haveelectronic deficiencies, rendering them less effective in solving essential balancingrequirements.  They cannot achieve theconsistent low balance levels at 500-rpm (low speed) or at 7,500 rpm (highspeed) as the SBS system can.  Inaddition, these balancers have inferior brush and cable assemblies that causedown time and high maintenance. Finally, none of these companies can currently compete effectively withthe Company in providing mounting adapters for all grinding machines.

 

Water balancers are the oldeston the market and are employed in the SEG-installed systems.  They require expensive plumbing and waterchambers to be machined into the wheel hub while the SBS System does not.  They are currently priced about1.25 times the level of the SBS System. To install these systems, the grinding machines must be disassembled andparts remachined or replaced within the spindle assembly.  This can take two days, far longer thanrequired to install the SBS system.  Thewater system is “tuned” or “calibrated” to the machine by a factory servicetechnician while the SBS system can be installed by the operator.  Water systems work at mid- and high-speedsbut cannot balance in low rpm environments while SBS products work in bothenvironments.  Water systems requireperiodic monitoring while the SBS systems require little or no operator monitoring.

 

The SBS System list price isgenerally $7,995 worldwide. Competitors’ electromechanical systems are priced at $8,000 to $10,000worldwide while water balancers are priced at $9,000 to $11,000 worldwide.  Management market surveys indicate customersperceive the value of an automatic balancer to be approximately $8,000;therefore, Company pricing is geared to obtaining a dominant market positionand

 

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meeting competitive supplierprices.  The market strategy is toestablish the SBS System as the foremost product with the best quality,reliability and performance and superior economic value.

* *

***Measurement Products***

 

The Company manufactures andmarkets a line of laser-based, precision measurement systems and operates aprecision laser light scatter measurement laboratory.  Light scatter technology involves using lasers, optics anddetectors to throw a beam of light on a material sample and record itsreflection/transmission.  Analysis ofinformation can determine material characteristics such as surface roughness,defects and dimensional sizing without introducing contaminants and causingchanges to the tested material.  Theprincipal products are laser-based measurement products and technologyapplicable to both industrial and military markets.  The Company has used patents, patent applications, trademarks andother proprietary technology to focus marketing efforts on industrial markets,including electronics, computer disk and silicon wafer manufacturers.

 

There are four product lines:laser-based light-scatter measurement, dimensional sizing, research and otherlaser alignment products and a light-scatter measurement laboratory.

* *

***Laser-basedlight-scatter measurement:***

 

These products use a patentedlaser light scatter technology to perform rapid, accurate, repeatable andnon-destructive non-contact surface measurement tests that quantify surfacemicro-roughness.  Products are sold tomanufacturers of disk drives and silicon wafers, both industries with fabricationprocesses that require precise and reliable measurements.

 

Computer hard disks requireexact manufacturing control and a narrow tolerance band for acceptableroughness. The read/write head flies over the disk drive surface on a cushionof air generated when the rough surface of the rotating disk pulls air underthe head.  The head may stick or bind tothe disk when the surface is too smooth. If it is too rough, the head will flytoo far from the disk surface, causing a reduction in data density or storagecapacity.  The DUV and TMS productseries meet the challenges of disk drive manufacturers.  Customers include IBM, Seagate Substrates,Western Digital and Komag, Inc.

 

The original TMS-2000 (TextureMeasurement System) product, the world’s fastest and most accurate non-contacttexture measurement system, revolutionized disk-manufacturing technology.  The product (used on aluminum substrates) iscurrently used worldwide by most major disk drive manufacturers and providesfast, accurate and repeatable microroughness measurements and quadruplesproduction throughput when compared to other testing devices.  Surface roughness can now be measured tolevels below 0.5 Angstroms (the point of a needle is one million Angstroms indiameter).

 

The TMS-2000-DUV productmeasures the surface microroughness of glass rather than aluminumsubstrates.  Manufacturers require thetechnology and products to measure surface roughness of these substrates to thesame exact levels as those that measure aluminum. The Deep Ultra-violet light(DUV) technology and product uses the patented light scatter technology tomeasure the surface roughness of glass substrates to levels less than oneAngstrom.

 

Both products simultaneouslymeasure disk surface roughness in two directions, radially, when the read/writehead is moving to another disk sector and circumferentially, when theread/write head is processing information on the disk.  The two separate roughness levels arerequired for proper head operation. This measurement method is not possible through any other cost effectivemeasurement means.

 

The TMS-2000W and TMS-3000Wprovide fast, accurate, repeatable measurements for manufacturers of siliconwafers, computer chips and memory devices. This industry demands manufacturingprecision to increase performance and capacity and these products help achievethose goals. Silicon wafers are carefully cut and polished to provide the baseupon which a computer or memory chip is produced.  Therefore, chip manufacturing is extremely dependent on thebeginning surface roughness of the wafer. Since all silicon wafers exhibit a microscopic level of surfaceroughness, stemming from chemical deposition, grinding, polishing, etching, orany number of other production techniques, some method of measuring thesesurface characteristics is required. The wafer measurement products provide a way for SMS customers in thisindustry to quantify and control their manufacturing process. The systemprovides measurements to a few hundredths of an Angstrom, a level unachievableby other testing devices.

** **

**4**

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** **

**Dimensional Sizing Products:**

 

ARI develops and assembleslaser distance sensors for industrial and OEM use. Applications include steelcasting, paper production, medical imaging, crane control and micron-level partand surface inspection.  Presently,there are four product lines: the AR4000 distance measurement sensor, theAR4000 Line Scanner and the AR600 and AR200 series of triangulating laserdisplacement sensors.

 

The AccuRange 4000 is anoptical distance measurement sensor for most diffuse reflective surfaces.  It operates by emitting a collimated laserbeam that is reflected from the target surface and collected by a sensor.  The sensor is suitable for a wide variety ofdistance measurement applications that demand high accuracy and fast responsetimes.  Notable features include theoperating range for most surfaces (zero to fifty feet), fast response time (50kHz maximum sample rate), compact and lightweight power design and has atightly collimated output beam for small spot size.  The product has three output beam configurations available:visible infrared, eye safe infrared and reflective tape targets.  It is ideally suited to level and positionmeasurement, machine vision, autonomous vehicle navigation and 3D imagingapplications.

 

The AR4000 Line Scanner is usedwith the AccuRange 4000 to scan and collect distance data over a fullcircle.  The scanner consists of abalanced, rotating mirror and motor with position encoder and mounting hardwarefor use with the AccuRange 4000.  Thescanner deflects the beam 90 degrees, sweeping it through a full circle as itrotates.  The product can scan at ratesof up to 2600 lines per minute, sweeps the laser beam through a full 360degrees and is both compact and lightweight.

 

The AR600 series is a family oftriangulating laser displacement sensors with excellent accuracy andsensitivity.  The sensor projects a beamof visible laser light that creates a spot on the target surface. Reflectedlight from the surface is viewed from an angle by a line scan camera and thetarget’s distance is computed from the image pixel data. The line includes 11models measuring displacements from 1/8” to 50” and accuracy’s down to .00015” (4microns). They can operate on all types of surfaces at speeds up to 1250samples/second.  The product isextremely sensitive and can detect glass and liquid surfaces and also detectmultiple surfaces of transparent materials, allowing great flexibility inspecialized applications.

 

The AR200 line is AcuityResearch’s most compact series of triangulating laser displacement sensors.Four models cover metric measurement ranges from six to fifty millimeters.  All models boast a 1/500 accuracy rating formeasurements within twelve microns.  TheAR200 sensor is the only sensor of its kind to feature pushbutton selection ofoutput signals.  All models are standardwith Analog, Limit Switch and Serial outputs. The AR200 sensors, much like the longer-range AR600 sensors, project abeam of visible laser light that creates a spot on the target surface.Reflected light from the surface is viewed from an angle by a line scan cameraand the target’s distance is computed from the image pixel data.  The AR200-6M, -12M, -25M and -50M haveranges in millimeters that match their model number.  The AR200 displacement sensor can not be overloaded and measuresaccurately even when a mirror reflects the entire light beam back to thedetector.

 

**Research and Other Measurement Products:**

 

**CASI Scatterometers are sold to companies and institutionsinvolved in research efforts. A Scatterometer uses ultraviolet or infraredlaser light as a nondestructive probe to measure surface quality, opticalperformance, smoothness, appearance, defects and contamination on a widevariety of materials. These products are measurement instruments providingcustomers with precise roughness measurements of optical surfaces, diffusematerials, semiconductor wafers, magnetic storage media and precision-machinedsurfaces, as well as surfaces affecting the cosmetic appearance of consumerproducts. Customers include Pratt & Whitney, Boeing, The U.S. Navy andRockwell Collins North America.**

 

The μScan System is aportable device consisting of a hand-held control unit, an interchangeablemeasurement head and a separate charging unit. To perform a measurement, the operator places the measurement head onthe objective area and presses a button. Each measurement takes less than five seconds with results displayed andstored in system memory.  The μScancan store 700 measurements in 255 files and provides the capability to programpass/fail criteria.  Software isavailable for control, analysis and file conversion. From a single measurement,a user can determine RMS surface roughness, reflectance and scatter lightlevels (BRDF) on flat or curved surfaces under any lighting conditions.

** **

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** **

**Testing Laboratory:**

 

The Company provides a highlyadvanced measurement services laboratory to a wide variety of industrial andcommercial businesses that require precise measurements only advanced laserlight scatter technology can provide. The laboratory uses CASI Scatterometers for measuring surface roughness.The true value of the laboratory is not only its extremely precise measurementcapability but also the test item is not altered, touched or destroyed.  Thus, the laboratory is widely used bymanufacturers of critical optical components in aerospace and defense systems,including such companies as Aerojet, AT&T Bell Labs, Eastman Kodak, GeneralElectric, IBM, NASA and dozens of other industrial companies, universities andgovernment agencies.

 

In Fiscal 2003, 2002 and 2001,net sales of Measurement products totaled $1,938,511, $1,599,103 and $1,550,124respectively and accounted for 26%, 23% and 20% of the Company’s total sales inFiscal 2003, 2002 and 2001 respectively.

 

**Business and Marketing Strategy**

 

The Company designs, assemblesand markets all of its products with operations divided into a number ofdifferent areas.  The Vice President ofOperations directs SBS System production, and is responsible for all assembly,purchasing and production engineering as well as the technical servicesdivision that provides technical support to customers.  The President/CEO directs the production,assembly, purchasing, engineering and technical services functions for the SMSand ARI product lines.  The Product MarketingDivision, managed by the President/CEO, is responsible for the sale of SBSSystem products.  Two Marketing Managersare responsible for domestic sales while a third is responsible for sales inMainland China, Taiwan and Korea.  TheCompany also has one person who performs field service/sales.  The President/CEO is responsible forEuropean sales and oversees the efforts of the European Marketing Manager whois headquartered in the United Kingdom. Finally, there is a research and development group supervised directlyby the President/CEO and the Vice President of Operations.

 

The Company markets and sellsthe SBS System in a variety of ways. First, are the channels provided by independent manufacturer’srepresentatives and distributors.  Thereare currently approximately 25 individuals and/or organizations in the UnitedStates acting in one of these capacities. Independent sales agents are paid a10% commission; distributors are sold products at a 15% discount.

 

Second, worldwide trade showshave proven to be an excellent source of business.  Company representatives, usually one or more of the MarketingManagers and/or the President/CEO, attend these events along with local Companyrepresentatives.  These individualsoperate a display booth featuring an SBS System demonstration stand and productand technical literature.  Representativesfrom all facets of the Company’s target markets attend these trade shows.

 

Third, original equipment manufacturers(OEMs) include the SBS System on the machine tools they produce. Users thuspurchase the SBS System concurrently with the machine tools. Conversely, endusers of grinding machines that have purchased the SBS system directly from theCompany, and after enjoying the benefits of the products, often request thatSBS products be included with the new equipment they order from OEMs. The SBS Systemsare often installed by machine builders prior to displaying their own machinetools at various trade shows, becoming endorsements that prove beneficial tothe Company’s sales efforts.

** **

**In the United States, most products are shipped directly tocustomers from the Company’s distribution center in Portland, Oregon.  Where the Company has distributors, theproduct is shipped to the distributor, who in turn pays the Company directlyand then delivers and installs the product for the end user.  European distribution to customers ishandled by shipping the product directly from the Company’s Portlandheadquarters to the European subsidiaries, who in turn sell and distribute theproducts.**

 

Similar to the parent company,SMS uses a variety of methods to market and sell its measurement products.  First, a Marketing Manager, under thedirection of the President/CEO, directs the overall worldwide marketingefforts.  Second, the Company uses anindependent manufacturer’s representative group to market and sell products tovarious customers in the Western United States. That group is paid a 20%commission on units they are responsible for selling.  Third, the Company has a nonexclusive distribution agreement witha

 

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company in Japan for thepromotion and sale of SMS products in Japan, Korea, Malaysia, Singapore, thePhilippines and Taiwan. Fourth, trade shows represent a significant amount ofmarketing/sales effort.  The President/CEOattends these events along with various Company representatives.  These individuals operate a display boothfeaturing SMS product demonstrations and product and technical literature.  Representatives from all facets of themarket to which the Company directs its sales efforts attend these tradeshows.  Finally, one of the bestmarketing channels is the testing laboratory. Once customers see the capabilities of the technology, it can lead toorders for the Company’s laser based light scatter measurement products.

** **

**All SMS products are assembled in the Portland, Oregonfacility and shipped worldwide directly to customers.**

** **

**Acuity exclusively markets and sells its measurementproducts through a worldwide network of manufacturer’s representatives anddistributors.  The Marketing Manager ofARI, under the direction of the Company’s President/CEO, directs the overallmarketing efforts.  There are sevenrepresentatives in North America and seven located in countries throughout theworld.  The United Statesrepresentatives receive a 15% commission while the foreign representativesreceive a 25% commission on all units they sell. Management of both the Companyand ARI will also attend trade shows where the products are displayed anddemonstrated.  All ARI products areassembled in the Menlo Park, California facility and shipped worldwide directlyto customers.**

** **

**The SBS, SMS and ARI customer bases consist of over 250,200 and 300 companies respectively.**

** **

# **Manufacturing**

 

There are no unique sources ofsupply or raw materials in any product lines. Essential electronic components, available in large quantities fromvarious suppliers, are assembled into the Balancing and Measurement electroniccontrol units under the Company’s quality and assembly standards.  Company-owned software and firmware arecoupled with the electronic components to provide the basis of the Company’svarious electronic control units. Management believes several supply sources exist for all electroniccomponents and assembly work incorporated into its electronic controlsystems.  The primary outside supplierof electronic assemblies is Vanguard EMS of Beaverton, Oregon, a customsupplier of assembled electronic products for several Pacific Northwestcompanies.  In the event of supplyproblems, the Company believes that two or three alternatives could bedeveloped within 30 days to supplement or replace Vanguard.

