**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended: May 31, 2007**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                     to                     **

**CommissionFile Number:  000-23996**

**SCHMITT INDUSTRIES, INC.**

(Exact name of registrantas specified in its charter)

| **Oregon**                       |   | **93-1151989**                        |
|----------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of |   | (IRS Employer  Identification Number) |
| incorporation or  organization)  |   |                                  |

 

**2765 N.W. Nicolai Street**

**Portland, Oregon 97210**

(Address of principalexecutive offices) (Zip Code)

**(503) 227-7908**

(Registrant’s telephonenumber, including area code)

Securities registered pursuant to Section 12(b) of theAct:

| **Title of each class**      |   | **Name of each exchange on which registered** |
|------------------------------|--------|-----------------------------------------------|
| Common Stock -  no par value |   | The NASDAQ Stock  Market LLC                  |

 

Securities registered pursuant to Section 12(g) of theAct: **None**

Indicate by check mark whether the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o   No x

Indicate by check mark whether the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) of theExchange Act.

Yes o   No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

Yes x   No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (check one):

| Large accelerated  filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o   No x

The aggregate market value of the voting stock held bynon-affiliates of the registrant as of November 30, 2006, the last business dayof the registrant’s most recently completed second fiscal quarter, wasapproximately $14,370,000 based upon the closing price of $7.18 reported forsuch date on the NASDAQ Capital Market. For purposes of this disclosure, sharesof Common Stock held by persons who hold more than 10% of the outstandingshares of Common Stock and shares held by officers and directors of theregistrant, have been excluded because such persons may be deemed to beaffiliates.  This determination is notnecessarily conclusive for other purposes.

As of July 24, 2007, the registrant had 2,668,933outstanding shares of Common Stock.

**DocumentsIncorporated by Reference**

Portionsof the registrant’s definitive Proxy Statement for its 2007 Annual Meeting ofShareholders are incorporated by reference into Part III hereof.

 

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**PART I**

**Item 1.            Business**

***Introduction***

Schmitt Industries, Inc. (theCompany), an Oregon corporation, designs, assembles and markets computer-controlledbalancing equipment (the Balancer Segment) primarily to the machine toolindustry.  Through its wholly ownedsubsidiary, Schmitt Measurement Systems, Inc. (SMS), an Oregon corporation, theCompany designs, manufactures and markets precision laser measurement systems(the Measurement Segment).  The Companyalso sells and markets its products in Europe through its wholly ownedsubsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom.  Effective May 30, 2005, the Companyliquidated and dissolved its German subsidiary, Schmitt Europa, GmbH.  The Company’s executive offices are locatedat 2765 N.W. Nicolai Street, Portland, Oregon 97210, and itstelephone number is (503) 227-7908.

***Balancer Segment***

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 as an inexpensive highlyaccurate permanent installation on grinding machines.  The Company acquired its original balancingequipment technology pursuant to a series of agreements from 1987 through 1991,substantially enhancing and advancing the patented technology since thattime.  Since inception the targetedcustomer base has been operators of grinding machines.

TheSBS System is fully automated, eliminating the need to pre-balance suchdevices as grinding wheels.  This reducesmachine setup time and ensures a smoother and more efficient operation.  Operating on a principle of mass compensationfor wheel imbalance, the balance head contains two movable eccentric weights,each driven by electric motors through a precision gear train.  These weights are repositioned to offset anyimbalance in a grinding wheel or other application.  Imbalance or vibration is picked up by thesensor that feeds a signal to a controller that filters the signal byrevolutions per minute.  The controllerthen drives the balance head weights in a direction that reduces the amplitudeof the vibration signal.  The balancecycle is complete when the weights are positioned to achieve the lowestvibration level.

Notablefeatures of the SBS System include its ability to fit almost all machines, easeof installation, compact and modular construction, ability to balance a wheelwhile on a machine, virtual elimination of wheel vibration, automaticmonitoring of balancing, display in both English and metric systems, instrumentgrade calibration, short balance process, measurement of both displacementand/or velocity and minimal user maintenance.

Benefitsto the system user include improved quality of finished parts, ease of productadaptation, minimal downtime, complete and ready installation, elimination ofstatic balancing, longer life of the grinding wheel, diamond dressings andspindle bearings, the ability to balance within 0.02 microns and itsadaptability to all types of machines.

Precisiongrinding is necessary in major manufacturing areas including the automotiveindustry (camshafts, crankshafts, valves), bearings (roller and tapered types),ceramics (precision shaping), electric motors (shafts), pumps (shafts andturbines), aircraft (engine parts), and general manufacturing.  Precision grinding has an establishedworldwide presence in all industrialized countries and is expanding as a methodof material removal and processing. Within the Company’s customer base for the SBS System, there are threemajor market segments:

***Machine Tool Builders -***These companies design and manufacture a varietyof cylindrical, surface and specialty application grinding machines.  SBS Systems are distributed to a variety ofworld markets through OEM (original equipment manufacturer) accounts, where aspecial pricing (20% discount) is offered to the machine builder incorporatingthe SBS System into its machine.

Examples of some well-known worldwide machine tool builders whohave offered and/or installed the SBS System include ANCA (Australia), CapcoMachinery (U.S.), Ecotech/SMTW (China/U.S.), Erwin Junker (U.S.), LandisGrinding (U.S.), Koyo Machinery (US, Japan), Micron Machinery Limited(Japan/U.S.), USACH Technologies, Tschudin (U.S.) and Weldon Machine Tool(U.S.).  The Company currently sells itsproducts directly to major machine builders in the U.S, Europe and Asia.

***Machine Tool Rebuilders —*** These customers, found in most, if not all,industrialized nations, develop their business by offering to completely updateand refurbish older grinding machines. These rebuilders typically tear the old machine apart and install newcomponents, such as the SBS System.  TheCompany currently sells its products directly to major machine rebuilders inthe U.S. and Europe.

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***Grinding Machine Users -*** These end users become aware of the SBS Systemthrough trade shows, trade magazine advertising, distributors, fieldrepresentatives, referrals and new machine suppliers.  The Company’s business is conducted worldwidewith some better known customers including: Black & Decker, Briggs andStratton, Caterpillar, Eaton, Emerson Power Transmission, Ford Motor Company,General Electric, General Motors, Ingersoll Rand, Komatsu, Sumitomo HeavyIndustries, SKF Bearing Industries, Timken, TRW Automotive Components andUniversal Bearing.

InFiscal 2007, 2006 and 2005, net sales of the Company’s balancing productstotaled $7,923,627, $7,818,669 and $7,430,287, respectively.  Net sales of balancing products accounted for67%, 68% and 70% of the Company’s total sales in Fiscal 2007, 2006 and 2005,respectively.  See Note 7 to ConsolidatedFinancial Statements.

***Competition***

Management believes the SBSSystem is one of only a few fully automatic balancing systems marketed in theworld.  Most competitive products requirespecial setup and training or calibration to the specific machine.  The Company believes the SBS System iscurrently the only balancing product that fits all machines with wheel sizesfrom 6 to 48 inches in diameter and a spindle rpm of 500 through 12,500.