 

Mechanical parts for theCompany’s products are produced by high quality CNC machine shops.  The Company is not dependent on any onesupplier of mechanical components. Principal suppliers of components for the Company’s products includeMacKay Manufacturing of Spokane, Washington; OEM Manufacturing of Corvallis,Oregon; Eagle Industries of Newberg, Oregon; and Forest City Gear of Roscoe,Illinois.

 

The Company uses in-house skilledassemblers to construct and test vendor-supplied components. Componentinventory of finished vendor-supplied parts is held on Company property toassure adequate flow of parts to meet customer order requirements.  Inventory is monitored by a computer controlsystem designed to assure timely re-ordering of components.

 

In-house personnel assemblevarious products and test all finished components before placing them in thefinished goods inventory.  Finishedgoods inventory is maintained via computer to assure timely shipment andservice to customers.  All customershipments are from the finished goods inventory.

 

In November 1996, the Company’sQuality Control Program received full ISO-9001 certification.  This certification was renewed in November2002.

 

**Proprietary Technology**

 

The Company’s success dependsin part on its proprietary technology, which the Company attempts to protectthrough patents, copyrights, trademarks, trade secrets and other measures.

 

The Company has U.S. patentscovering its SBS, SMS and ARI products, processes and methods which the Companybelieves provide it with a competitive advantage.  The Company has a policy of seeking patents where appropriate oninventions concerning new products and improvements developed as part of its

 

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ongoing research, developmentand manufacturing activities.  Whilepatents provide certain legal rights of enforceability, there can be noassurance the historic legal standards surrounding questions of validity andenforceability will continue to be applied or that current defenses as toissued patents will, in fact, be considered substantial in the future.  There can be no assurance as to the degreeand range of protection any patent will afford and whether patents will beissued or the extent to which the Company may inadvertently infringe uponpatents granted to others.

 

“SBS” and “SMS” are registeredtrademarks and are affixed to all products and literature created in theCompany’s balancer and measurement product lines, respectively.

 

The Company manufactures itsSBS products under copyright protection in the U.S. for electronic boarddesigns.  Encapsulation of the finishedproduct further protects the Company’s technologies including software.

 

The Company also relies upontrade secret protection for its confidential and proprietary information.  There can be no assurance that others willnot independently develop substantially equivalent proprietary information andtechniques or otherwise gain access to the Company’s trade secrets or disclosesuch technology or that the Company can meaningfully protect its trade secrets.

 

While the Company pursues patent,trademark, trade secret and copyright protection for products and variousmarks, it also relies on know-how and continuing technology advancement,manufacturing capabilities, affordable high-quality products, new productintroduction and direct marketing efforts to develop and maintain itscompetitive position.

 

**Product Development**

 

In Fiscal 1997, the Companybegan a research and development program to expand the product lines andcapabilities of SBS and SMS products. That policy has been incorporated into the operations of ARI as well.  The goal of this program is to expand theproduct base in historic markets and to enter new market areas so as to reducereliance on historic market segments. Since that Fiscal year, the Company has continued to develop thefollowing new balancing and laser measurement products.

** **

**The SB-4500 unit is now a multi-function unit providing theversatility to control several activities including all of Schmitt’s balancerproducts.  It controls balancing inapplications with speeds ranging from 300 to 30,000 rpm compared to a range of500 to 10,000 rpm with the prior Schmitt product.  Vibrations are measured to 0.02 microns or 0.75 millionths of aninch, a ten-fold performance improvement over the prior control unit.  It also allows customers to balance theirgrinding machines faster, reducing costly down time and increasing factorythroughput. This generation of computer control allows the future addition ofnew Schmitt products.**

 

The AEMS (Acoustical Emissions MonitoringSystem) is controlled by the SB-4500 unit and monitors the customers’ dressingand grinding processes by direct measurement of machine-generated acousticsignals.  By monitoring the highfrequency sound signal generated by contact between the wheel and work piece,the system automatically determines when wheel contact is made.  Users can eliminate the “gap” time fromtheir grinding process and also automatically detect the beginning of a wheel“crash” and immediately signal the grinder to stop before real damageoccurs.  The benefits of the AEMSproduct to the customer include time savings from quick and easy setups,improved dressing and grinding processes, and elimination of expensive part andmachine damage.

 

The disk drive industrypresented the Company with the challenge of developing the technology andproducts to measure the surface roughness of glass substrates. Existing SMStechnology was modified to produce the required light scatter information toprovide the necessary measurements.  Theengineering staff developed the DUV (Deep Ultra-violet light) technology tomeasure surface microroughness of glass substrates to the same precise levelsas existing products and at levels required by the industry. This technologycompliments existing products and provides the Company the ability to supplysolutions for all media used by the disk drive industry.

** **

**During Fiscal 2003, 2002 and 2001, the Company’sresearch and development expense totaled $192,686, $217,444 and $327,474respectively.**

 

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**Business Risks**

 

This report includes“forward-looking statements” as that term is defined in Section 21E of theSecurities Exchange Act of 1934. Forward-looking statements can be identified by the use offorward-looking terminology such as “believes,” “expects,” “may,” “will,”“should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,”“anticipates,” or “hopes,” or the negative of those terms or other comparableterminology, or by discussions of strategy, plans or intentions. For example,this section contains numerous forward-looking statements. All forward-lookingstatements in this report are made based on management’s current expectationsand estimates, which involve risks and uncertainties, including those describedin the following paragraphs. Among these factors are the following:

 

•                  Demand forcompany products may change.

•                  New products maynot be developed to satisfy changes in consumer demands.

•                  Failure toprotect intellectual property rights could adversely affect future performanceand growth.

•                  Production timeand the overall cost of products could increase if any of the primary suppliersare lost or if any primary supplier increased the prices of raw materials.

•                  Fluctuations inquarterly and annual operating results make it difficult to predict futureperformance.

•                  The Company maynot be able to reduce operating costs quickly enough if sales decline.

•                  The Companymaintains a significant investment in inventories in anticipation of futuresales.

•                  The lack of aline of credit agreement could impact future liquidity.

•                  Future successdepends in part on attracting and retaining key management and qualifiedtechnical and sales personnel.

•                  The Companyfaces risks from international sales and currency fluctuations.

 

Such risks and uncertaintiescould cause actual results to be materially different from those in theforward-looking statements. Readers are cautioned not to place undue relianceon the forward-looking statements in this report. We assume no obligation toupdate such information.

 

*Demand for Company products may change:*

 

For several months, the Companyhas experienced soft market demand for its Balancer products.  While specific reasons are difficult topinpoint, the low demand can generally be attributed to worldwide economicconditions, specifically those in the grinding machine industry, the primarymarket for the Company’s Balancer products. Based upon analysis by management and the sales staff, the decline insales does not appear to arise from the customer base shifting to competitorproducts.

 

Management has responded tothese soft market conditions in several ways. First, it appears there is a significant portion of the marketplace thatis not using the automatic balancing products of the Company or any of itscompetitors.  The Company will thereforecontinue to devote a significant part of its R&D efforts in Fiscal 2004 and2005 toward developing products that will both broaden the scope of productsoffered to the current customer base plus offer products for new marketsthereby reducing the reliance on historic markets.  Second, management initiated a restructuring plan in Europe inthe fourth Fiscal quarter of 2001 that was intended to increase worldwideoperating efficiency.  All engineeringdesign and manufacturing operations are now consolidated in the United States,a step that has reduced operating costs. In addition, all European operations are now focused totally onmarketing and sales.  Finally,management will continue to evaluate all operating costs and seek to reducecosts where necessary.

 

The Measurement segment hasrelied heavily upon sales to disk drive and silicon wafer manufacturers.  Conditions in those markets adverselyaffected sales beginning in Fiscal 1999 and those poor conditions continuedinto Fiscal 2003. Disk drive demand is largely tied to and dependent upondemand for personal computers.  InFiscal 2001, personal computer manufacturers warned of lower sales expectationsand many initiated actions to significantly reduce costs.  These soft market conditions have continuedinto Fiscal Years 2002 and 2003. Consequently, demand for drives has fallen and operations of thosecompanies have suffered with one result being reduced capital spending.  This has resulted in minimal demand for andsporadic sales of the Company’s TMS products. Industry forecasts are for these conditions to continue in theforeseeable future.

 

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The semiconductor industry isalso currently facing a down cycle. Beginning in Fiscal 2002 the semiconductorindustry experienced backlog cancellations, resulting in slower revenue growthand these conditions continued into Fiscal 2003.  The result is similar to disk drive manufacturers in that capitalspending has declined significantly and consequently so has demand for andsales of the Company’s wafer products. Forecasts for that industry are for improvements in market conditions tobegin sometime in calendar 2003, although there is no certainty thoseimprovements will occur during that time period.

 

Management will continue tomarket these products to these historic markets as it appears no othertechnology has been introduced that would make the TMS products technologicallyobsolete.  There is the belief that oncemarket conditions improve in the disk drive and silicon wafer markets, demandfor the Company’s products and technology will increase although most likelynot to historic levels.  Also,management believes there are other uses for the Company’s laser light scattertechnology and continues to evaluate R&D efforts to develop new productsand introduce them to the marketplace.

 

*New products may not be developed to satisfychanges in consumer demands:*

 

The failure to develop newtechnologies, or react to changes in existing technologies, could materiallydelay development of new products, which could result in decreased revenues anda loss of market share to competitors. Financial performance depends on theability to design, develop, manufacture, assemble, test, market and support newproducts and enhancements on a timely and cost-effective basis.  New product opportunities may not beidentified and developed and brought to market in a timely and cost-effectivemanner.  Products or technologiesdeveloped by other companies may render products or technologies obsolete ornoncompetitive or a fundamental shift in technologies in the product marketscould have a material adverse effect on the Company’s competitive positionwithin historic industries.

 

*Failure to protect intellectual propertyrights could adversely affect future performance and growth:*

 

Failure to protect existingintellectual property rights may result in the loss of valuable technologies orpaying other companies for infringing on their intellectual propertyrights.  The Company relies on patent,trade secret, trademark and copyright law to protect such technologies.  There is no assurance any of the Company’sU.S. patents will not be invalidated, circumvented, challenged or licensed toother companies.

 

*Production time and the overall cost ofproducts could increase if any of the primary suppliers are lost or if aprimary supplier increased the prices of raw materials:*

 

Manufacturing operations dependupon obtaining adequate supplies of raw materials on a timely basis.  The results of operations could be adverselyaffected if adequate supplies of raw materials cannot be obtained in a timelymanner or if the costs of raw materials increased significantly.

 

*Fluctuations in quarterly and annualoperating results make it difficult to predict future performance:*

 

Quarterly and annual operatingresults are likely to fluctuate in the future due to a variety of factors, someof which are beyond management’s control. As a result of quarterly operatingfluctuations, it is important to realize quarter-to-quarter comparisons ofoperating results are not necessarily meaningful and should not be relied uponas indicators of future performance

 

*The Company may not be able to reduceoperating costs quickly enough if sales decline:*

 

Operating expenses aregenerally fixed in nature and largely based on anticipated sales.  During the second quarter of Fiscal 2002,Management responded to declining sales by instituting an expense reductionprogram that significantly reduced the break-even sales point.  However, should sales decline, there is noguarantee management could take actions that would further reduce operatingexpenses in either a timely manner or without seriously impacting theoperations of the Company.

 

*The Company maintains a significantinvestment in inventories in anticipation of future sales:*

 

The Company believes itmaintains a competitive advantage by shipping product to its customers morerapidly than its competitors.  As aresult, the Company has a significant investment in inventories.  These

 

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inventories are recorded usingthe lower-of-cost or market method, which requires management to make certainestimates.  Management evaluates therecorded inventory values based on customer demand, market trends and expectedfuture sales and changes these estimates accordingly.  A significant shortfall of sales may result in carrying higherlevels of inventories of finished goods and raw materials thereby increasingthe risk of inventory obsolescence and corresponding inventorywrite-downs.  As a result, the Companymay not carry adequate reserves to offset such write-downs.

 

*The lack of a line of credit agreement couldimpact future liquidity:*

 

The short-term credit lineexpired on April 30, 2003 and the commercial bank chose not to renew thearrangement.  While management believesit could secure credit from another source, there is no guarantee this can beaccomplished or, if it is accomplished, the terms may not be as favorable asthose under the expired line of credit.

 

***Future success dependsin part on attracting and retaining key management and qualified technical andsales personnel:***

 

Future success depends on theefforts and continued services of key management, technical and salespersonnel.  Significant competitionexists for such personnel and there is no assurance key technical and salespersonnel can be retained nor assurances there will be the ability to attract,assimilate and retain other highly qualified technical and sales personnel asrequired.  There is also no guaranteekey employees will not leave and subsequently compete against the Company. Theinability to retain key personnel could adversely impact the business,financial condition and results of operations.

 

***The Company faces risksfrom international sales and currency fluctuations:***

 

The Company markets and sells its productsworldwide and international sales have accounted for and are expected tocontinue to account for a significant portion of future revenue.  International sales are subject to a numberof risks, including: the imposition of governmental controls; traderestrictions; difficulty in collecting receivables; changes in tariffs andtaxes; difficulties in staffing and managing international operations;political and economic instability; general economic conditions; and fluctuationsin foreign currencies.  No assurancescan be given these factors will not have a material adverse effect on futureinternational sales and operations and, consequently, on business, financialcondition and results of operations.

 

**International Sales**

The Company’s sales in the lastthree Fiscal years by geographic areas are:

 

|        |   | **North  America** |      | **Europe** |   | **Asia and  Others** |   |
|-------------|--------|--------------------|-----------|------------|--------|----------------------|--------|
| Fiscal 2003 |   | $                  | 4,150,797 |       | $      | 2,348,102            |   | $ | 920,622 |   |
| Fiscal 2002 |   | $                  | 4,337,917 |       | $      | 1,627,203            |   | $ | 909,539 |   |
| Fiscal 2001 |   | $                  | 5,041,830 |       | $      | 1,950,395            |   | $ | 587,929 |   |

 

**Backlog**

 

The Company does not generallytrack backlog.  Normally, orders areshipped within a few days after receipt unless the customer requests otherwise.

 

**Employees**

** **

**As of July 7, 2003, the Company employed43 individuals worldwide on a full-time basis.  There were no regular part-time employees.  None of the Company’s employees is coveredby a collective bargaining agreement.**

 

**Item 2.    Properties**

 

The Company’s design andassembly facilities and executive offices are located in a 7,500-square footCompany-owned building in Portland, Oregon and SMS operations are in a33,000-square foot Company-owned facility located across the street from theexecutive offices.  SEL occupies a1,893-square foot facility

 

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in Coventry, England pursuantto a three-year lease beginning June 1, 2002 with a basic monthly rent of£1,875 (approximately $2,750 as of July 7, 2003).  SEG occupies a 620 square foot facility in Pfungstadt, Germanypursuant to a five-year lease beginning December 1, 2001 with a basic monthlyrent of 658 Euros (approximately $775 as of July 7, 2003).  ARI occupies a 3,670 square foot facility inMenlo Park, California pursuant to a one-year lease beginning November 1, 2002with a current monthly rent of $7,487 as of July 5, 2003.  Management believes its facilities areadequate to meet its currently foreseeable needs.

 

**Item 3.    LegalProceedings**

 

There are no material legalproceedings currently pending against the Company.

 

**Item 4.    Submissionof Matters to a Vote of Security Holders**

 

No matters were submitted to avote of the security holders of the Company during the fourth quarter endedMay 31, 2003.

 

**PART II**

 

**Item 5.    Marketfor Registrant’s Common Equity and Related Stockholder Matters**

 

The Company’s Common Stock istraded on the Nasdaq SmallCap Market under the symbol “SMIT.”

** **

**The following tables set forth the high and low salesprices of the Company’s Common Stock as reported on the Nasdaq National Marketand The Nasdaq Smallcap Market (after May 23, 2002) for the periods indicated.**

** **

| **Year Ended  May 31, 2003** |   | **High** |   | **Low** |   |
|------------------------------|--------|----------|--------|---------|--------|
| First Quarter                |   | $        | 1.65   |    | $      | 1.05 |   |
| Second Quarter               |   | $        | 1.95   |    | $      | 1.11 |   |
| Third Quarter                |   | $        | 1.50   |    | $      | 1.07 |   |
| Fourth Quarter               |   | $        | 1.60   |    | $      | 0.80 |   |

 

| **Year Ended May 31, 2002** |   | **High** |   | **Low** |   |
|-----------------------------|--------|----------|--------|---------|--------|
| First Quarter               |   | $        | 3.27   |    | $      | 2.13 |   |
| Second Quarter              |   | $        | 2.76   |    | $      | 0.87 |   |
| Third Quarter               |   | $        | 1.68   |    | $      | 1.05 |   |
| Fourth Quarter              |   | $        | 2.16   |    | $      | 1.02 |   |

 

As of July 7, 2003, therewere 2,417,932 shares of Common Stock outstanding held by approximately130 holders of record.  The numberof holders does not include individual participants in security positionlistings; the Company believes that there are more than 2,500 individualholders of shares of Common Stock.

 

The Company has not paid anydividends on its Common Stock since 1994. The Company’s current policy is to retain earnings to finance theCompany’s business.  Future dividendswill be dependent upon the Company’s financial condition, results ofoperations, current and anticipated cash requirements, acquisition plans andplans for expansion and any other factors that the Company’s Board of Directorsdeems relevant.  The Company has nopresent intention of paying dividends on its Common Stock in the foreseeablefuture.

 

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**Item 6.    SelectedFinancial Data**

 

***In thousands, except per share information***

 
| **Year Ended**                             |   | **5/31/03** |   | **5/31/02** |   | **5/3101** |   | **5/31/00** |   | **5/31/99** |   |
|--------------------------------------------|--------|-------------|--------|-------------|--------|------------|--------|-------------|--------|-------------|--------|
| Sales                                      |   | $           | 7,420  |        | $      | 6,875      |   | $           | 7,580  |        | $      | 8,854 |   | $ | 7,958 |   |
| Net (Loss) Income                          |   | $           | (1,487 | )           | $      | (1,599     | )      | $           | (2,367 | )           | $      | 561 |   | $ | (259 | ) |
| Net (Loss) Income Per Share, Basic         |   | $           | (.60   | )           | $      | (.64       | )      | $           | (.90   | )           | $      | 0.21 |   | $ | (0.09 | ) |
| Weighted Average No. Shares, Basic         |   | 2,468       |   | 2,488       |   | 2,635      |   | 2,701       |   | 2,531       |   |
| Net (Loss) Income Per Share, Diluted       |   | $           | (.60   | )           | $      | (.64       | )      | $           | (.90   | )           | $      | 0.21 |   | $ | (0.09 | ) |
| Weighted Average No. Shares, Diluted       |   | 2,468       |   | 2,488       |   | 2,635      |   | 2,869       |   | 2,531       |   |
| Stockholders’ Equity                  |   | $           | 5,665  |        | $      | 7,251      |   | $           | 8,930  |        | $      | 10,128 |   | $ | 10,587 |   |
| Total Assets                               |   | $           | 6,272  |        | $      | 8,161      |   | $           | 10,291 |        | $      | 10,953 |   | $ | 11,282 |   |
| Long-term debt (including current portion) |   | $           | 24     |        | $      | 280        |   | $           | 353    |        | $      | — |   | $ | — |   |

##### ** **

**Item 7.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

** **

**The following information contains certain forward-lookingstatements that anticipate future trends or events.  These statements are based on certain assumptions that may proveto be erroneous and are subject to certain risks including but not limited tothe uncertainties of the Company’s new product introductions, the risks ofincreased competition and technological change in the Company’s industries andother factors detailed in the Company’s SEC filings.  Accordingly, actual results may differ, possibly materially, fromthe predictions contained herein.**

# ** **

# **RESULTS OF OPERATIONS**

 

Critical Accounting Policies

 

Revenue Recognition – TheCompany recognizes revenue when persuasive evidence of an arrangement exists,delivery has occurred, the sales price is fixed or determinable andcollectibility is probable.  For salesto all customers, including manufacturer representatives, distributors or theirthird-party customers, these criteria are met at the time product isshipped.  When other significantobligations remain after products are delivered, revenue is recognized onlyafter such obligations are fulfilled.

 

Accounts Receivable – TheCompany maintains credit limits for all customers that are developed based uponseveral factors, included but not limited to payment history, published creditreports and use of credit references. On a monthly basis, Management performs various analyses to evaluateaccounts receivable balances to ensure recorded amounts reflect estimated netrealizable value.  This review includesaccounts receivable agings, other operating trends and relevant businessconditions, including general economic factors, as they relate to each of theCompany’s domestic and international customers. If these analyses leadManagement to the conclusion that potential significant accounts areuncollectible, a reserve will be provided. The Company has had no significant bad debt write-offs since itsinception in 1986. As of May 31, 2003, management established a reserve of$24,060 to cover potential doubtful accounts.

 

Inventories – These assets arestated at the lower of cost or market on an average cost basis. Each Fiscalquarter, Management utilizes various analyses based on sales forecasts,historical sales and inventory levels to ensure the current carrying value ofinventory accurately reflects current and expected requirements within a reasonabletimeframe. As a result of this analysis at May 31, 2003, Management believesthe inventory levels are sufficient based upon the expected requirements inFiscal 2004 and beyond.  Based upon thesame analysis in Fiscal 2003 and 2001, Management determined $401,673 and$1,646,517 respectively of inventories were in excess of expected requirementsand therefore these amounts were written off.

 

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Long-term Deferred Tax Asset–The Company applies the asset and liability method in recording income taxes,under which deferred income tax assets and liabilities are determined based onthe differences between the financial reporting and tax bases of assets andliabilities and are measured using currently enacted tax rates and laws.Additionally, deferred tax assets are evaluated and a valuation allowance isestablished if it is more likely than not that all or a portion of the deferredtax asset will not be realized. During the year ended May 31, 2003, and based uponthe losses in the past three Fiscal years, Management believed it was prudentfor the Company to increase the valuation reserve to fully offset the estimatedvalue of the deferred tax assets.

 

Intangible Assets – There is aperiodic review of intangible and other long-lived assets for impairment.  This review consists of the analysis ofevents or changes in circumstances that would indicate the carrying amount ofthe asset may not be recoverable. Recoverability is determined by comparing theforecasted future net cash flows from the operations to which the assetsrelate, based on management’s best estimates using the appropriate assumptionsand projections at the time, to the carrying amount of the assets.  If the carrying value is determined to be inexcess of  future operating cash flows,the asset is considered impaired and a loss is recognized equal to the amountby which the carrying amount exceeds the estimated fair value of the assets.  As of May 31, 2003, Management does notbelieve impairment, as defined above, exists.

 

**Discussion of operating results:**

 

Sales were $7,419,521, $6,874,659 and$7,580,154 in Fiscal 2003, 2002 and 2001 respectively.  Worldwide sales of Schmitt Balancingproducts in Fiscal 2003 increased to $5,481,010 from $5,275,556 in Fiscal 2002but decreased from $6,030,030 in Fiscal 2001. Measurement sales increased to $1,938,511 from $1,599,103 and $1,550,124in Fiscal 2002 and 2001 respectively. The net loss for Fiscal 2003 of $1,487,131 compares to net losses of$1,598,619 and $2,366,953 in Fiscal 2002 and 2001 respectively.  The net loss in Fiscal 2003 was due to fouritems; a $612,200 non-operating charge for a write-down of the Company’slong-term investment in Air Packaging Technologies, Inc, $401,673 inwrite-downs of excess inventory quantities, an increase in the deferred taxasset valuation allowance of $636,006 and a $24,060 reserve for doubtfulaccounts.  When these items areexcluded, the net income would have been $186,808.  The net loss in Fiscal 2002 was primarily attributable to a$1,516,000 non-operating charge for a write-down of the Company’s long-terminvestment in Air Packaging Technologies, Inc. When that item is excluded, the net loss in Fiscal 2002 would have been$82,619.  The net loss in Fiscal 2001was primarily attributable to a $1,536,267 write-off of excess inventory in thesubsidiary which designs and assembles laser light scatter products.  Also, late in Fiscal 2001 Managementrestructured operations in Europe and recognized expenses of $226,525 in associationwith that restructure.  When those twoitems are excluded, the net loss would have been $604,161.  The final item contributing to the losses inFiscal 2002 and 2001 was decreasing sales, primarily in the Balancer segment,with the general economic slowdown in North America and Europe believed to bethe biggest cause.

 

Domestic and foreign revenues in the past several months havebeen affected by the slowdown in the global economy, resulting in soft demandfor Balancer products and reduced demand for Measurement devices.  The Balancer segment sales focus onend-users, rebuilders and original equipment manufacturers throughout theworld.  Sales staff, representatives anddistributors throughout these geographic areas spend a large amount of time withthe targeted customers.  They have foundmany of the customers in the automotive, bearing and aircraft industries havereferred to the state of the economy and its impact on the machine toolindustry as reasons for their reduced ordering activity.  The primary target markets for Measurementproducts have historically been disk drive and silicon wafermanufacturers.  Management and salesstaff monitor industry publications and public financial information in order tojudge the potential demand for Measurement products by these targetedindustries.  As in the prior Fiscalyear, this information has discussed at length declining demand for and salesof the products of those two industries and has generally defined industriesthat are in a severe recession.  Also,frequent discussions with customers have confirmed the information presented inthe public information and their inability to purchase Measurement products dueto their lack of a capital budget.

 

Historically, the Company hasenjoyed low cost of sales percentages, with those on its Balancing productsless than 50% and those on its Measurement products less than 40%.  Fiscal 2003 consolidated cost of sales as apercentage of sales totaled 47% compared to those in Fiscal 2002 and 2001 of41% and 68% respectively.  The cost ofsales in Fiscal 2003 includes $401,673 for the write-off of excess inventory

 

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quantities, which, whenexcluded from cost of sales would decrease the percentage to 42%.  Fiscal 2001 cost of sales includes$1,646,517 for the write-off of excess inventory quantities, which whenexcluded from cost of sales would decrease the percentage to 47%.  Cost of sales in the Balancer segmentincreased to 49% from 46% in Fiscal 2002 and decreased from 51% in Fiscal2001.  The percentage increased inFiscal 2003 due to the higher percentage of sales in the European markets.  Market conditions in that geographic marketare more competitive than in other areas and therefore unit sales prices arelower and conversely cost of sales percentages are higher.  The cost of sales for Balancer products inFiscal 2003 also includes $18,561 for the write-off of excess inventoryquantities.  The cost of salespercentage in Fiscal 2001 includes a write-off of obsolete inventory in theGerman subsidiary of $110,250 which, when excluded from cost of sales, woulddecrease the percentage to 49%.  Cost ofsales for Measurement products was 42%, up from 25% in Fiscal 2002 and downfrom 136% in 2001.  The cost of sales inFiscal 2003 included write-off of excess inventory quantities in the amount of$383,112 which, when excluded from cost of sales, would reduce the percentageto 22%.  Fiscal 2001 includes aninventory writedown of $1,536,267 and, when the inventory write-down isexcluded, the cost of sales percentage for Fiscal 2001 would be 37%.  The variation from the percentage in theprior years is due to the sales mix. Management expects the trends in sales and profits during Fiscal 2004for the Balancer segment to improve slightly while those of the Measurementsegment will approximate results for Fiscal 2003 (when the write-off of excessinventory quantities is excluded). However, no assurances can be made that the Company will be profitableor will generate increased sales in future time periods.