Competitiveproducts come from European companies located in Switzerland, Germany, Spainand Italy.  These competitors produceelectromechanical and water balancers similar to the SBS Systems.  The Company considers these companies, withtheir established European base, to be the major competitors.  The Company believes that these balancershave electronic deficiencies, rendering them less effective in solvingessential balancing requirements.  TheCompany also believes that they cannot achieve consistent balance levels at lowspeed (500 rpm) or at high speed (7,500 rpm) as the SBS system can.  In addition, the Company also believes thesebalancers have inferior brush and cable assemblies that cause down time andhigh maintenance.  Finally, the Companydoes not believe these companies can currently compete effectively with the SBSSystem in providing mounting adapters for all grinding machines.

Waterbalancers are an older European design still on the market that can be suppliedby Schmitt when specifically requested by users.  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 service technicianwhile the SBS system can be installed by the operator.  Water systems work at mid- andhigh-speeds but cannot balance in low rpm environments while SBS products workin both environments.  Water systemsrequire periodic monitoring while the SBS systems require little or no operatormonitoring.

TheSBS System list price is generally $7,995 worldwide.  Based on published price lists, competitors’electromechanical systems are priced at $8,000 to $10,000 worldwide while waterbalancers generally are priced at $9,000 to $11,000 worldwide.  Management believes customers perceive thevalue of an automatic balancer to be approximately $8,000, a sales price thathas been constant for several years. Company pricing is geared to obtaining a dominant market position andmeeting competitive supplier prices.  Themarket strategy is to establish the SBS System as the foremost product with thebest quality, reliability and performance and superior economic value.

***Measurement Segment***

The Company manufactures and marketsa line of laser-based, precision measurement systems and operates aprecision laser light scatter measurement laboratory.  Light scatter technology involves usinglasers, optics and detectors to direct a beam of light on a material sample andrecord its reflection/transmission. Analysis of information can determine material characteristics such assurface roughness, defects and dimensional sizing without introducingcontaminants and causing changes to the tested material.  The principal products are laser-basedmeasurement products and technology applicable to both industrial and militarymarkets.  The Company has used patents,patent applications, trademarks and other proprietary technology to focusmarketing efforts on industrial markets including electronics, computer diskand silicon wafer manufacturers.

Thereare four product lines: laser-based light-scatter measurement,dimensional sizing, research and other laser alignment products and a light-scattermeasurement laboratory.

***Surface measurement products***

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 withfabrication processes that require precise and reliable measurements.

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Computerhard disks require exact manufacturing control and a narrow tolerance band foracceptable roughness, with surface roughness outside that narrow band resultingin a reduction in data density or storage capacity.  The Company’s technology simultaneouslymeasures disk surface roughness in two directions, radially, when theread/write head is moving to another disk sector, and circumferentially, whenthe read/write head is processing information on the disk.  The two separate roughness levels arerequired for proper head operation.  TheCompany believes the precise measurement methods provided by its products arenot possible through any other cost effective measurement means.

Thefollowing two products meet the challenges of disk drive manufacturers:

·                  TheTMS-2000-RC (Texture Measurement System) product is an accurate non-contacttexture measurement system.  The product(used on aluminum substrates) is currently used worldwide by most major diskdrive manufacturers, providing fast, accurate and repeatable microroughnessmeasurements while quadrupling production throughput when compared to othertesting devices.  Surface roughness canbe measured to levels below 0.5 Angstroms (the point of a needle is one millionAngstroms in diameter).

·                  TheTMS-2000-DUV-RC product measures the surface microroughness of ceramic/glassrather than aluminum substrates. Manufacturers require the technology and products to measure surfaceroughness of these ceramic/glass substrates to the same exact levels as thosethat measure aluminum.  The DeepUltra-violet light (DUV) technology and product uses the patented light scattertechnology to measure the surface roughness of glass substrates to levels lessthan 0.5 Angstroms.

Customers includeHitachi/IBM, Seagate Substrates, Western Digital and Komag, Inc.

The Company offers twoproducts devoted to the silicon wafer industry, the TMS-2000W-RC andTMS-3000W-RC.  Both products providefast, accurate, repeatable measurements for manufacturers of silicon wafers,computer chips and memory devices.  Thisindustry demands manufacturing precision to increase performance and capacityand these products help achieve those goals. Silicon wafers are carefully cut and polished to provide the base uponwhich a computer or memory chip is produced. Therefore, chip manufacturing is extremely dependent on the beginningsurface roughness of the wafer.  Sinceall silicon wafers exhibit a microscopic level of surface roughness, stemmingfrom chemical deposition, grinding, polishing, etching, or any number of otherproduction techniques, some method of measuring these surface characteristicsis required.  The wafer measurementproducts provide a way for customers in this industry to quantify and controltheir manufacturing process.  The systemprovides measurements to a few hundredths ofan Angstrom, a level unachievable by competing devices.

***Dimensionalsizing products***

These products are used in a widerange of industrial applications including steel casting, paper production,medical imaging, crane control and micron-level part and surfaceinspection.  Presently, there are fourAccuRange  (AR) product lines: the AR4000distance measurement sensor, the AR4000 Line Scanner and the AR600 and AR200series of triangulating laser displacement sensors.

TheAR4000 optical distance measurement sensor is used for most diffuse reflectivesurfaces, but is ideally suited to level and position measurement, machinevision, autonomous vehicle navigation and 3D imaging applications.  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 a tightlycollimated output beam for small spot size. There are three output beam configurations available: visible infrared,eye safe infrared and reflective tape targets.

TheAR4000 Line Scanner is used with the AR4000 to scan and collect distance dataover a full circle.  The scanner consistsof a balanced, rotating mirror and motor with position encoder and mountinghardware for use with the AR4000.  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.

TheAR600 series is a family of triangulating laser displacement sensors withexcellent accuracy and sensitivity.  Thesensor projects a beam of visible laser light that creates a spot on the targetsurface.  Reflected light from thesurface is viewed from an angle by a line scan camera and the target’s distanceis computed from the image pixel data. The line includes 11 models measuring displacements from 1/8” to 50” andaccuracy’s down to .00015” (4 microns). They can operate on all types of surfaces at speeds up to 1250samples/second.  The product is extremelysensitive and can detect glass and liquid surfaces and also detect multiplesurfaces of transparent materials, allowing great flexibility in specializedapplications.

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TheAR700 is a new series of triangulation laser displacement sensors that theCompany is developing and testing to supplement the existing line of AR600sensors.   The AR700 will provideperformance advanced over the AR600 in accuracy, repeatability, and samplespeed.  The first product offering ofthis new family of sensors will be released in Fiscal 2007 and includemeasurement ranges from displacements of 1/8” up to 4” and accuracy down to..00006” (1.5microns ).  The AR700 issmaller than the AR600 and features increased speeds of up to 5000samples/second while maintaining the flexibility to measure extremely sensitivesurfaces.

TheAR200 line is the most compact series of triangulating laser displacementsensors.  Four models cover metricmeasurement 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 viewedfrom an angle by a line scan camera and the target’s distance is computed fromthe image pixel data.  The AR200-6M,-12M, -25M and -50M have ranges in millimeters that match their model number.  The AR200 displacement sensor cannot beoverloaded and measures accurately even when a mirror reflects the entire lightbeam back to the detector.

***Research and other measurement products***

The Company’s CASI Scatterometersare sold to companies and institutions involved in research efforts.  The CASI Scatterometer uses visible,ultraviolet or infrared laser light as a nondestructive probe to measuresurface quality, optical performance, smoothness, appearance, defects andcontamination on a wide variety of materials. These products are measurement instruments providing customers withprecise roughness measurements of optical surfaces, diffuse materials,semiconductor wafers, magnetic storage media and precision-machinedsurfaces, as well as surfaces affecting the cosmetic appearance of consumerproducts.

TheμScan System is a portable device consisting of a hand-held controlunit, an interchangeable measurement head and a separate charging unit.  To perform a measurement, the operator placesthe measurement head on the objective area and presses a button.  Each measurement takes less than five secondswith results displayed and stored in system memory.  The μScan can store 700 measurements in255 files and provides the capability to program pass/fail criteria.  Software is available for control, analysisand file conversion.  From a singlemeasurement, a user can determine RMS surface roughness, reflectance andscatter light levels (BRDF) on flat or curved surfaces under any lightingconditions.

***Light-scatter measurement laboratory***

The Company provides a highlyadvanced measurement services laboratory, using CASI Scatterometers, to a widevariety of industrial and commercial businesses that require precisemeasurements only advanced laser light scatter technology can provide.  The value of the laboratory is not only itsextremely precise measurement capability but also the test item is not altered,touched or destroyed.  Thus, thelaboratory is widely used by manufacturers of critical optical components inaerospace and defense systems and other industrial companies, universities andgovernment agencies.

InFiscal 2007, 2006 and 2005, net sales of Measurement products totaled$3,958,449, $3,684,691 and $3,160,942 respectively and accounted for 33%, 32%and 30% of the Company’s total sales in Fiscal 2007, 2006 and 2005respectively.  See Note 7 toConsolidated Financial Statements.

***Competition***

Management believes its surfacemeasurement products are one of only a few systems that provide fast, accurate,repeatable microroughness measurements for computer hard disk manufacturers andthe silicon wafer industry. TheCompany believes its surface measurement products are currently the onlysystems that can provide measurements to a few hundredths of an angstrom (Å-aunit of measure equal to 1 hundred-millionth of a centimeter) withreproducibility +/- 0.2Å or 1% and repeatability of +/-0.1Å.  Thedifferences between our surface measurement products and other opticaltechniques (which include profilometers, scanning tunneling microscopes, atomicforce microscopes or interferometers) are that scanning tunneling microscopes,atomic force microscopes and optical profilometers require the intervention ofa skilled operator and perform measurements relatively slowly, whereas oursurface measurement product is much simpler and, consequently, can makemeasurements more rapidly while still maintaining excellent repeatability andaccuracy.  Stylus profilometers aresimpler devices which require less skilled operators, however, measurements mustbe conducted under vibration isolation conditions, and large areas requirenumerous scans, they are generally destructive to soft materials such as mostcoated optics.

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The market fordimensional sizing products is extremely competitive, characterized by rapidlychanging technology. The Company believes the principal elements of competitioninclude quality of ongoing technical support and maintenance coupled withresponsiveness to customer needs, as well as price, product quality,reliability and performance.  The differences between our sensors andcompetitive products we feature pushbutton selection of output signals incertain models and our sensors can be programmed using serial commands througha PC computer.  The AR200 displacementsensor can not be overloaded and measures accurately even when a mirrorreflects the entire light beam back to the detector.

Competitivesurface measurement products and dimensional sizing products come from established multinational competitors,some of which are significantly larger and have greater financial, engineering,manufacturing and marketing resources. Company pricing is geared to obtaining a dominant market position andmeeting competitive supplier prices.  Themarket strategy is to establish measurement products as products with the bestquality, reliability and performance and superior economic value.

***Sales by Geographic Area***

In Fiscal 2007, 2006 and 2005,the Company recorded net sales of its products in the United States, itscountry of domicile, of $5,855,118, $5,709,044 and $5,610,274, respectively.  Sales in the last three fiscal years bygeographic areas are:

|             | ** ** | **North America** | ** ** | **Europe** | ** ** | **Asia**  | ** ** | **Others** | ** ** |
|-------------|------------|------------------------|------------|------------|------------|-----------|------------|------------|------------|
| Fiscal 2007 |       | $                      | 6,055,129  |       | $          | 2,098,677 |       | $          | 2,702,531  |   | $ | 1,025,739 |   |
| Fiscal 2006 |       | $                      | 5,878,538  |       | $          | 1,764,347 |       | $          | 2,919,556  |   | $ | 940,919 |   |
| Fiscal 2005 |       | $                      | 5,872,740  |       | $          | 2,076,089 |       | $          | 2,122,384  |   | $ | 520,016 |   |

***Business and Marketing Strategy***

The Company designs, assemblesand markets all of its products with operations divided into a number ofdifferent areas.

***Balancer Segment Products***

The Vice President of Operationsdirects production of Balancer segment products including production, assembly,and purchasing, engineering and technical services.  Product marketing for all Balancer segmentproducts is managed by the President/CEO. Two marketing managers are responsible for domestic sales, one marketingmanager is responsible for sales in Europe and another is responsible for salesin mainland China, Taiwan and Korea.  TheCompany also has one person who performs field service/sales.  Finally, research and development efforts aresupervised directly by the President/CEO and the Vice President of Operations.

TheCompany markets and sells the Balancer segment products in a variety ofways.  First are the channels provided byindependent manufacturer’s representatives and distributors.  There are currently approximately 25individuals and/or organizations in the United States acting in one of thesecapacities.  Independent sales agents arepaid a 10% commission; distributors are sold products at a 20% discount.

Second,OEMs include the Balancer segment products on the machine tools theyproduce.  Users thus purchase theBalancer segment products concurrently with the machine tools.  Conversely, end users of grinding machinesthat have purchased the SBS system directly from the Company, and afterenjoying the benefits of the products, often request that SBS products beincluded with the new equipment they order from OEMs.  The SBS Systems are often installed bymachine builders prior to displaying their own machine tools at various tradeshows, becoming endorsements that prove beneficial to the Company’s salesefforts.

Third,worldwide trade shows have proven to be an excellent source of business.  Company representatives, usually one or moreof the marketing managers and/or the President/CEO, attend these events alongwith local Company representatives. These individuals operate a display booth featuring an SBS Systemdemonstration stand and product and technical literature.  Representatives from all facets of theCompany’s target markets attend these trade shows.

In North America andAsia, products are shipped directly to customers from the Company’sdistribution center in Portland, Oregon. Where the Company has distributors, the product is shipped to thedistributor, who in turn pays the Company directly and then delivers andinstalls the product for the end user. European distribution to customers is handled by shipping the productdirectly from the Company’s Portland headquarters to the European subsidiary inthe United Kingdom, who in turn sells and distributes the products.

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***Measurement Segment Products***

The Vice President of Operationsdirects production of all Measurement segment products including production,assembly, and purchasing, engineering and technical services.

Similarto the Balancer segment, the Measurement segment uses a variety of methods tomarket and sell its products.  First, aMarketing Manager, under the direction of the President/CEO, directs theoverall worldwide marketing efforts for surface measurement products.  Second, both a marketing and a sales manager,again under the direction of the President/CEO, direct the overall worldwidemarketing and sales efforts for dimensional sizing products.  Third, the Company has an exclusivedistribution agreement with a company in Asia for the promotion and sale of surfacemeasurement products in China, Taiwan, Malaysia, Singapore, Thailand and thePhilippines.  In addition, there aredistribution agreements with one company in Japan and two in Korea.  Trade shows also represent a significantamount of marketing/sales effort. Company representatives operate a display booth featuring demonstrationsof Measurement segment products along with product and technicalliterature.  Representatives from allfacets of the market to which the Company directs its sales efforts attendthese trade shows.  Finally, one of thebest marketing channels is the testing laboratory.  Once customers see the capabilities of thetechnology, it can lead to orders for the Company’s laser based light scattermeasurement products.