 

General, administrative andsales expenses as a percentage of net sales were 56% in Fiscal 2003 compared to56% in Fiscal 2002 and 57% in Fiscal 2001. In terms of dollars, these expenses were $4,139,013, $3,856,354 and $4,297,130in Fiscal 2003, 2002 and 2001 respectively. The increase in expenses in the most recent Fiscal year was due tohigher sales and a higher level of employees at the Acuity subsidiary.  Late in Fiscal 2003, Management reduced thenumber of employees at Acuity.  Thedecrease in expenses in Fiscal 2002 occurred as a result of management actionsinitiated in the second Fiscal quarter of that year.  In future Fiscal periods, Management believes the Company’s costswill not increase at the same rate****that****sales are anticipated to increase,although there can be no such assurance.

 

Research and developmentexpenses as a percentage of net sales were 2.6% in Fiscal 2003 compared to 3.2%and 4.3% in Fiscal 2002 and 2001 respectively. In terms of dollars, these expenses were $192,686, $217,444 and $327,474in Fiscal 2003, 2002 and 2001 respectively. The Company’s future operatingresults depend, to a considerable extent, on its ability to maintain acompetitive advantage in both the products and services it provides.  For this reason, Management believes futureinvestments in research and development are critical to ensure the flow ofinnovative, productive, high-quality products and support services.  Accordingly, Management expects to continueto place a high priority on research and development projects in the future.

 

The Company realized a net lossof $1,487,131 ($0.60 per share) compared to net losses of $1,598,619 ($0.64 pershare) and $2,366,953 ($0.90 per share) in Fiscal 2002 and 2001respectively.  The loss in Fiscal 2003was due to four items, a $612,200 non-operating charge for a write-down of theCompany’s long-term investment in Air Packaging Technologies, Inc. ($0.25 pershare), a $401,673 in write-downs of excess inventory quantities ($0.16 per share),an increase in the deferred tax asset valuation allowance of $636,006 ($0.26per share) and a $24,060 reserve for doubtful accounts ($0.01 per share).  When these items are excluded, net incomewould have been $186,808 or ($0.08 per share). The loss in Fiscal 2002 was primarily attributable to a $1,516,000non-operating charge ($0.61 per share) for a write-down of the Company’slong-term investment in Air Packaging Technologies, Inc.  The loss in Fiscal 2001 was primarilyattributable to a write-off of $1,646,517 ($0.62 per share) related to thewrite-off of excess inventories in the Measurement segment and obsoleteinventories of the German subsidiary and $116,275 ($0.04 per diluted share)related to the expenses incurred in relation to the restructure of the Germansubsidiary.

 

Net sales outside North America accountedfor approximately 44% of the Company’s revenues in Fiscal 2003, 37% in Fiscal2002 and 33% in Fiscal 2001.  Someforeign customers purchase in their own country’s currencies, thereby imposingon the Company a currency risk.  AllU.S. sales (56% of total sales in Fiscal 2003) were in U.S. dollars and theremaining Fiscal 2003 sales were in currencies other than U.S. dollars.  To date, currency fluctuations have hadminimal impact on revenues.  However,significant variations in the value of the U.S. dollar, relative to currenciesof countries in which the Company has significant competitors, can impactfuture sales.  The Company does notengage in currency hedging.  In

 

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addition, the longer payment cycles ofinternational sales can have a negative impact on liquidity.  The Company believes international saleswill continue to grow in future periods.

 

A substantial portion of theCompany’s revenues are derived from sales to end users through selling agents.The Company is dependent on the sales activities of its selling agents, andthere can be no assurance these agents will continue to be successful in theirefforts to market the Company’s products. The Company enjoys substantial repeat business from a broad base ofcustomers, but there is no assurance these customers will continue to buy theCompany’s products.

 

For Fiscal years 2003, 2002 and2001, sales to a single customer did not exceed 10% of total revenues.

 

The Company operates in highlycompetitive industries characterized by increasingly rapid technologicalchanges.  The Company’s competitiveadvantage and future success are therefore dependent on its ability to developnew products, qualify these new products with its customers, successfullyintroduce these products to the marketplace on a timely basis, commenceproduction to meet customer demands and develop new markets in the industriesfor its products and services.  Thesuccessful introduction of new technology and products is increasinglycomplex.  If the Company is unable, forwhatever reason, to develop and introduce new products in a timely manner inresponse to changing market conditions or customer requirements, its results ofoperations could be adversely impacted.

 

# **LIQUIDITY AND CAPITAL RESOURCES**

 

The Company’s ratio of currentassets to current liabilities increased to 7.7 to 1 at May 31, 2003 compared to5.7 to 1 at May 31, 2002.  As of May 31,2003 the Company had $410,245 in cash compared to $447,679 at May 31, 2002.

 

During the year ended May 31, 2003, cashprovided from operating activities amounted to $565,083 with the changesdescribed as follows:

 

**•**                  The net loss forthe year ended May 31, 2003 of $1,487,131 plus five non-cash items:depreciation and amortization of $240,265, the write-down of the long-terminvestment of $612,200, the write-down of the excess inventory quantities of$401,673, the increase in the valuation allowance for the deferred tax asset of$636,006 and the provision for doubtful accounts of $24,060.

 

•                  Accountsreceivable used cash as the balance increased by $213,224 (exclusive of theallowance for doubtful accounts) to a May 31, 2003 balance of $1,324,200compared to $1,135,036 at May 31, 2002. At May 31, 2003, $24,060 in accountsreceivable were considered a doubtful collection and therefore a reserve inthat amount has been provided for.  TheCompany generally experiences a payment cycle of 30-90 days on invoices,depending on the geographic market. Management believes its credit and collection policies are effective andappropriate for the marketplace.  Therecan be no assurance that the Company’s collection procedures will continue tobe successful, particularly with current economic conditions.

 

•                  Inventoriesdecreased $80,518 (exclusive of the inventory write-downs of $401,673) to a May31, 2003 balance of $2,725,931 compared to $3,208,122 at May 31, 2002.  The Company maintains levels of inventorysufficient to satisfy normal customer demands plus an increasing short-termdelivery requirement for a majority of its Balancer products.  Management believes its ability to provideprompt delivery gives it a competitive advantage for certain sales.

 

•                  Prepaid expensesincreased by $5,312 due to the addition of prepaid trade show costs less theamortization of several items including prepaid trade show costs, professionalfees and various business and life insurance costs.

 

•                  Income taxesreceivable declined by $123,977 due to Federal and local tax refunds receivedduring the year ended May 31, 2003.

 

•                  Trade accountspayable increased by $116,321 with the increase due to increased purchasingactivities of the Balancer segment and an extension of payment terms fromthirty to forty-five days.

 

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•                  Other accruedliabilities (including commission, payroll items and other accrued expenses)increased by $35,730.

 

During the year ended May 31,2003, net cash used in investing activities was $48,106 consisting of netadditions to property and equipment. Net cash used in financing activities amounted to $466,795, whichconsists of repayments of long-term debt of $294,408, additions to long-termdebt of $38,250, repayment on the credit line of $200,000 and repurchases ofcommon stock for $10,637.

 

The following summarizescontractual obligations at May 31, 2003 and the effect on future liquidity andcash flows:

 

| **Years Ending  May 31,** |   | **Capital  Lease  Obligations** |   | **Operating  Leases** |   | **Total  Contractual  Obligations** |    |
|---------------------------|--------|---------------------------------|--------|-----------------------|--------|-------------------------------------|---------|
| 2004                      |   |                            | $      | 20,030                |   | $                                   | 96,939  |   | $ | 116,969 |   |
| 2005                      |   |                            | 4,274  |                  | 42,193 |                                | 46,467  |   |
| 2006                      |   |                            | — |                  | 9,289  |                                | 9,289   |   |
| 2007                      |   |                            | — |                  | 4,645  |                                | 4,645   |   |
| 2008                      |   |                            | — |                  | — |                                | —  |   |
| Thereafter                |   |                            | — |                  | — |                                | —  |   |
| Total                     |   |                            | $      | 24,304                |   | $                                   | 153,066 |   | $ | 177,370 |   |

 

The acquisition of SMS in Fiscal1995 resulted in a tax loss of approximately $5.5 million, which is availableto offset domestic earnings through the year 2009.  As of May 31, 2003, approximately $2.0 million of these lossesremain.

 

# **The Company’s$500,000 short-term line of credit agreement with a commercial bank expired onApril 30, 2003.  While managementbelieves it could secure credit from another source, there is no guarantee thiscould be accomplished or, if it is accomplished, the terms will be as favorableas those under the current line of credit.**

 

Specific business challengesfaced by the Company over the past few years have had a negative impact onoperations.  Management has responded tothese challenges by reducing operating expenses, developing new products andattempting to penetrate new markets for the Company’s products.  As a result of these efforts, Managementbelieves its cash flows from operations and its cash position will provideadequate funds on both a short-term and long-term basis to cover currentlyforeseeable debt payments, lease commitments and payments under existing andanticipated supplier agreements. Management believes that such cash flow (without the raising of externalfunds) is sufficient to finance current operations, projected capitalexpenditures, anticipated long-term sales agreements and otherexpansion-related contingencies during Fiscal 2004. However, in the event theCompany fails to achieve its operating and financial goals for Fiscal 2004,management may be required to take certain actions to finance operations inthat time period.  These actions couldinclude, but are not limited to, implementation of additional cost cuttingmeasures, increased borrowings from existing credit facilities or entering intoadditional borrowing arrangements collateralized by assets.

 

**Item 7A. Qualitative and Quantitative Disclosures about Market Risk**

 

**Interest Rate Risk**

 

The Company did not have anyderivative financial instruments as of May 31, 2003.  However, the Company is exposed to interest rate risk.  The Company employs established policies andprocedures to manage its exposure to changes in the market risk of itsmarketable securities.

 

The Company’s interest incomeand expense are most sensitive to changes in the general level of U.S. andEuropean interest rates.  Therefore,changes in U.S. and European interest rates affect the interest earned on theCompany’s cash equivalents and marketable securities as well as interest paidon debt.

 

17

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The Company has lines of creditand other debt whose interest rates are based on various published prime ratesthat may fluctuate over time based on economic changes in the environment.  The Company is subject to interest rate riskand could be subject to increased interest payments if market interest ratesfluctuate.  The Company does not expectany change in the interest rates to have a material adverse effect on theCompany’s results from operations.

 

**Foreign Currency Risk**

 

The Company operatessubsidiaries in the United Kingdom and Germany.  The Company’s business and financial condition is, therefore,sensitive to currency exchange rates or any other restrictions imposed on theircurrencies.  To date, the foreigncurrency exchange rates have not significantly impacted the Company’sprofitability.

 

18

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**Item8.****                                                           FinancialStatements and Supplementary Data**

 

**SCHMITTINDUSTRIES, INC.CONSOLIDATEDBALANCE SHEETSMAY 31, 2003 AND 2002**

 
|                                                                                                                                                     |   | **2003**   |      | **2002**  |     |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|-----------|-----------|----------|
| **ASSETS**                                                                                                                                               |   |       |      |      |     |
| ***Current Assets***                                                                                                                                     |   |       |      |      |     |
| Cash                                                                                                                                                     |   | $          | 410,245   |      | $        | 447,679 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $24,060 and $0 in 2003 and 2002 respectively                                             |   | 1,324,200  |      | 1,135,036 |     |
| Inventories                                                                                                                                              |   | 2,725,931  |      | 3,208,122 |     |
| Prepaid expenses                                                                                                                                         |   | 167,192    |      | 161,880   |     |
| Income taxes receivable                                                                                                                                  |   | 32,659     |      | 156,636   |     |
|                                                                                                                                                     |   | 4,660,227  |      | 5,109,353 |     |
|                                                                                                                                                     |   |       |      |      |     |
| ***Property and Equipment***                                                                                                                             |   |       |      |      |     |
| Land                                                                                                                                                     |   | 299,000    |      | 299,000   |     |
| Buildings and improvements                                                                                                                               |   | 1,208,417  |      | 1,206,346 |     |
| Furniture, fixtures and equipment                                                                                                                        |   | 991,828    |      | 947,866   |     |
| Vehicles                                                                                                                                                 |   | 93,887     |      | 139,091   |     |
|                                                                                                                                                     |   | 2,593,132  |      | 2,592,303 |     |
| Less accumulated depreciation and  amortization                                                                                                          |   | 1,307,100  |      | 1,174,560 |     |
|                                                                                                                                                     |   | 1,286,032  |      | 1,417,743 |     |
| ***Other Assets***                                                                                                                                       |   |       |      |      |     |
| Long-term investment                                                                                                                                     |   | 6,800      |      | 619,000   |     |
| Long-term deferred tax asset                                                                                                                             |   | —     |      | 636,006   |     |
| Other assets                                                                                                                                             |   | 318,880    |      | 379,328   |     |
|                                                                                                                                                     |   | 325,680    |      | 1,634,334 |     |
| **TOTAL ASSETS**                                                                                                                                         |   | $          | 6,271,939 |      | $        | 8,161,430 |   |
|                                                                                                                                                     |   |       | * *  |      | * * |
| ***LIABILITIES AND STOCKHOLDERS’ EQUITY***                                                                                                          |   |       | * *  |      | * * |
|                                                                                                                                                     |   |       | * *  |      | * * |
| ***Current Liabilities***                                                                                                                                |   |       |      |      |     |
| Line of credit                                                                                                                                           |   | $          | —    |      | $        | 200,000 |   |
| Accounts payable                                                                                                                                         |   | 355,329    |      | 239,008   |     |
| Accrued commissions                                                                                                                                      |   | 148,953    |      | 157,325   |     |
| Other accrued liabilities                                                                                                                                |   | 78,080     |      | 33,978    |     |
| Current portion of long-term  debt                                                                                                                       |   | 20,031     |      | 264,845   |     |
|                                                                                                                                                     |   | 602,393    |      | 895,156   |     |
|                                                                                                                                                     |   |       |      |      |     |
| **Long-term Debt**                                                                                                                                       |   | 4,273      |      | 15,617    |     |
|                                                                                                                                                     |   |       |      |      |     |
| **Commitments and Contingencies (Note 8)**                                                                                                               |   |       |      |      |     |
|                                                                                                                                                     |   |       |      |      |     |
| ***Stockholders’  Equity***                                                                                                                         |   |       |      |      |     |
| Common stock, no par value,  20,000,000 shares authorized, 2,457,932 and 2,468,424 shares issued and  outstanding at May 31, 2003 and 2002, respectively |   | 7,332,984  |      | 7,343,621 |     |
| Accumulated other  comprehensive loss                                                                                                                    |   | (280,363   | )         | (192,747  | )        |
| (Accumulated deficit)  retained earnings                                                                                                                 |   | (1,387,348 | )         | 99,783    |     |
|                                                                                                                                                     |   | 5,665,273  |      | 7,250,657 |     |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                      |   | $          | 6,271,939 |      | $        | 8,161,430 |   |