All Measurement segment productsare assembled in the Portland, Oregon facility and shipped worldwide directlyto customers.  The Balancer andMeasurement segment customer bases each consist of over 250 companies.

***Backlog***

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

# ***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 supplier ofelectronic assemblies is Silicon Forest Electronics of Vancouver, Washington, acustom supplier of assembled electronic products for several Pacific Northwestcompanies.  In the event of supplyproblems, the Company believes that two or three alternatives could bedeveloped within thirty days to supplement or replace Silicon ForestElectronics.

Mechanicalparts for the Company’s products are produced by high quality CNC machineshops.  The Company is not dependent onany one supplier of mechanical components. Principal suppliers of components for the Company’s products includeMacKay Manufacturing of Spokane, Washington; Davis Tool of Portland, Oregon;and Forest City Gear of Roscoe, Illinois.

TheCompany uses in-house skilled assemblers to construct and testvendor-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 assemble various productsand test all finished components before placing them in the finished goodsinventory.  Finished goods inventory ismaintained via computer to assure timely shipment and service tocustomers.  All customer shipments arefrom the finished goods inventory.

TheCompany’s Quality Control Program first received full ISO 9001 certification in1996.  On November 4, 2005, the Companyreceived its certification to the newer ISO 9001:2000 requirements.

***Proprietary Technology***

The Company’s success depends inpart on its proprietary technology, which the Company attempts to protectthrough patents, copyrights, trademarks, trade secrets and other measures.  The Company has U.S. patents covering both Balancerand Measurement products, processes and methods that the Company believesprovide 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 itsongoing research, development and manufacturing activities.  While patents provide certain legal rights ofenforceability, there can be no assurance the historic legal standardssurrounding questions of validity and enforceability will continue to beapplied or that current defenses as to issued patents will, in fact, beconsidered substantial in the future. There can be no assurance as to the degree and range of protection anypatent will afford and whether patents will be issued or the extent to whichthe Company may inadvertently infringe upon patents granted to others.

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“SBS”and “SMS” are registered trademarks and are affixed to all products andliterature created in the Company’s balancer and measurement product lines,respectively.

TheCompany manufactures its Balancer segment products under copyright protectionin the U.S. for electronic board designs. Encapsulation of the finished product further protects the Company’stechnologies including software.

TheCompany also relies upon trade secret protection for its confidential andproprietary information.  There can be noassurance that others will not independently develop substantially equivalentproprietary information and techniques or otherwise gain access to the Company’strade secrets or disclose such technology or that the Company can meaningfullyprotect its trade secrets.

Whilethe Company pursues patent, trademark, trade secret and copyright protectionfor products and various marks, it also relies on know-how and continuingtechnology advancement, manufacturing capabilities, affordable high-qualityproducts, new product introduction and direct marketing efforts to develop andmaintain its competitive position.

***Product Development***

The Company maintains an ongoingresearch and development program to expand the product lines and capabilitiesof both product segments.  The goal ofthis program is to expand the product base in historic markets and to enter newmarket areas so as to reduce reliance on historic market segments.  In the past fiscal year, the Company hasdeveloped the following new product:

TheAR700 is a new series of triangulation laser displacement sensors that theCompany is developing and testing to supplement the existing line of AR600sensors.   The AR700 will provideperformance advanced over the AR600 in accuracy, repeatability, and samplespeed.  The first product offering ofthis new family of sensors will be released in Fiscal 2008 and includemeasurement ranges from displacements of 1/8” up to 4” and accuracy down to..00006” (1.5microns ).  The AR700 issmaller than the AR600 and features increased speeds of up to 5000samples/second while maintaining the flexibility to measure extremely sensitivesurfaces.

DuringFiscal 2007, 2006 and 2005, the Company’s research and development expensetotaled $88,425, $81,815 and $42,395, respectively.  The Fiscal 2007 levels are consistent withFiscal 2006 and are higher than Fiscal 2005 as the Company devoted much of its2005 internal labor efforts (most R&D costs are internal labor costs) toexpanding production levels and the transition of engineering and production ofdimensional sizing products from Menlo Park, CA to Portland, OR.  Management expects amounts expended forR&D in Fiscal 2008 to increase over the levels experienced in Fiscal 2007.

***Employees***

As of July 16, 2007, the Companyemployed 34 individuals worldwide on a full-time basis.  There were no regular part-timeemployees.  None of the Company’semployees is covered by a collective bargaining agreement.

**Item1A.         RiskFactors**

**Business Risks**

This report includes “forward-lookingstatements” as that term is defined in Section 21E of the Securities ExchangeAct of 1934.  Forward-looking statementscan be identified by the use of forward-looking terminology such as “believes,”“expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,”“estimates,” “anticipates,” or “hopes,” or the negative of those terms or othercomparable terminology, or by discussions of strategy, plans orintentions.  For example, this sectioncontains numerous forward-looking statements. All forward-looking statements in this report are made based onmanagement’s current expectations and estimates, which involve risks anduncertainties, including those described in the following paragraphs.  Among these factors are the following:

·                  *Demand for Company products may change.*

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

·                  *Failure to protect intellectual property rightscould adversely affect future performance and growth.*

·                  *Production time and the overall cost of productscould increase if any of the primary suppliers are lost or if any primarysupplier increased the prices of raw materials.*

·                  *Fluctuations in quarterly and annual operatingresults make it difficult to predict future performance.*

·                  *The Company may not be able to reduce operatingcosts quickly enough if sales decline.*

·                  *The Company maintains a significant investment ininventories in anticipation of future sales.*

·                  *Future success depends in part on attracting andretaining key management and qualified technical and sales personnel.*

·                  *The Company faces risks from international salesand currency fluctuations*.

8

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Suchrisks and uncertainties could cause actual results to be materially differentfrom those in the forward-looking statements. Readers are cautioned not to place undue reliance on the forward-lookingstatements in this report.  We assume noobligation to update such information.

*Demand forCompany products may change:*

During Fiscal 2006 and 2005 theCompany experienced increased demand for its Balancer products in NorthAmerica, its largest market, attributed primarily to an improving economy inNorth America.  However, during Fiscal2007 Balancer sales in North America have declined 8.3% when compared to Fiscal2006. The conditions and circumstances could change in future periods and as aresult demand for the Company’s products could decline.  Management is responding to these risks intwo ways.  First, it appears there isstill a significant portion of the marketplace that is not using the automaticbalancing products of the Company or any of its competitors.  The Company will therefore continue to devotepart of its future R&D efforts toward developing products that will bothbroaden the scope of Balancing products offered to the current customerbase.  Second, there are uses for theCompany’s Balancer products in industries other than those in the Company’shistoric customer base.  Management isdevoting time to identify these markets and educate those markets on the valueof those products within their operations.

 The laser light-scatter products of theMeasurement segment have relied heavily upon sales to disk drive and siliconwafer manufacturers.  The Company hadexperienced increasing sales in Fiscal 2006; however, sales during Fiscal 2007have decreased 13.6%.  Previousinformation had indicated continued improving demand for and sales of diskdrive products.  U.S. retail sales ofexternal drives by disk drive manufacturers rose an estimated 75% during thethird calendar quarter of 2006 citing demand fueled by need to convert photos,video and other content into digital form. Recently, however, certain disk drive manufacturers have scaled backtheir outlook for the current calendar year, blaming a price war overhigh-capacity desktop computer drives, which now store as much as about onetrillion bytes of data.  The long-termimpact on demand for the Company’s surface Measurement products cannot bepredicted with any certainty.

Managementwill continue to market these products to these historic markets as it appearsno other technology has been introduced that would make the laser light-scatterproducts technologically obsolete.  Thereis the belief that once market conditions improve in the disk drive and siliconwafer markets, demand for the Company’s products and technology will increasealthough most likely not to historic levels. Also, management believes there are other uses for the Company’s laserlight scatter technology and continues to evaluate R&D efforts to developnew products and introduce them to the marketplace.

*New productsmay not be developed to satisfy changes in consumer demands:*

The failure to develop newtechnologies, or react to changes in existing technologies, could materially delaydevelopment of new products, which could result in decreased revenues and aloss of market share to competitors. Financial performance depends on the ability to design, develop,manufacture, assemble, test, market and support new products and enhancementson a timely and cost-effective basis. New product opportunities may not be identified and developed andbrought to market in a timely and cost-effective manner.  Products or technologies developed by othercompanies may render products or technologies obsolete or noncompetitive, or afundamental shift in technologies in the product markets could have a materialadverse effect on the Company’s competitive position within historicindustries.

*Failure toprotect intellectual property rights could adversely affect future performanceand 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.

*Productiontime and the overall cost of products could increase if any of the primarysuppliers are lost or if a primary supplier increased the prices of rawmaterials:*

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.

9

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*Fluctuationsin quarterly and annual operating results make it difficult to predict futureperformance:*

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 operating fluctuations, it is important torealize quarter-to-quarter comparisons of operating results are not necessarilymeaningful and should not be relied upon as indicators of future performance.

 *The Company may not beable to reduce operating costs quickly enough if sales decline:*

Operating expenses are generallyfixed in nature and largely based on anticipated sales.  However, should future sales declinesignificantly and rapidly, there is no guarantee management could take actionsthat would further reduce operating expenses in either a timely manner orwithout seriously impacting the operations of the Company.

*The Companymaintains a significant investment in inventories in anticipation of futuresales:*

The Company believes it maintainsa competitive advantage by shipping product to its customers more rapidly thanits competitors.  As a result, theCompany has a significant investment in inventories.  These inventories are recorded using thelower-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 resultin carrying higher levels of inventories of finished goods and raw materialsthereby increasing the risk of inventory obsolescence and correspondinginventory write-downs.  As a result, theCompany may not carry adequate reserves to offset such write-downs.

*Futuresuccess depends in part on attracting and retaining key management andqualified technical and sales 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 guarantee keyemployees will not leave and subsequently compete against the Company.  The inability to retain key personnel couldadversely impact the business, financial condition and results of operations.

*The Companyfaces risks from international sales and currency fluctuations:*

The Company markets and sells itsproducts worldwide and international sales have accounted for and are expectedto continue 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; andfluctuations in foreign currencies.  Noassurances can be given these factors will not have a material adverse effecton future international sales and operations and, consequently, on business,financial condition and results of operations.

**Item1B.         UnresolvedStaff Comments**

None.

**Item 2.            Properties**

The Company’s design and assembly facilities and executive offices arelocated in Portland, Oregon in three company-owned buildings with totalapproximate square footage of 40,500 square feet.  SEL occupies a 755-square foot facilityin Coventry, England pursuant to a two year lease beginning May 7, 2007 with abasic monthly rent of £1,360 (approximately $2,690 as of May 31, 2007).

**Item 3.            Legal Proceedings**

There are no material legal proceedings currently pending against theCompany.

**Item 4.            Submission of Matters to a Vote ofSecurity Holders**

No matters were submitted to a vote of the security holders of theCompany during the fourth quarter ended May 31, 2007.

 

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**PART II**

**Item 5.****                                   Market for Registrant’s Common Equity, RelatedStockholder Matters and Issuer Purchases of Equity Securities**

The Company’s Common Stock is traded on the NASDAQ Capital Market underthe symbol “SMIT.”

The following tables set forth the high and low salesprices of the Company’s Common Stock as reported on the NASDAQ Capital Marketfor the periods indicated.

| Year Ended May 31, 2007 | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                               |       | $        | 7.99       |    | $          | 6.58 |   |
| Second Quarter                              |       | $        | 7.86       |    | $          | 6.27 |   |
| Third Quarter                               |       | $        | 7.98       |    | $          | 7.04 |   |
| Fourth Quarter                              |       | $        | 8.20       |    | $          | 7.20 |   |

 

| Year Ended May 31, 2006 | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                               |       | $        | 11.95      |    | $          | 7.69 |   |
| Second Quarter                              |       | $        | 9.10       |    | $          | 5.40 |   |
| Third Quarter                               |       | $        | 7.47       |    | $          | 5.47 |   |
| Fourth Quarter                              |       | $        | 8.39       |    | $          | 5.78 |   |

Asof July 24, 2007, there were 2,668,933 shares of Common Stock outstanding heldby approximately 175 holders of record. The number of holders does not include individual participants insecurity position listings; the Company believes that there are more than1,750 individual holders of shares of Common Stock.

TheCompany has not paid any dividends on its Common Stock since 1994.  The Company’s current policy is to retainearnings to finance the Company’s business. Future dividends will be dependent upon the Company’s financialcondition, results of operations, current and anticipated cash requirements,acquisition plans and plans for expansion and any other factors that theCompany’s Board of Directors deems relevant. The Company has no present intention of paying dividends on its CommonStock in the foreseeable future.

**Issuer Purchases of EquitySecurities**

None.

**Item 6.            SelectedFinancial Data**

***In thousands, except per share information***
| **Year Ended**                               | *** *** | **5/31/07** | ** ** | **5/31/06** | ** ** | **5/31/05** | ** ** | **5/31/04** | ** ** | **5/31/03** | *** *** |
|---------------------------------------------------|--------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|--------------|
|  Sales                                       |         | $           | 11,882     |        | $          | 11,503      |       | $           | 10,591     |        | $            | 7,925 |   | $ | 7,420 |   |
|  Net Income (Loss)                           |         | $           | 1,285      |        | $          | 1,350       |       | $           | 1,608      |        | $            | 517 |   | $ | (1,487 | ) |
|  Net Income (Loss) Per Share, Basic          |         | $           | .49        |        | $          | .52         |       | $           | .64        |        | $            | .21 |   | $ | (.60 | ) |
|  Weighted Average No. Shares, Basic          |         | 2,649       |       | 2,606       |       | 2,528       |       | 2,439       |       | 2,468       |         |
|  Net Income (Loss) Per Share, Diluted        |         | $           | .47        |        | $          | .49         |       | $           | .59        |        | $            | .20 |   | $ | (.60 | ) |
|  Weighted Average No. Shares, Diluted        |         | 2,763       |       | 2,746       |       | 2,709       |       | 2,524       |       | 2,468       |         |
|  Stockholders’ Equity                   |         | $           | 11,365     |        | $          | 9,814       |       | $           | 7,979      |        | $            | 6,114 |   | $ | 5,665 |   |
|  Total Assets                                |         | $           | 12,471     |        | $          | 10,927      |       | $           | 9,075      |        | $            | 7,100 |   | $ | 6,272 |   |
|  Long-term Debt (including  current portion) |         | $           | —     |        | $          | 22          |       | $           | 53         |        | $            | 67 |   | $ | 24 |   |

**Item 7.            Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

Thefollowing information contains certain forward-looking statements thatanticipate future trends or events. These statements are based on certain assumptions that may prove to beerroneous and are subject to certain risks including but not limited to the uncertaintiesof the Company’s new product introductions, the risks of increased competitionand technological change in the Company’s industries and other factors detailedin the Company’s SEC filings. Accordingly, actual results may differ, possibly materially, from thepredictions contained herein.