 

#### *The accompanying notes are an integral part of theseconsolidated statements*

 

19

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##### **SCHMITTINDUSTRIES, INC.CONSOLIDATED STATEMENTS OFOPERATIONSFOR THE YEARS ENDED MAY 31, 2003, 2002 AND 2001**

 
|                                               |   | **2003**  |       | **2002**   |   | **2001**   |   |
|----------------------------------------------------|--------|-----------|------------|------------|--------|------------|--------|
| **Net Sales**                                      |   | $         | 7,419,521  |       | $      | 6,874,659  |   | $ | 7,580,154 |   |
|                                               |   |      |       |       |   |       |   |
| **Cost of Sales**                                  |   |      |       |       |   |       |   |
| Operations, exclusive of  inventory write-downs    |   | 3,088,566 |       | 2,844,937  |   | 3,529,991  |   |
| Inventory write-downs                              |   | 401,673   |       | —     |   | 1,646,517  |   |
| Total cost of sales                                |   | 3,490,239 |       | 2,844,937  |   | 5,176,508  |   |
|                                               |   |      |       |       |   |       |   |
| Gross profit                                       |   | 3,929,282 |       | 4,029,722  |   | 2,403,646  |   |
|                                               |   |      |       |       |   |       |   |
| **Operating expenses:**                            |   |      |       |       |   |       |   |
| General, administrative, and  sales                |   | 4,139,013 |       | 3,856,354  |   | 4,297,130  |   |
| Research and development                           |   | 192,686   |       | 217,444    |   | 327,474    |   |
| Restructure expenses                               |   | —    |       | —     |   | 116,275    |   |
| Total operating expenses                           |   | 4,331,699 |       | 4,073,798  |   | 4,740,879  |   |
|                                               |   |      |       |       |   |       |   |
| Operating loss                                     |   | (402,417  | )          | (44,076    | )      | (2,337,233 | )      |
|                                               |   |      |       |       |   |       |   |
| **Other income and (expense):**                    |   |      |       |       |   |       |   |
| Interest expense                                   |   | (22,824   | )          | (53,468    | )      | (15,016    | )      |
| Interest income                                    |   | 558       |       | 4,665      |   | 36,513     |   |
| Loss on write-down of long-term  investment        |   | (612,200  | )          | (1,516,000 | )      | —     |   |
| Gain (loss) on foreign currency  exchange          |   | 192,010   |       | (15,470    | )      | (63,855    | )      |
| Rental income                                      |   | 22,800    |       | 22,800     |   | 18,407     |   |
| Miscellaneous (expense) income                     |   | (29,052   | )          | 2,930      |   | (5,769     | )      |
| Other income and (expense)                         |   | (448,708  | )          | (1,554,543 | )      | (29,720    | )      |
|                                               |   |      |       |       |   |       |   |
| **Loss before provision for income taxes**         |   | (851,125  | )          | (1,598,619 | )      | (2,366,953 | )      |
|                                               |   |      |       |       |   |       |   |
| **Provision  for income taxes**                    |   | 636,006   |       | —     |   | —     |   |
|                                               |   |      |       |       |   |       |   |
| **Net loss**                                       |   | $         | (1,487,131 | )          | $      | (1,598,619 | )      | $ | (2,366,953 | ) |
|                                               |   |      |       |       |   |       |   |
| Net loss per common share,  basic                  |   | $         | (0.60      | )          | $      | (0.64      | )      | $ | (0.90 | ) |
|                                               |   |      |       |       |   |       |   |
| Weighted average number of  common shares, basic   |   | 2,467,651 |       | 2,488,458  |   | 2,634,933  |   |
|                                               |   |      |       |       |   |       |   |
| Net loss per common share,  diluted                |   | $         | (0.60      | )          | $      | (0.64      | )      | $ | (0.90 | ) |
|                                               |   |      |       |       |   |       |   |
| Weighted average number of  common shares, diluted |   | 2,467,651 |       | 2,488,458  |   | 2,634,933  |   |

 

#### *The accompanying notes are an integral part of theseconsolidated financial statements*

#### * *

20

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##### **SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF CHANGESIN STOCKHOLDERS’ EQUITY**FOR THE YEARS ENDED MAY 31, 2003, 2002 AND 2001

** **
|                                              |   | **Shares** |   | **Amount** |      | **Accumulated  Other  Comprehensive  (Loss)** |   | **Retained  Earnings  (Accumulated  Deficit)** |   | **Total**  |       | **Total  Comprehensive  (Loss)** |       |
|---------------------------------------------------|--------|------------|--------|------------|-----------|-----------------------------------------------|--------|------------------------------------------------|--------|------------|------------|----------------------------------|------------|
|                                              |   |       |   |       |      |                                          |   |                                           |   |       |       |                             |       |
| **Balance, May 31, 2000**                         |   | 2,660,129  |   | $          | 7,259,399 |                                          | $      | (1,196,683                                     | )      | $          | 4,065,355  |                             | $          | 10,128,071 |   | $ |   |
| Common shares issued to purchase Acuity Research  |   | 91,666     |   | 747,725    |      | —                                        |   | —                                         |   | 747,725    |       |                             |       |
| Common shares retired                             |   | (97,750    | )      | (586,500   | )         | —                                        |   | —                                         |   | (586,500   | )          |                             |       |
| Note cancelled in return for stock                |   | —     |   | 586,500    |      | —                                        |   | —                                         |   | 586,500    |       |                             |       |
| Common shares repurchased                         |   | (152,114   | )      | (599,648   | )         | —                                        |   | —                                         |   | (599,648   | )          |                             |       |
| Net (loss)                                        |   | —     |   | —     |      | —                                        |   | (2,366,953                                     | )      | (2,366,953 | )          | (2,366,953                       | )          |
| Other comprehensive income                        |   | —     |   | —     |      | 1,020,729                                     |   | —                                         |   | 1,020,729  |       | 1,020,729                        |       |
| **Balance, May 31, 2001**                         |   | 2,501,931  |   | 7,407,476  |      | (175,954                                      | )      | 1,698,402                                      |   | 8,929,924  |       |                             |       |
| **Comprehensive  loss, year ended May 31, 2001**  |   |       |   |       |      |                                          |   |                                           |   |       |       | $                                | (1,346,224 | ) |
|                                              |   |       |   |       |      |                                          |   |                                           |   |       |       |                             |       |
| Common shares repurchased                         |   | (33,499    | )      | (63,855    | )         | —                                        |   | —                                         |   | (63,855    | )          |                             |       |
| Net (loss)                                        |   | —     |   | —     |      | —                                        |   | (1,598,619                                     | )      | (1,598,619 | )          | (1,598,619                       | )          |
| Other comprehensive loss                          |   | —     |   | —     |      | (16,793                                       | )      | —                                         |   | (16,793    | )          | (16,793                          | )          |
| **Balance, May 31, 2002**                         |   | 2,468,432  |   | $          | 7,343,621 |                                          | $      | (192,747                                       | )      | $          | 99,783     |                             | $          | 7,250,657 |   |   |   |
| **Comprehensive  loss, year ended  May 31, 2002** |   |       |   |       |      |                                          |   |                                           |   |       |       | $                                | (1,615,412 | ) |
|                                              |   |       |   |       |      |                                          |   |                                           |   |       |       |                             |       |
| Common shares repurchased                         |   | (10,500    | )      | (10,637    | )         | —                                        |   | —                                         |   | (10,637    | )          |                             |       |
| Net (loss)                                        |   | —     |   | —     |      | —                                        |   | (1,487,131                                     | )      | (1,487,131 | )          | (1,487,131                       | )          |
| Other comprehensive loss                          |   | —     |   | —     |      | (87,616                                       | )      | —                                         |   | (87,616    | )          | (87,616                          | )          |
| **Balance, May 31, 2003**                         |   | 2,457,932  |   | $          | 7,332,984 |                                          | $      | (280,363                                       | )      | $          | (1,387,348 | )                                | $          | 5,665,273 |   |   |   |
| **Comprehensive  loss, year ended  May 31, 2003** |   |       |   |       |      |                                          |   |                                           |   |       |       | $                                | (1,574,747 | ) |

 

##### ***The accompanying notes are an integral part of theseconsolidated financial statements***

 

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##### **SCHMITTINDUSTRIES, INC.**

##### **CONSOLIDATED STATEMENTS OF CASH FLOWS**

## ***FORTHE YEARS ENDED MAY 31, 2003, 2002 AND 2001***

 
|                                                                                      |   | **2003** |       | **2002**  |   | **2001**   |   |
|-------------------------------------------------------------------------------------------|--------|----------|------------|-----------|--------|------------|--------|
| **Cash Flows Relating to Operating Activities**                                           |   |     |       |      |   |       |   |
| Net loss                                                                                  |   | $        | (1,487,131 | )         | $      | (1,598,619 | )      | $ | (2,366,953 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities |   |     |       |      |   |       |   |
| Write-down of long-term investment                                                        |   | 612,200  |       | 1,516,000 |   | —     |   |
| Write-down of excess inventory quantities                                                 |   | 401,673  |       | —    |   | 1,646,517  |   |
| Depreciation and amortization                                                             |   | 240,265  |       | 245,138   |   | 269,631    |   |
| Deferred taxes                                                                            |   | 636,006  |       | 122,865   |   | —     |   |
| Provision for bad debts                                                                   |   | 24,060   |       | —    |   | —     |   |
| (Increase) decrease in:                                                                   |   |     |       |      |   |       |   |
| Accounts receivable                                                                       |   | (213,224 | )          | 92,121    |   | 215,525    |   |
| Inventories                                                                               |   | 80,518   |       | 350,916   |   | (495,524   | )      |
| Prepaid expenses                                                                          |   | (5,312   | )          | 24,690    |   | (115,202   | )      |
| Income taxes receivable                                                                   |   | 123,977  |       | (122,975  | )      | (8,743     | )      |
| Increase (decrease) in:                                                                   |   |     |       |      |   |       |   |
| Accounts payable                                                                          |   | 116,321  |       | (179,079  | )      | (59,226    | )      |
| Accrued commissions and other accrued  liabilities                                        |   | 35,730   |       | (198,594  | )      | 36,847     |   |
| Net cash provided by (used in) operating  activities                                      |   | 565,083  |       | 252,463   |   | (877,128   | )      |
|                                                                                      |   |     |       |      |   |       |   |
| **Cash Flows Relating to Investing Activities**                                           |   |     |       |      |   |       |   |
| Purchase of property and equipment                                                        |   | (74,505  | )          | (110,458  | )      | (147,616   | )      |
| Disposal of property and equipment                                                        |   | 26,399   |       | 39,377    |   | 17,067     |   |
| Cash acquired in purchase of wholly-owned  subsidiary                                     |   | —   |       | —    |   | 113,604    |   |
| Net cash used in investing activities                                                     |   | (48,106  | )          | (71,081   | )      | (16,945    | )      |
|                                                                                      |   |     |       |      |   |       |   |
| **Cash Flows Relating to Financing Activities**                                           |   |     |       |      |   |       |   |
| Line of credit repayments                                                                 |   | (200,000 | )          | (400,000  | )      | —     |   |
| Line of credit borrowings                                                                 |   | —   |       | 400,000   |   | 200,000    |   |
| Proceeds of long-term borrowings                                                          |   | 38,250   |       | 33,877    |   | —     |   |
| Repayment of long-term debt                                                               |   | (294,408 | )          | (106,015  | )      | (119,400   | )      |
| Common stock repurchased                                                                  |   | (10,637  | )          | (63,855   | )      | (127,648   | )      |
| Net cash used in financing activities                                                     |   | (466,795 | )          | (135,993  | )      | (47,048    | )      |
|                                                                                      |   |     |       |      |   |       |   |
| **Effect of foreign exchange translation on  cash**                                       |   | (87,616  | )          | 111,207   |   | (32,271    | )      |
|                                                                                      |   |     |       |      |   |       |   |
| **(Decrease) increase in cash**                                                           |   | (37,434  | )          | 156,596   |   | (973,392   | )      |
|                                                                                      |   |     |       |      |   |       |   |
| **Cash,** beginning of  year                                                              |   | 447,679  |       | 291,083   |   | 1,264,475  |   |
|                                                                                      |   |     |       |      |   |       |   |
| **Cash,** end of year                                                                     |   | $        | 410,245    |      | $      | 447,679    |   | $ | 291,083 |   |
|                                                                                      |   |     |       |      |   |       |   |
| **Supplemental Disclosure of Cash Flow  Information**                                     |   |     |       |      |   |       |   |
| Cash paid during the period for interest                                                  |   | $        | 22,824     |      | $      | 58,771     |   | $ | 15,016 |   |
| Cash paid during the period for income  taxes                                             |   | $        | 26,110     |      | $      | 110        |   | $ | 20,132 |   |
|                                                                                      |   |     |       |      |   |       |   |
| **Supplemental Schedule of Noncash Investing  and Financing Activities**                  |   |     |       |      |   |       |   |
| Increase (decrease) in market value of  long-term investment                              |   | $        | —     |      | $      | (273,000   | )      | $ | 1,596,000 |   |
| Increase (decrease) in long-term deferred  tax asset                                      |   | $        | —     |      | $      | 145,000    |   | $ | (543,000 | ) |
| Common stock issued to purchase  wholly-owned subsidiary                                  |   | $        | —     |      | $      | —     |   | $ | 747,725 |   |
| Wholly-owned subsidiary – net tangible  assets acquired                              |   | $        | —     |      | $      | —     |   | $ | (325,901 | ) |
| Wholly owned subsidiary – intangible assets  acquired                                |   | $        | —     |      | $      | —     |   | $ | (421,824 | ) |
| Long-term debt incurred to repurchase stock                                               |   | $        | —     |      | $      | —     |   | $ | 472,000 |   |

#### * *

#### *The accompanying notes are an integral part of theseconsolidated statements*

 

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**SCHMITT INDUSTRIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**FOR THE YEARS ENDED MAY 31, 2003, 2002 AND2001**

 

# **NOTE 1**

# **ORGANIZATION AND NATURE OF OPERATIONS**

 

Schmitt Industries, Inc. (theCompany) designs, assembles, markets and distributes electronic and mechanicalcomponents for machine tool products and laser measurement systems worldwide.