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**RESULTS OFOPERATIONS**

**Overview**

Balancer segment sales focusthroughout the world on end-users, rebuilders and original equipmentmanufacturers of grinding machines with the target geographic markets in NorthAmerica, Asia and Europe.  Combined Balancersales increased 1.3% for the year ended May 31, 2007 compared to the year endedMay 31, 2006.  North American salesdeclined (8.3%) in the year ended May 31, 2007 compared to the year ended May31, 2006.  Recent weakness in industrialproduction toward the end of 2006 especially in the motor vehicle sectors hascaused production in other manufacturing industries to soften.  General economic data indicates a slowing inthe growth of business capital spending on orders and shipments of equipmentother than high-tech and transportation equipment. These economic conditions inthe worldwide automotive, bearing and aircraft industries and its impact on themachine tool industry are the reason for softening Balancer orders.  Machine tool industry customers are optimisticregarding short term demand for grinding machines although the recent weaknessin industrial production and business conditions in North America indicategrowth rates for their products which incorporate the Balancer segment productline will be lower than those experienced in Fiscal 2006 and 2005.  Market demand in Asia for the Balancersegment products remains strong with that region showing a 33.7% increase forthe year ended May 31, 2007 compared to the year ended May 31, 2006.  The European market grew 10.1% in Fiscal 2007compared to Fiscal 2006.  Sales in allOther markets decreased (29.3%) in the year ended May 31, 2007 compared to theyear ended May 31, 2006.  As with theNorth American market, the duration of the stronger demand in Asia andconditions in the European and all Other markets cannot be forecasted with anycertainty.

TheMeasurement segment product line consists of both laser light-scatter anddimensional sizing products. Combined Measurement sales increased 7.4% for theyear ended May 31, 2007 compared to the year ended May 31, 2006.  The increased sales volume is primarily dueto the delivery of a CASI Scatterometer during the second fiscal quarter of2007, increase in sales dimensional sizing products of 18.8% offset by decreasedshipments of laser light-scatter products for disk drive and silicon wafermanufacturers of (2.7%).  The Measurementsegment’s largest market, North America, increased 25.5% in the year ended May31, 2007 compared to the year ended May 31, 2006.  Market demand in Asia, historically thesecond largest geographic market for Measurement products, showed a (54.5%)decrease for the year ended May 31, 2007 compared to the year ended May 31,2006 as sales in the three months ended May 31, 2007 were off (71.8%) from thesales reported in the three months ended May 31, 2006 on lower unit sales oflaser light-scatter products for disk drive and silicon wafermanufacturers.  As noted below sales canbe very cyclical in the Measurement segment. The business operations and prospects for these product lines aresummarized as follows:

Laserlight-scatter products for disk drive and silicon wafer manufacturers — Theprimary target markets for Measurement products have been disk drive andsilicon wafer manufacturers and companies and organizations involved inresearch efforts. Certain segments of these targeted industries have seenconsolidation into very large international manufacturers.  Sales totaled $1,895,185 for the year endedMay 31, 2007 compared to the $1,948,386 for the year ended May 31, 2006.  Previous information had indicated continuedimproving demand for and sales of disk drive products.  U.S. retail sales of external drives by diskdrive manufacturers rose an estimated 75% during the third calendar quarter of2006 citing demand fueled by need to convert photos, video and other contentinto digital form.  Recently, however,certain disk drive manufacturers have scaled back their outlook for the currentcalendar year, blaming a price war over high-capacity desktop computer drives,which now store as much as one trillion bytes of data.  Sales to customers in these industries can bevery cyclical and therefore the impact of the demand in the disk drive industryon sales to the Company’s laser light-scatter products is unknown at this timeand cannot be forecasted with any certainty.

Laserlight-scatter products for research organizations — The Company continues toreceive inquiries for these products and provide quotes to interestedparties.  The Company completed thedelivery of a CASI Scatterometer in the second fiscal quarter, the firstdelivery of a new CASI Scatterometer since Fiscal 2004.

Dimensionalsizing products — These products are marketed and sold into a wide array ofindustries and used in applications from steel casting, paper production, cranecontrol and medical imaging to micron level part and surface inspection.  Sales totaled $2,063,264 for the year endedMay 31, 2007 compared to the $1,736,305 for the year ended May 31, 2006.  Sales of these products can be cyclical andtherefore the duration of the continued demand cannot be forecasted with anycertainty.

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TheCompany entered into a convertible promissory note agreement with XteroDatacom, Inc. of Vancouver, British Columbia pursuant to which the Company willloan up to $250,000 USD to Xtero to fund product development and testing ofXtero satellite measurement technologies. The advances under the loan agreement are based on establishedmilestones being achieved by Xtero in the beta field testing of theirtechnology over the next 90 days.  Theloan is convertible into equity of Xtero at the sole option of SchmittIndustries, Inc.  On February 14, 2007,Schmitt advanced $125,000 to Xtero and advanced an additional $75,000 on May24, 2007.

**CriticalAccounting Policies**

Revenue Recognition — The Companyrecognizes revenue when persuasive evidence of an arrangement exists, deliveryhas occurred, the sales price is fixed or determinable and collectibility isprobable.  For sales to all customers,including manufacturer representatives, distributors or their third-partycustomers, these criteria are met at the time product is shipped.  When other significant obligations remainafter products are delivered, revenue is recognized only after such obligationsare fulfilled.

CashEquivalents and Short Term Investments — The Company generally invests excesscash in money market funds and investment grade highly liquid securities. TheCompany considers securities that are highly liquid, readily convertible intocash and have original maturities of less than three months when purchased tobe cash equivalents.  At May 31, 2007,short-term investments are classified as available-for-sale.  The carrying amounts of cash equivalents andshort term investments are stated at cost, which approximate fair market valuebecause of their short maturities.  Therewere no related unrealized holding gains or losses at May 31, 2007.

AccountsReceivable — The Company maintains credit limits for all customers that aredeveloped based upon several factors, including but not limited to paymenthistory, published credit reports and use of credit references.  On a monthly basis, management performsvarious analyses to evaluate accounts receivable balances to ensure recordedamounts reflect estimated net realizable value. This review includes accounts receivable agings, other operating trendsand relevant business conditions, including general economic factors, as theyrelate to the Company’s domestic and international customers. If these analyseslead management to the conclusion that potential significant accounts areuncollectible, a reserve is provided.

 Inventories — These assets are stated at thelower of cost or market on an average cost basis. Each fiscal quarter,management utilizes various analyses based on sales forecasts, historical salesand inventory levels to ensure the current carrying value of inventoryaccurately reflects current and expected requirements within a reasonabletimeframe.

DeferredTaxes— The Company applies the asset and liability method in recording incometaxes, under which deferred income tax assets and liabilities are determined,based on the differences between the financial reporting and tax bases ofassets and liabilities and are measured using currently enacted tax rates andlaws. Additionally, deferred tax assets are evaluated and a valuation allowanceis established if it is more likely than not that all or a portion of thedeferred tax asset will not be realized. In Fiscal 2005 and Fiscal 2006, management concluded future operationswould produce sufficient earnings so that a portion of this asset could be usedin future periods to reduce federal and state tax liabilities.  Management continues to review the level ofthe valuation allowance on a quarterly basis. There can be no assurance that the Company’s future operations willproduce sufficient earnings so that the deferred tax asset can be fullyutilized.

IntangibleAssets — There is a periodic review of intangible and other long-lived assets forimpairment.  This review consists of theanalysis of events or changes in circumstances that would indicate the carryingamount of the asset may not be recoverable. Recoverability is determined bycomparing the forecasted future net cash flows from the operations to which theassets relate, based on management’s best estimates using the appropriateassumptions and projections at the time, to the carrying amount of theassets.  If the carrying value isdetermined to be in excess of  futureoperating cash flows, the asset is considered impaired and a loss is recognizedequal to the amount by which the carrying amount exceeds the estimated fairvalue of the assets.  As of May 31, 2007,management does not believe impairment, as defined above, exists.

**Recentlyissued accounting pronouncements**

SeeNote 1 of Notes to Consolidated Financial Statements for a discussion ofrecently issued accounting pronouncements.

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**Discussion of operating results**
| ** **         | ** ** | **Year ended May 31, 2007** | ** ** |
|--------------------|------------|-------------------------------------------------|------------|
| ** **         | ** ** | **Consolidated**                                | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **         | ** ** | **Dollars**                                     | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales              |       | $                                               | 11,882,076 |   | 100.0 |   | $ | 7,923,627 |   | 100.0 |   | $ | 3,958,449 |   | 100.0 |   |
| Cost of sales      |       | 5,254,205                                       |       | 44.2 |   | 3,898,908 |   | 49.2 |   | 1,355,297 |   | 34.2 |   |
| Gross profit       |       | 6,627,871                                       |       | 55.8 |   | $ | 4,024,719 |   | 50.8 |   | $ | 2,603,152 |   | 65.8 |   |
| Operating expenses |       | 4,859,421                                       |       | 40.9 |   |   |   |   |   |   |   |   |   |
| Operating income   |       | $                                               | 1,768,450  |   | 14.9 |   |   |   |   |   |   |   |   |   |

 
| ** **         | ** ** | **Year ended May 31, 2006** | ** ** |
|--------------------|------------|-------------------------------------------------|------------|
| ** **         | ** ** | **Consolidated**                                | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **         | ** ** | **Dollars**                                     | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales              |       | $                                               | 11,503,360 |   | 100.0 |   | $ | 7,818,669 |   | 100.0 |   | $ | 3,684,691 |   | 100.0 |   |
| Cost of sales      |       | 5,029,714                                       |       | 43.7 |   | 3,772,692 |   | 48.3 |   | 1,257,022 |   | 34.1 |   |
| Gross profit       |       | 6,473,646                                       |       | 56.3 |   | $ | 4,045,977 |   | 51.7 |   | $ | 2,427,669 |   | 65.9 |   |
| Operating expenses |       | 4,740,050                                       |       | 41.2 |   |   |   |   |   |   |   |   |   |
| Operating income   |       | $                                               | 1,733,596  |   | 15.1 |   |   |   |   |   |   |   |   |   |

 
| ** **         | ** ** | **Year ended May 31, 2005** | ** ** |
|--------------------|------------|-------------------------------------------------|------------|
| ** **         | ** ** | **Consolidated**                                | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **         | ** ** | **Dollars**                                     | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales              |       | $                                               | 10,591,229 |   | 100.0 |   | $ | 7,430,287 |   | 100.0 |   | $ | 3,160,942 |   | 100.0 |   |
| Cost of sales      |       | 4,460,769                                       |       | 42.1 |   | 3,473,858 |   | 46.8 |   | 986,911 |   | 31.2 |   |
| Gross profit       |       | 6,130,460                                       |       | 57.9 |   | $ | 3,956,429 |   | 53.2 |   | $ | 2,174,031 |   | 68.8 |   |
| Operating expenses |       | 4,914,000                                       |       | 46.4 |   |   |   |   |   |   |   |   |   |
| Operating income   |       | $                                               | 1,216,460  |   | 11.5 |   |   |   |   |   |   |   |   |   |

Worldwidesales of Balancer products increased 1.3% in the year ended May 31, 2007compared to the year ended May 31, 2006 as sales to the Asian markets increasedby 33.7% offset by a decline in the North American market of (8.3%).  European sales grew 10.1% in Fiscal 2007 to$1,651,631 compared to Fiscal 2006 sales of 1,500,214.  Sales in all Other markets decreased to$597,426 in the year ended May 31, 2006 compared to the $845,198 for the yearended May 31, 2005, a (29.3%) decrease. Unit sales prices of Balancer products in North America, Asia and Othermarkets are relatively stable and therefore any increases or decreases in thedollar amount of sales between fiscal periods can generally be attributed to anincrease or decrease in the number of units sold.  The Balancer product sales increase in Asiais attributed to continued expansion and penetration of the sales efforts inChina.  The increased sales in Europe areprimarily attributed to changes in foreign exchange rates between the twofiscal periods.  The large percentagedecrease in Other markets was predominately a result of lower unit sales inAustralia, Japan and South American markets.

Measurementproduct sales increased 7.4% in the year ended May 31, 2007 compared to theyear ended May 31, 2006 as sales of the Company’s dimensional sizing productsincreased by 18.8% offset by decrease in surface measurement products of (2.7%).  The sales of surface measurement products inthe year ended May 31, 2007 compared to the year ended May 31, 2006 decreasedas unit sales to customers in the Asia markets declined.

Costof sales for both the Balancer and Measurement segments increased (as apercentage of sales) in the year ended May 31, 2007 compared to the year endedMay 31, 2006 primarily due to the product sales mix as production labor andoverhead costs were relatively stable. Balancer margins were also negatively impacted as a result of highersales in foreign markets as a large portion of those sales are made throughdistributors who receive pricing net of commissions and other sales costs.

Thedecrease in operating expenses (as a percentage of sales) between Fiscal 2007and 2006 occurred primarily due to increased sales and continued reduction ofoperating expenses in the Company’s foreign operations. The decrease inoperating expenses between Fiscal 2006 and 2005 resulted from the liquidationand dissolution of the Company’s German subsidiary, Schmitt Europa, GmbH,effective May 30, 2005.  The costs in theforeign operations decreased due to the reduction in sales and administrationstaff that occurred due to the consolidation of Schmitt Europa, GmbH operationsinto Schmitt Europe Ltd.

 

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Salesby Schmitt Europe Ltd. totaled $2,184,351 for the year ended May 31, 2007compared to sales of $1,810,377 in the year ended May 31, 2006.  Approximately 11.5% of the increase was dueto higher unit sales volumes, primarily due to the CASI Scatterometer sale, andalso general expansion of the sales efforts in the dimensional sizing productswith the remainder due to the changes in foreign exchange rates between the twofiscal periods.