 

# **NOTE 2**

**SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

# **Principles of Consolidation**

 

# **These consolidatedfinancial statements include those of the Company and its wholly ownedsubsidiaries: Schmitt Measurement Systems, Inc. (SMS), Schmitt Europe, Ltd.(SEL), Schmitt Europa GmbH (SEG) and Acuity Research Incorporated (ARI). All significant intercompany accounts andtransactions have been eliminated in the preparation of the consolidatedfinancial statements.**

# ** **

# **Foreign Currency Translation**

 

Financial statements for theCompany’s subsidiaries outside the United States are translated into U.S.dollars at year-end exchange rates for assets and liabilities and weightedaverage exchange rates for income and expenses.  The resulting translation adjustments are included as a separatecomponent of stockholders’ equity titled “Accumulated Other ComprehensiveLoss.”

 

**Revenue Recognition**

 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is probable.  For sales to all customers, including manufacturer representatives, distributors or their third-party customers, these criteria are met at the time product is shipped.  When other significant obligations remain after products are delivered, revenue is recognized only after such obligations are fulfilled.

 

# **Research and Development Costs**

 

Research and development costsare charged to expense when incurred.

 

# **Stock-Based Compensation**

 

Statement of FinancialAccounting Standards No. 123, “Accounting for Stock-Based Compensation,” (FAS123) encourages, but does not require, companies to record compensation costfor stock-based employee compensation plans at fair value. The Company haschosen to continue to account for stock-based compensation using the intrinsicvalue method prescribed in Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (APB 25).  Accordingly, compensation cost for stock options is measured asthe excess, if any, of the quoted market price of the Company’s stock at thedate of the grant over the amount an employee must pay to acquire the stock.

 

The Company has adopted thedisclosure only provisions of SFAS 123. Accordingly, no compensation cost has been recognized for the stockoption plans. Adjustments are made for options forfeited prior to vesting.  For the years ended May 31, 2003, 2002 and2001, total value of options granted was computed to be $7,158, $110,532 and$621,850, respectively, which would be amortized on the straight-line basisover the vesting period of the options. Had compensation cost for the Company’s stock option plans beendetermined based on the fair value at the grant date for the awards in 2003,2002 and 2001, consistent with the provisions of SFAS 123, the Company’s proforma net (loss) income for the years ended May 31, 2003, 2002 and 2001, wouldbe $(1,591,321), $(1,709,151) and $(2,758,930), respectively.  Pro forma basic

 

23

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(loss) earnings per share forthe years ended May 31, 2003, 2002 and 2001 would be $(.64) $(.69) and $(1.05)respectively.

 

Pursuant to SFAS 123, the fairvalue of each option granted is estimated on the date of the grant using theBlack-Scholes option and pricing model. The weighted average assumptions used for Fiscal 2003, 2002 and 2001were a risk-free interest rate of 3.50% for 2003, 4.00% for 2002 and 5.00% for2001, an expected dividend yield of 0% for all years, an expected life of fouryears for Fiscal 2003 and 2002 and eight years for Fiscal 2001, and avolatility of 119%, 121% and 80%, respectively.

 

The effects of applying SFASNo. 123 in the proforma disclosure are not indicative of future amounts.

 

# **Income Taxes**

 

Deferred tax assets andliabilities are recognized for the future tax consequences of differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax bases.

# ** **

# **Earnings Per Share**

 

Basic earnings per share are computed usingthe weighted average number of shares outstanding.  Diluted earnings per share are computed using the weightedaverage number of shares outstanding, adjusted for dilutive incremental sharesattributed to outstanding options to purchase common stock.  In Fiscal 2003, 2002 and 2001, 243,290,380,142 and 384,442 incremental shares were excluded from the diluted loss pershare calculation, as their effect was anti-dilutive.

# ** **

# **Cash and Cash Equivalents**

 

The Company considersshort-term investments that are highly liquid, readily convertible into cashand have original maturities of less than three months to be cash equivalents.

 

**Accounts Receivable**

 

The Company maintains creditlimits for all customers that are developed based upon several factors,included but not limited to payment history, published credit reports and useof credit references.  On a monthlybasis, Management performs various analyses to evaluate accounts receivablebalances to ensure recorded amounts reflect estimated net realizablevalue.  This review includes accountsreceivable agings, other operating trends and relevant business conditions,including general economic factors, as they relate to each of the Company’sdomestic and international customers. If these analyses lead Management to theconclusion that potential significant accounts are uncollectible, a reservewill be provided.  The Company has hadno significant bad debt write-offs since its inception in 1986. As of May 31,2003, management established a reserve of $24,060 to cover potential doubtfulaccounts.

 

**Inventory**

 

Inventory is valued at thelower of cost or market with cost determined on the average cost basis.  As of May 31, 2003 and 2002, inventoriesconsisted of raw materials ($1,346,513 and $1,870,507, respectively), work-in-process($1,527 and $1,151, respectively), and finished goods ($1,377,891 and$1,336,464, respectively).

 

# **Property and Equipment**

 

Property and equipment arestated at cost.  Depreciation iscomputed using the straight-line method over estimated useful lives of three toseven years for furniture fixtures, and equipment; three years for vehicles;and twenty-five years for buildings and improvements.

 

24

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**Concentration of Credit Risk**

 

Financial instruments thatpotentially expose the Company to concentration of credit risk are tradeaccounts receivable.  Credit termsgenerally include a discount of 1-1/2% if the invoice is paid within ten days,with the net amount payable in 30 days.

 

# **Financial Instruments**

 

The carrying amounts offinancial instruments approximate their fair values at May 31, 2003.

 

# **Use of Estimates**

 

The preparation of theconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. Actual results could differ from those estimates.

# ** **

# **New Accounting Pronouncements**

 

InJuly 2002, FASB issued SFAS No. 146, “Accounting for Costs Associated with Exitor Disposal Activities,” which replaces Emerging Issues Task Force (EITF) IssueNo. 94-3, “Liability Recognition for Certain Employee Termination Benefits andOther Costs to Exit an Activity (including Certain Costs Incurred in aRestructuring).”  SFAS No. 146 requirescompanies to recognize costs associated with exit or disposal activities, suchas lease termination costs and certain employee severance costs, when they areincurred rather than at the date of a commitment to an exit or disposalplan.  The principal effect of applyingSFAS No. 146 will be on the timing of recognition of costs associated with exitor disposal activities.  The Companywill apply SFAS No. 146 to exit or disposal activities initiated afterDecember 31, 2002.

 

In December 2002, theFASB issued Statement No. 148 (SFAS 148), “Accounting for Stock-BasedCompensation – Transition and Disclosure: an amendment of FASB Statement 123”(SFAS 123), to provide alternative transition methods for a voluntary change tothe fair value based method of accounting for stock-based employeecompensation.  In addition, SFAS 148amends the disclosure requirements of SFAS 123 to require prominent disclosuresin annual financial statements about the method of accounting for stock-basedemployee compensation and the pro forma effect on reported results of applyingthe fair value based method for entities that use the intrinsic value method ofaccounting.  The pro forma effectdisclosures are also required to be prominently disclosed in interim periodfinancial statements.  This statement iseffective for financial statements for fiscal years ending after December 15,2002 and is effective for financial reports containing condensed financialstatements for interim periods beginning after December 15, 2002, with earlierapplication permitted.  The Company doesnot plan a change to the fair value based method of accounting for stock-basedemployee compensation and has included the disclosure requirements of SFAS 148above.

 

In November 2002, theFASB issued Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers” (“FIN 45”). FIN 45 expands previously issued accounting guidance anddisclosure requirements for certain guarantees.  FIN 45 requires an entity to recognize an initial liability forthe fair value of an obligation assumed by issuing a guarantee. The disclosurerequirements of FIN 45 are effective for all financial statements issued afterDecember 15, 2002. The provision for initial recognition and measurement of theliability will be applied on a prospective basis to guarantees issued ormodified after December 31, 2002. The adoption of FIN 45 is not expected to havea material adverse impact on the Company’s financial position, results ofoperations or cash flows.

 

In January 2003, theFASB issued Interpretation No. 46, “Consolidation of Variable InterestEntities, an Interpretation of ARB No. 51,” (“FIN 46”). FIN 46 requires allVariable Interest Entities (“VIEs”) to be consolidated by the primarybeneficiary. The primary beneficiary is the entity that holds the majority ofthe

 

25

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beneficial interests inthe VIE. In addition, FIN 46 expands disclosure requirements for both VIEs thatare consolidated as well as VIEs from which the entity is the holder of asignificant amount of the beneficial interest, but not the majority. Thedisclosure requirements of FIN 46 are effective for all financial statementsissued after January 31, 2003. The consolidation requirements of thisinterpretation are effective for all periods beginning after June 15, 2003. Theadoption of FIN 46 is not expected to have a material adverse impact on theCompany’s financial position, results of operations or cash flows at this time.

 

# **NOTE 3**

# **LONG-TERM INVESTMENTS**

# **The Company owns1,375,716 shares or approximately 9% of the outstanding shares of Air PackagingTechnologies, Inc.  That company isengaged in the design, manufacture, marketing and sales of “Air Box” patentedpackaging systems used in the retail, industrial protective and promotionalpackaging markets worldwide.  Thisinvestment is classified as “Available-for-sale securities” under Statement ofFinancial Accounting Standards No. 115 (SFAS No. 115).  As required under that statement, allunrealized gains and losses are reported in Accumulated Other ComprehensiveLoss and included as a separate component in Other Comprehensive Loss in Stockholders’Equity until realized or until unrealized losses are deemed to be “other thantemporary”.**

# ** **

# **At May 31, 2003Management determined the decline in value of the investment from acquisitioncost was “other than temporary”, and, as required under SFAS No. 115, thelong-term investment was written down by $612,200 to its fair market value asof May 31, 2003.  Fair market value wasthe closing price of the stock on the over-the-counter market at May 31, 2003.  As required under SFAS No. 115, the new costbasis shall not be changed for subsequent recoveries in fair value.  Future temporary gains and losses will bereported as required under SFAS No. 115.**

 

# **NOTE 4**

# **LINE OF CREDIT**

# ** **

# **The Company had a$500,000 short-term line of credit agreement with a commercial bank, secured byU.S. accounts receivable and inventories, that expired on April 30, 2003.  The line was guaranteed by the Company’swholly owned subsidiary, Schmitt Measurement Systems, Inc.  Interest was payable at the bank’s primerate plus 1.50%.  As of May 31, 2002,$200,000 was outstanding on this line of credit.**

# ** **

# **NOTE 5**

**INCOME TAXES**

 

The provision (benefit) forincome taxes was as follows

 
|                             |   | ***Years ended May 31,*** |    |
|----------------------------------|--------|---------------------------|---------|
|                             |   | ***2003***                |    | ***2002*** |   | ***2001*** |   |
| Current                          |   | $                         | —  |   | $ | — |   | $ | — |   |
| Deferred                         |   | (363,021                  | )       | (533,183 | ) | (718,431 | ) |
| Increase in valuation allowance  |   | 999,027                   |    | 533,183 |   | 718,431 |   |
| Total provision for income taxes |   | $                         | 636,006 |   | $ | — |   | $ | — |   |

 

Deferred tax assets(liabilities) are comprised of the following components:

 

26

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|                                                                                  |   | **2003**     |     | **2002**     |     |
|---------------------------------------------------------------------------------------|--------|--------------|----------|--------------|----------|
| *Depreciation*                                                                        |   | *$*          | *19,679* | * *     | *$*      | *19,679* | * * |
| *Net operating loss carryforwards*                                                    |   | *1,448,463*  | * * | *1,319,512*  | * * |
| *Deferred taxes related to the decline in fair  market value of long-term investment* |   | *817,229*    | * * | *582,144*    | * * |
| *Other deferred assets*                                                               |   | *89,501*     | * * | *90,516*     | * * |
| *Gross deferred tax assets*                                                           |   | *2,374,872*  | * * | *2,011,851*  | * * |
|                                                                                  |   |         | * * |         | * * |
| *Deferred tax asset valuation allowance*                                              |   | *(2,374,872* | *)*      | *(1,375,845* | *)*      |
|                                                                                  |   |         | * * |         | * * |
| *Net deferred tax asset*                                                              |   | *$*          | *—* | * *     | *$*      | *636,006* | * * |

 

TheCompany has approximately $2.0 million of U.S. federal net operating losscarryforwards that were acquired as part of the acquisition of SchmittMeasurement Systems, Inc.  These NOLsare subject to limitations that restrict their use and expire in the years 2007through 2009.

 

Due tothe uncertainty of utilization of certain of the Company’s NOLs and inconsideration of other factors, management has recorded a valuation allowanceon the deferred tax asset in 2003 and 2002 to reduce the net deferred tax assetto the amount that it has deemed will more likely than not be realized.

 

Theprovision for income taxes differs from the amount of income taxes determinedby applying the U.S. statutory federal tax rate to pre-tax (loss) income due tothe following:

 
|                                       |   | ***Years Ended May 31,*** |   |
|--------------------------------------------|--------|---------------------------|--------|
|                                       |   | ***2003***                |   | ***2002*** |   | ***2001*** |   |
| Statutory federal tax rate                 |   | (34.0                     | )%     | (34.0 | )% | (34.0 | )% |
| State taxes, net of federal benefit        |   | —                    |   | — |   | — |   |
| Change in deferred tax valuation allowance |   | 117.4                     | %      | 29.8 |   | 30.3 |   |
| Permanent and other differences            |   | (8.7                      | )      | 4.2 |   | 3.7 |   |
|                                       |   |                      |   |   |   |   |   |
| Effective tax rate                         |   | 74.7                      | %      | — | % | — | % |

 

**NOTE 6**

**EMPLOYEE BENEFIT PLANS**

 

The Company adopted the Schmitt Industries,Inc. 401(k) Profit Sharing Plan & Trust effective June 1, 1996.  Employees must meet certain age and servicerequirements to be eligible. Participants may contribute up to 15% of their eligible compensationwhich may be partially matched by the Company. The Company may further make either a profit sharing contribution or adiscretionary contribution.  There wereno contributions made by the Company to this Plan during the year ended May 31,2003 while during the years ended May 31, 2002 and 2001 contributions were$47,881 and $128,543 respectively.

 

# **NOTE 7**

**LONG-TERM DEBT**

 

During Fiscal 2002, the Companyentered into two equipment lease agreements for $33,877.  The agreements call for monthly principaland interest payments of $534 and $580 with one requiring no interest paymentsand the other bearing interest of 13.8%. One lease expires in Fiscal 2004 and the second in Fiscal 2005.

 

During Fiscal 2001, the Companypurchased 400,000 shares of its common stock from a private investor for$472,000.  Under the terms of the stockpurchase agreement, the Company paid $94,400 in cash at closing with theremainder due under a note agreement. The agreement called for quarterly principal payments of $25,000, plusinterest at 9.00%.The remaining balance was paid prior to December 31, 2002.

 

27

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As of May 31, 2003, futurecapital lease payments are:

 
| Year Ending May 31, |   |   |   |
|---------------------|--------|--------|--------|
| 2004                |   |   | $      | 20,031 |   |   |
| 2005                |   |   | $      | 4,273 |   |   |
|                     |        |        |        |  |  |  |  |

 

# **NOTE 8**

# **COMMITMENTS AND CONTINGENCIES**

 

In a transaction related to theacquisition of Schmitt Measurement Systems, Inc., formerly TMA Technologies,Inc. (TMA), the Company established a royalty pool and vested in eachshareholder and debt holder of the acquired company an interest in the royaltypool equal to the amount invested or loaned including interest payable throughMarch 1995.  The royalty pool will befunded at 5% of net sales (defined as gross sales less returns, allowances andsales commissions) of Schmitt Measurement Systems, Inc.’s products and futurederivative products developed by Schmitt Industries, Inc., which utilize thesetechnologies.  As part of the royaltypool agreement, each former shareholder and debt holder released TMA from anyclaims with regard to the acquisition except their rights to futureroyalties.  Royalty expense applicableto the years ended May 31, 2003, 2002 and 2001 amounted to $48,517, $27,763 and$36,964, respectively.

# ** **

The Company has entered intovarious non-cancelable leases for facilities used to support operations in theUnited Kingdom, Germany and California. Rent expense for the years ended May 31, 2003, 2002 and 2001 amounted to$136,953, $136,374 and $136,388 respectively.

 

Lease commitments

 
| Year Ending May 31, |   |   |   |
|---------------------|--------|--------|--------|
| 2004                |   |   | $      | 96,939 |   |   |
| 2005                |   |   | $      | 42,193 |   |   |
| 2006                |   |   | $      | 9,289 |   |   |
| 2007                |   |   | $      | 4,645 |   |   |
| 2008                |   |   | $      | — |   |   |
| Thereafter          |   |   | $      | — |   |   |
|                     |        |        |        |  |  |  |  |

 

During Fiscal 2003, the Companyagreed to purchase 74,859 shares of its outstanding common stock from theformer President of its wholly owned subsidiary, Acuity Research Incorporated,for $74,859.  The agreement calls forthree payments of $20,000 each and the balance to be paid on August 15,2003.  At the time of each note payment,the stockholder will surrender an amount of shares equal in value to thepayment amount.  The note does notrequire any interest.  No shares havebeen surrendered to the Company and accordingly, no payments have been made asof May 31, 2003.

 

Specific business challengesfaced by the Company over the past few years have had a negative impact onoperations and liquidity.  Managementhas responded to these challenges by reducing operating expenses, developingnew products and penetrating new markets for the Company’s products.  As a result of these efforts, Managementbelieves its cash flows from operations and its cash position will provideadequate funds on both a short-term and long-term basis to cover currentlyforeseeable debt payments, lease commitments and payments under existing andanticipated supplier agreements. Management believes that such cash flow (without the raising of externalfunds) is sufficient to finance current operations, projected capitalexpenditures, anticipated long-term sales agreements and otherexpansion-related contingencies during Fiscal 2004. However, in the event theCompany fails to achieve its operating and financials goals in for Fiscal 2004,management may be required to take certain actions to finance operations inthat time period.  These actions couldinclude, but are not limited to, implementation of additional cost cuttingmeasures, increased borrowings from existing credit facilities or entering intoadditional borrowing arrangements that are collateralized by assets.

# ** **

28

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# **NOTE 9**

# **SEGMENTS OF BUSINESS**

 

The Company operatesprincipally in two segments of business: the design and assembly of dynamicbalancing systems and components (Balancing) for the machine tool industry, andthe design and assembly of laser measurement systems (Measurement).  The Company also operates in two principalgeographic markets, United States and Europe.

 

## ***Segment Information***

 
|                          |   | **Year Ended  May 31,**    |      |
|-------------------------------|--------|----------------------------|-----------|
|                          |   | **2003**                   |      | **2002** |   | **2001** |   |
|                          |   | **Mechanical  Components** |      | **Measurement  Systems** |   | **Mechanical  Components** |   | **Measurement  Systems** |   | **Mechanical  Components** |   | **Measurement  Systems** |   |
| Gross sales                   |   | $                          | 6,283,987 |   | $ | 1,961,086 |   | $ | 6,197,649 |   | $ | 1,605,288 |   | $ | 7,112,415 |   | $ | 1,644,309 |   |
| Intercompany sales            |   | $                          | 802,977   |   | $ | 22,575 |   | $ | 922,093 |   | $ | 6,185 |   | $ | 1,082,385 |   | $ | 94,185 |   |
| Net sales                     |   | $                          | 5,481,010 |   | $ | 1,938,511 |   | $ | 5,275,556 |   | $ | 1,599,103 |   | $ | 6,030,030 |   | $ | 1,550,124 |   |
|                          |   |                       |      |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from operations |   | $                          | (281,900  | ) | $ | (120,517 | ) | $ | (270,416 | ) | $ | 226,340 |   | $ | (353,064 | ) | $ | (1,984,169 | ) |
|                          |   |                       |      |   |   |   |   |   |   |   |   |   |   |
| Intercompany rent             |   | $                          | —    |   | $ | 30,000 |   | $ | — |   | $ | 30,000 |   | $ | — |   | $ | 30,000 |   |
|                          |   |                       |      |   |   |   |   |   |   |   |   |   |   |
| Depreciation expense          |   | $                          | 119,331   |   | $ | 60,486 |   | $ | 136,864 |   | $ | 53,671 |   | $ | 147,719 |   | $ | 67,352 |   |
|                          |   |                       |      |   |   |   |   |   |   |   |   |   |   |
| Amortization expense          |   | $                          | 20,002    |   | $ | 40,446 |   | $ | 20,000 |   | $ | 34,603 |   | $ | 20,000 |   | $ | 34,560 |   |
|                          |   |                       |      |   |   |   |   |   |   |   |   |   |   |
| Capital expenses              |   | $                          | 38,970    |   | $ | 35,535 |   | $ | 80,491 |   | $ | 29,967 |   | $ | 98,014 |   | $ | 49,602 |   |

## * *

## ***Geographic Information***

|                  |   | **Year Ended  May 31,** |      |
|-----------------------|--------|-------------------------|-----------|
| **Geographic  Sales** |   | **2003**                |      | **2002** |   | **2001** |   |
| North American Sales  |   |                    |      |   |   |   |   |
| United States         |   | $                       | 3,985,882 |   | $ | 4,230,818 |   | $ | 5,181,886 |   |
| Intercompany          |   | $                       | 22,134    |   | $ | 72,319 |   | $ | 396,660 |   |
|                  |   | $                       | 3,963,748 |   | $ | 4,158,499 |   | $ | 4,785,226 |   |
| Canada                |   | $                       | 153,022   |   | $ | 151,732 |   | $ | 242,115 |   |
| Mexico                |   | $                       | 34,027    |   | $ | 27,686 |   | $ | 14,489 |   |
| North America total   |   | $                       | 4,150,797 |   | $ | 4,337,917 |   | $ | 5,041,830 |   |
|                  |   |                    |      |   |   |   |   |
| European Sales        |   |                    |      |   |   |   |   |
| Germany               |   | $                       | 781,375   |   | $ | 897,670 |   | $ | 1,317,399 |   |
| Intercompany          |   | $                       | —    |   | $ | 206,824 |   | $ | 320,354 |   |
| Germany total         |   | $                       | 781,375   |   | $ | 690,846 |   | $ | 997,045 |   |
|                  |   |                    |      |   |   |   |   |
| United Kingdom        |   | $                       | 1,253,639 |   | $ | 1,065,416 |   | $ | 1,278,375 |   |
| Intercompany          |   | $                       | 803,418   |   | $ | 649,135 |   | $ | 459,556 |   |
| United Kingdom total  |   | $                       | 450,221   |   | $ | 416,281 |   | $ | 818,819 |   |
|                  |   |                    |      |   |   |   |   |
| Other European Sales  |   | $                       | 1,116,506 |   | $ | 520,076 |   | $ | 134,531 |   |
|                  |   |                    |      |   |   |   |   |
| Total Europe          |   | $                       | 2,348,102 |   | $ | 1,627,203 |   | $ | 1,950,395 |   |
|                  |   |                    |      |   |   |   |   |
| Asia                  |   | $                       | 849,940   |   | $ | 887,093 |   | $ | 542,485 |   |
| Others                |   | $                       | 70,682    |   | $ | 22,446 |   | $ | 45,444 |   |
|                  |   | $                       | 7,419,521 |   | $ | 6,874,659 |   | $ | 7,580,154 |   |

 
|                          |   | **Year Ended  May 31,** |     |
|-------------------------------|--------|-------------------------|----------|
|                          |   | **2003**                |     | **2002** |   | **2001** |   |
|                          |   | **United  States**      |     | **Europe** |   | **United  States** |   | **Europe** |   | **United  States** |   | **Europe** |   |
| Income (loss) from operations |   | $                       | (292,905 | ) | $ | (109,512 | ) | $ | 113,812 |   | $ | (157,888 | ) | $ | (2,032,282 | ) | $ | (304,951 | ) |
|                          |   |                    |     |   |   |   |   |   |   |   |   |   |   |
| Depreciation expense          |   | $                       | 164,877  |   | $ | 14,940 |   | $ | 177,851 |   | $ | 12,684 |   | $ | 174,593 |   | $ | 40,478 |   |
|                          |   |                    |     |   |   |   |   |   |   |   |   |   |   |
| Amortization expense          |   | $                       | 60,448   |   | $ | — |   | $ | 54,603 |   | $ | — |   | $ | 54,560 |   | $ | — |   |
|                          |   |                    |     |   |   |   |   |   |   |   |   |   |   |
| Capital expenses              |   | $                       | 68,363   |   | $ | 6,142 |   | $ | 107,388 |   | $ | 3,070 |   | $ | 133,153 |   | $ | 14,463 |   |

## * *

29

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## ***Long-term Assets***

 
|          |   | **May 31,  2003** |      | **May 31,  2002** |   |
|---------------|--------|-------------------|-----------|-------------------|--------|
| Segment:      |   |              |      |              |   |
| Mechanical    |   | $                 | 994,798   |              | $      | 2,191,973 |   |
| Measurement   |   | $                 | 616,914   |              | $      | 860,104 |   |
|          |   |              |      |              |   |
| Geographic:   |   |              |      |              |   |
| United States |   | $                 | 1,588,599 |              | $      | 3,021,905 |   |
| Europe        |   | $                 | 23,113    |              | $      | 30,172 |   |

 

Note – Europe is defined as thetwo European subsidiaries, Schmitt Europe, Ltd. and Schmitt Europa, GmbH

 

**NOTE 10**

# **STOCK OPTIONS**

 

The Board of Directors adopteda Stock Option Plan in December 1995, which plan was amended in August 1996 andrestated in August 1998.  An optiongranted under the Amended and Restated Stock Option Plan might be either anincentive stock option (ISO), or a nonstatutory stock option (NSO).  ISOs may be granted only to employees andmembers of the Board of Directors of the Company and are subject to certainlimitations, in addition to restrictions applicable to all stock options underthe Plan.  Options not meeting theselimitations will be treated as NSOs. The purchase price of ISOs is fair market value on the date of grant;the purchase price of NSOs may vary from fair market value.  Vesting is at the discretion of the optioncommittee of the Board of Directors but generally is 50% at grant date and16.7% on each anniversary thereafter. The Company has 400,000 shares reserved for issuance under the stockoption plan.  All outstanding optionswill expire no later than 2012.

 

The following summarizes theoptions outstanding as of May 31, 2003:

##### ** **

|                              |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Weighted  Average  Remaining  Contractual  Life** |       |
|-----------------------------------|--------|------------|--------|----------------------------------------|--------|-----------------------------------------------------|------------|
| Options outstanding, May 31, 2000 |   | 194,416    |   | $                                      | 8.82   |                                                |       |   |
|                              |   |       |   |                                   |   |                                                |       |
| Options granted                   |   | 215,000    |   | $                                      | 4.08   |                                                |       |   |
| Options repurchased               |   | (109,750   | )      | $                                      | 9.00   |                                                |       |   |
| Options forfeited/cancelled       |   | (74,000    | )      | $                                      | 8.46   |                                                |       |   |
|                              |   |       |   |                                   |   |                                                |       |
| Options outstanding May 31, 2001  |   | 225,666    |   | $                                      | 4.32   |                                                |       |   |
|                              |   |       |   |                                   |   |                                                |       |
| Options granted                   |   | 287,334    |   | $                                      | 1.44   |                                                |       |   |
| Options forfeited/cancelled       |   | (269,000   | )      | $                                      | 4.08   |                                                |       |   |
|                              |   |       |   |                                   |   |                                                |       |
| Options outstanding May 31, 2002  |   | 244,000    |   | $                                      | 1.20   |                                                |       |   |
| Options granted                   |   | 6,666      |   | $                                      | 1.20   |                                                |       |   |
| Options forfeited/cancelled       |   | (6,677     | )      | $                                      | 1.20   |                                                |       |   |
|                              |   |       |   |                                   |   |                                                |       |
| Options outstanding May 31, 2003  |   | 243,989    |   | $                                      | 1.20   |                                                | 8.79 Years |   |
|                              |   |       |   |                                   |   |                                                |       |
| Options vested at May 31, 2003    |   | 160,433    |   | $                                      | 1.20   |                                                | 8.79 Years |   |

 

30

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**NOTE 11**

# **COMPREHENSIVE OTHER LOSS**

 
|                                                                                                                                                               |   | **Years  ended May 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|
|                                                                                                                                                               |   | **2003**                 |       | **2002** |   | **2001** |   |
| Significant components of net (loss)  income:                                                                                                                      |   |                     |       |   |   |   |   |
| Write-down of long-term investment to fair  market value                                                                                                           |   | $                        | (612,200   | ) | $ | (1,516,000 | ) | $ | — |   |
| Inventory write-downs                                                                                                                                              |   | (401,673                 | )          | — |   | (1,646,517 | ) |
| Restructure costs                                                                                                                                                  |   | —                   |       | — |   | (116,275 | ) |
| Increase in reserve for deferred tax asset                                                                                                                         |   | (636,006                 | )          | — |   | — |   |
| Reserve for doubtful accounts                                                                                                                                      |   | (24,060                  | )          | — |   | — |   |
| Income (loss) from operations exclusive of  inventory write-downs, restructure costs increase in reserve for deferred tax  asset and reserve for doubtful accounts |   | 186,808                  |       | (82,619 | ) | (604,161 | ) |
| Net loss                                                                                                                                                           |   | (1,487,131               | )          | (1,598,619 | ) | (2,366,953 | ) |
|                                                                                                                                                               |   |                     |       |   |   |   |   |
| Other comprehensive (loss) income:                                                                                                                                 |   |                     |       |   |   |   |   |
| Increase (decrease) in fair market value of  long-term Investment, net of   taxes                                                                                  |   | —                   |       | (128,000 | ) | 1,053,000 |   |
| Foreign currency translation adjustment                                                                                                                            |   | (87,616                  | )          | 111,207 |   | (32,271 | ) |
|                                                                                                                                                               |   |                     |       |   |   |   |   |
| Total comprehensive loss                                                                                                                                           |   | $                        | (1,574,747 | ) | $ | (1,615,412 | ) | $ | (1,346,224 | ) |

 

**The long-term investment is considered an “Available-for-salesecurity”.  As required under Statementof Financial Accounting Standards No. 115, all unrealized gains and losses, netof tax benefits, are reported in Accumulated Other Comprehensive (Loss) Incomeand included as a separate component of Other Comprehensive (Loss) Income inStockholders’ Equity until realized or until unrealized losses are deemed to be“other than temporary”.  The cumulativetranslation adjustment consists of unrealized gains/losses from translationadjustments on intercompany foreign currency transactions that are of along-term investment nature.**

 

31

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#### ***SUMMARIZED QUARTERLY FINANCIAL DATA***

***In thousands, exceptper share information***

***(unaudited)***

 
| **2003 Quarter Ended**               |   | **August  31** |   | **November  30** |   | **February  28** |   | **May  31** |   |
|--------------------------------------|--------|----------------|--------|------------------|--------|------------------|--------|-------------|--------|
| Sales                                |   | $              | 2,001  |             | $      | 1,794            |   | $           | 1,621  |   | $ | 2,004 |   |
| Gross Profit                         |   | $              | 1,178  |             | $      | 1,074            |   | $           | 487    |   | $ | 1,190 |   |
| Net (Loss) income                    |   | $              | 55     |             | $      | 33               |   | $           | (1,715 | ) | $ | 140 |   |
| Net (Loss) income Per Share, Basic   |   | $              | .03    |             | $      | .01              |   | $           | (.69   | ) | $ | .05 |   |
| Net (Loss) income Per Share, Diluted |   | $              | .03    |             | $      | .01              |   | $           | (.69   | ) | $ | .05 |   |
| Market Price of Common Stock         |   |           |   |             |   |             |   |        |   |
| High                                 |   | $              | 1.65   |             | $      | 1.95             |   | $           | 1.50   |   | $ | 1.60 |   |
| Low                                  |   | $              | 1.05   |             | $      | 1.11             |   | $           | 1.07   |   | $ | 0.80 |   |

 
| **2002 Quarter Ended**               |   | **August  31** |   | **November  30** |   | **February  28** |   | **May  31** |   |
|--------------------------------------|--------|----------------|--------|------------------|--------|------------------|--------|-------------|--------|
| Sales                                |   | $              | 1,585  |             | $      | 1,879            |   | $           | 1,453  |   | $ | 1,958 |   |
| Gross Profit                         |   | $              | 868    |             | $      | 1,119            |   | $           | 861    |   | $ | 1,182 |   |
| Net (Loss) income                    |   | $              | (252   | )                | $      | 71               |   | $           | (65    | ) | $ | (1,353 | ) |
| Net (Loss) income Per Share, Basic   |   | $              | (.09   | )                | $      | .03              |   | $           | (.03   | ) | $ | (0.54 | ) |
| Net (Loss) income Per Share, Diluted |   | $              | (.09   | )                | $      | .03              |   | $           | .(03   | ) | $ | (0.54 | ) |
| Market Price of Common Stock         |   |           |   |             |   |             |   |        |   |
| High                                 |   | $              | 3.27   |             | $      | 2.76             |   | $           | 1.68   |   | $ | 2.16 |   |
| Low                                  |   | $              | 2.13   |             | $      | 0.87             |   | $           | 1.05   |   | $ | 1.02 |   |

 

*Report of Independent Accountants:*

 

Board of Directors andShareholders

Schmitt Industries, Inc.

 

We have audited theaccompanying consolidated balance sheet of Schmitt Industries, Inc. and itssubsidiaries as of May 31, 2003, and the related consolidated statements ofoperations, changes in stockholders’ equity and cash flows for the year thenended.  These financial statements arethe responsibility of the Company’s management.  Our responsibility is to express an opinion on these financialstatements based on our audit.

 

We conducted our audit inaccordance with auditing standards generally accepted in the United States ofAmerica.  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of Schmitt Industries, Inc. and its subsidiariesas of May 31, 2003, and the consolidated results of their operations and theirconsolidated cash flows for the year then ended, in conformity with accountingprinciples generally accepted in the United States of America.

 

 
|              | /s/ GRANT  THORNTON LLP |   |
|-------------------|-------------------------|--------|
|              |
| Portland,  Oregon |
| July 11,  2003    |

 

32

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*Report of Independent Auditors:*

 

To the Board of Directors andShareholders of

Schmitt Industries, Inc.

 

In our opinion, theaccompanying consolidated balance sheet****and the related consolidated statements ofoperations, of changes in shareholders’ equity and of cash flows presentfairly, in all material respects, the financial position of Schmitt Industries,Inc. and its subsidiaries****at May 31, 2002, and the results of theiroperations and their cash flows for the two years in the period ended May 31,2002 in conformity with accounting principles generally accepted in the UnitedStates of America.  These financialstatements are the responsibility of the Company’s management; ourresponsibility is to express an opinion on these financial statements based onour audits.  We conducted our audits ofthese statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

PricewaterhouseCoopers LLP

 

Portland, Oregon

July 3, 2002

 

**Item9.****                                         Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

** **

•                  Form 8-Kfiled May 30, 2003 to announce the dismissal of PricewaterhouseCoopers LLP asprincipal accountant to audit the Company’s financial statements.

 

•                  Form8-K filed June 23, 2003 to announce the retention of Grant Thornton LLP asprincipal accountant to audit the Company’s financial statements.

** **

**ITEM 9A.              CONTROLS AND PROCEDURES**

 

(a)                                  Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, asamended, as of the end of the period covered by this report.  Based on their evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective as of the end of the period covered bythis report.

 

(b)                                 Therehave been no changes in our internal controls that occurred during the periodcovered by this report that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

** **

**PARTIII**

** **

Certain information required byPart III is included in the Company’s definitive Proxy Statement for its 2003Annual Meeting of Shareholders (“Proxy Statement”) and is incorporated hereinby reference. The Proxy Statement will be filed pursuant to Regulation 14A ofthe Securities Exchange Act of 1934 not later than 120 days after the end ofthe Fiscal year covered by this Report.

 

**Items 10 and 11.            Directors and Executive Officers of the Registrant andExecutive Compensation**

 

The information required bythese items is included in the Proxy Statement under the headings “Election ofDirectors”, “Equity Compensation Plan,” “Executive Compensation,” “SummaryCompensation Table,” “Options Grants in Fiscal 2002,” “Aggregated OptionExpenses in Fiscal 2003 and Fiscal Year-End Option Values” and “Section 16(a)Beneficial Ownership Reporting Compliance” and is incorporated herein byreference.

 

33

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**Item 12.                           SecurityOwnership of Certain Beneficial Owners and Management**

 

The information required bythis item is included in the Proxy Statement under the heading “PrincipalShareholders” and is incorporated herein by reference.

 

**Item 13.                           CertainRelationships and Related Transactions**

 

The information required bythis item is included in the Proxy Statement under the heading “CertainTransactions” and is incorporated herein by reference.

 

**Item 14                            PrincipalAccounting Fees and Services**

 

The information required bythis item is included in the Proxy Statement under the heading “IndependentPublic Accountants” and is incorporated herein by reference.

 

**PART IV**

 

**Item 15.                           Exhibits,Financial Statement Schedules and Reports on Form 8-K**

*(a)                    FinancialStatements:*

 
| (1)    | Consolidated Balance Sheets as of May 31, 2003 and 2002                                                                                                                                                                     |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                        |
|   | Consolidated Statements of Operations for  the years ended May 31, 2003, 2002 and 2001                                                                                                                                      |
|   |                                                                                                                                                                                                                        |
|   | Consolidated Statements of Changes in  Stockholders’ Equity for the years ended May 31, 2003, 2002 and 2001                                                                                                            |
|   |                                                                                                                                                                                                                        |
|   | Consolidated Statements of Cash Flows for  the years ended May 31, 2003, 2002 and 2001                                                                                                                                      |
|   |                                                                                                                                                                                                                        |
|   | Notes to Consolidated Financial Statements                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                        |
|   | Report of Independent  Accountants                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                        |
| (2)    | *Financial Statement Schedules:*All financial statement schedules  are omitted either because they are not applicable, not required, or the  required information is included in the financial statements or notes thereto. |
|   |                                                                                                                                                                                                                        |
| (3)    | *Exhibits: *Reference is made to the list on page 36 of the Exhibits filed  with this report.                                                                                                                          |

* *

*(b)                    Reports onForm 8-K*:

•                  Form 8-Kfiled May 30, 2003 to announce the dismissal of PricewaterhouseCoopers LLP asprincipal accountant to audit the Company’s financial statements.

 

•                  Form8-K filed June 23, 2003 to announce the retention of Grant Thornton LLP asprincipal accountant to audit the Company’s financial statements.

 

34

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**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|   | **SCHMITT INDUSTRIES, INC.** |
|--------|------------------------------|
|   |                         |
|   |                         |
|   | By:                          | /s/ Wayne A.  Case |   |
|   | Wayne A. Case                |   |
|   |                         | *Chairman of the Board, President and Chief  Executive Officer* |   |
|   |                         |   |   |
|   | Date:                        | August 27,  2003 |   |

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities indicatedon August 27, 2003.

 
| **Signature**              |   | **Title**                                     |
|----------------------------|--------|-----------------------------------------------|
|                       |   |                                          |
| /s/ Wayne A.  Case         |   | Chairman of  the Board, President and Chief   |
| Wayne A.  Case             |   | Executive  Officer                            |
|                       |   | (Principal  Executive Officer)                |
|                       |   |                                          |
| /s/ Robert  C. Thompson    |   | Chief Financial  Officer/Treasurer            |
| Robert C.  Thompson        |   | (Principal  Financial and Accounting Officer) |
|                       |   |                                          |
| /s/ Maynard  Brown         |   | Director                                      |
| Maynard  Brown             |   |                                          |
|                       |   |                                          |
| /s/ Timothy  D.J. Hennessy |   | Director                                      |
| Timothy D.J.  Hennessy     |   |                                          |
|                       |   |                                          |
| /s/ Trevor  Nelson         |   | Director                                      |
| Trevor  Nelson             |   |                                          |
|                       |   |                                          |
| /s/ John A.  Rupp          |   | Director                                      |
| John A. Rupp               |   |                                          |

 

35

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**INDEX TO EXHIBITS**

 
| **Exhibits** |   | **Description**                                                                                                                                                                                                                              |
|--------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                         |
| 3(i)         |   | Second  Restated Articles of Incorporation of Schmitt Industries, Inc. (the  “Company”).  Incorporated by reference  to Exhibit 3(i) to the Company’s Annual Report on Form 10-K for the Fiscal  year ended May 31, 1999 |
|         |   |                                                                                                                                                                                                                                         |
| 3(ii)        |   | Second  Restated Bylaws of the Company Incorporated by reference to Exhibit 3(ii) to  the Company’s Annual Report on Form 10-K for the Fiscal year ended May 31,  1999                                                                  |
|         |   |                                                                                                                                                                                                                                         |
| *10.1        |   | Schmitt  Industries, Inc. Amended & Restated Stock Option Plan.  Incorporated by reference to Exhibit 10.1  to the Company’s Annual Report on Form 10-K for the Fiscal year ended May 31,  1999                                |
|         |   |                                                                                                                                                                                                                                         |
| **21.1       |   | Subsidiaries  of Schmitt Industries, Inc.                                                                                                                                                                                                    |
|         |   |                                                                                                                                                                                                                                         |
| **23.1       |   | Consent of  Grant Thornton LLP                                                                                                                                                                                                               |
|         |   |                                                                                                                                                                                                                                         |
| **23.2       |   | Consent of  PricewaterhouseCoopers                                                                                                                                                                                                           |
|         |   |                                                                                                                                                                                                                                         |
| **31.1       |   | Certification  of Principal Executive Officer pursuant to 18 U.S. C. Section 1350, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                     |
|         |   |                                                                                                                                                                                                                                         |
| **31.2       |   | Certification  of Principal Financial Officer pursuant to 18 U.S. C. Section 1350, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                     |
|         |   |                                                                                                                                                                                                                                         |
| **32.1       |   | Certification  of Principal Executive Officer and Principal Financial Officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of The Sarbanes-Oxley  Act of 2002                                                     |

 

----

*Management contract orcompensatory plan.

 

**Filed herewith

 

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