Netsales outside North America accounted for approximately 49% of the Company’srevenues in Fiscal 2007 and Fiscal 2006 and 45% in Fiscal 2005.  Some foreign customers purchase in their owncountry’s currencies, thereby imposing on the Company a currency risk.  Of total sales in Fiscal 2007, 2006 and 2005,approximately 18%, 15% and 20%, respectively, were denominated in currenciesother than U.S. dollars.  To date,currency fluctuations have had minimal impact on sales.  However, significant variations in the valueof the U.S. dollar, relative to currencies of countries in which the Companyhas significant competitors, can impact future sales.  The Company does not engage in currencyhedging.  In addition, the longer paymentcycles of international sales can have a negative impact on liquidity.  The Company believes international sales willcontinue to grow in future periods.

Thenet income for Fiscal 2007 of $1,284,825 ($0.47 per fully diluted share)compared to net income of $1,350,129 ($0.49 per fully diluted share) and netincome of $1,608,140 ($0.59 per fully diluted share) in Fiscal 2006 and 2005,respectively.  Net income in Fiscal 2006included a $280,223 reduction in the deferred tax asset valuation allowancewhich reduced the Fiscal 2006 income tax provision.  Net income in Fiscal 2005 included twosignificant items; a foreign exchange loss of $174,274 which was incurred dueto the closure of the German subsidiary (Schmitt Europa, GmbH); and $640,000income tax benefit due to the reduction in the deferred tax asset valuationallowance.  Management believes the effectivetax rate in future periods will reflect a normal combined state and federalrate.

Asubstantial portion of the Company’s revenues are derived from sales to endusers through selling agents. The Company is dependent on the sales activitiesof its selling agents, and there can be no assurance these agents will continueto be successful in their efforts to market the Company’s products.  The Company enjoys substantial repeatbusiness from a broad base of customers, but there is no assurance thesecustomers will continue to buy the Company’s products.

InFiscal years 2007, 2006 or 2005, sales to any single customer did not exceed10% of total revenues.

TheCompany operates in highly competitive industries characterized by increasinglyrapid technological changes.  The Company’scompetitive advantage and future success are therefore dependent on its abilityto develop new products, qualify these new products with its customers,successfully introduce these products to the marketplace on a timely basis,commence production to meet customer demands and develop new markets in theindustries for its products and services. The successful introduction of new technology and products isincreasingly complex.  If the Company isunable, for whatever reason, to develop and introduce new products in a timelymanner in response to changing market conditions or customer requirements, itsresults of operations could be adversely impacted.

# **LIQUIDITY AND CAPITAL RESOURCES**

TheCompany’s ratio of current assets to current liabilities increased to 9.8 to 1at May 31, 2007 compared to 8.1 to 1 at May 31, 2006.  Cash, cash equivalents and available for saleshort term investments totaled $5,477,711 as of May 31, 2007 compared to$3,538,012 at May 31, 2006.  As of May31, 2007 the Company had $1,513,061 in cash and cash equivalents compared to$1,552,072 at May 31, 2006.  As of May31, 2007 the Company had $3,964,650 in short term investments compared to$1,985,940 at May 31, 2006.  Short terminvestments consisted of highly liquid A1-P1 rated commercial paper securitiesmaturing through October 2007.

Duringthe year ended May 31, 2007, cash provided by operating activities amounted to$2,130,747 with the changes described as follows:

·                  Net income for the year ended May 31, 2007 of $1,284,825plus non-cash items: depreciation and amortization of $205,911, loss ondisposal of property and equipment $5,235, deferred taxes of $490,723, stockbased compensation related items of $25,704.

·                  Accounts receivable generated cash as the balancedecreased to a May 31, 2007 balance of $1,454,179 compared to $1,983,090 at May31, 2006, a 26.7% decrease. The Company generally experiences a payment cycleof 30-90 days on invoices, depending on the geographic market.  Management believes its credit and collectionpolicies are effective and appropriate for the marketplace.  There can be no assurance that the Company’scollection procedures will continue to be successful, particularly with currenteconomic conditions.

15

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·                  Inventories increased to a May 31, 2007 balance of$3,690,363 compared to $3,241,590 at May 31, 2006, a 13.8% increase.  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 expenses decreased to $71,331 from abalance of $77,626 at May 31, 2006 with the decrease due to prepaid fees, tradeshow costs and various business and insurance costs.

·                  Trade accounts payable used cash as the balancedecreased to $335,820 from a balance of $403,490 at May 31, 2006 primarily dueto normal fluctuations in timing of payment of outstanding payable balances.

·                  Other accrued liabilities (including customerdeposits, commissions, payroll items and other accrued expenses) increased to abalance of $628,436 from $626,785 at May 31, 2006.

Duringthe year ended May 31, 2007, net cash used in investing activities was $2,370,945,consisting of net additions to property and equipment of $192,235, $200,000 promissorynote advance and net purchases of short term investments of $1,978,710.  Net cash provided by financing activitiesamounted to $119,959 which consisted of common stock issued on exercised stockoptions and related items of $141,571 net of repayments of long-termobligations of $21,612.

Thefollowing summarizes contractual obligations at May 31, 2007 and the effect onfuture liquidity and cash flows:

| Years ending May 31, | ** ** | **Long term   obligations** | ** ** | **Operating  leases** | ** ** | **Total   contractual  obligations** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|-------------------------------------------|------------|
|                                |       |                                  |       |                  |       |                                      |       |
| 2008                                |       | $                                     | —     |                  | $          | 52,000                                    |       | $ | 52,000 |   |
| 2009                                |       | —                                |       | 38,000                |       | 38,000                                    |       |
| 2010                                |       | —                                |       | 5,000                 |       | 5,000                                     |       |
| Thereafter                          |       | —                                |       | —                |       | —                                    |       |
| Total                               |       | $                                     | —     |                  | $          | 95,000                                    |       | $ | 95,000 |  |

 

Managementhas historically responded to business challenges that had a negative impact onoperations and liquidity by reducing operating expenses, developing newproducts and attempting to penetrate new markets for the Company’sproducts.  As a result of these efforts,results of operations and cash flow from operations have improved.  Management believes its cash flows fromoperations, its available credit resources 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 2008.  However, in the event the Company fails toachieve its operating and financial goals for Fiscal 2008, management may be requiredto take certain actions to finance operations in that time period.  These actions could include, but are notlimited to, implementation of cost cutting measures and/or entering intoadditional borrowing arrangements collateralized by assets.

**Item 7A.         Quantitative and Qualitative Disclosuresabout Market Risk**

**InterestRate Risk**

TheCompany did not have any derivative financial instruments as of May 31,2007.  However, the Company could beexposed to interest rate risk at any time in the future and, therefore, employsestablished policies and procedures to manage its exposure to changes in themarket risk of its marketable securities.

TheCompany’s interest income and expense are most sensitive to changes in thegeneral level of U.S. and European interest rates.  In this regard, changes in U.S. and Europeaninterest rates affect the interest earned on the Company’s interest bearingcash equivalents and short term investments. The Company has a variable rate line of credit facility with a bank butthere is no outstanding balance as of May 31, 2007.  Also, there is no other long-term obligationwhose interest rates are based on variable rates that may fluctuate over timebased on economic changes in the environment. Therefore, at this time, the Company is not subject to interest raterisk on outstanding interest bearing obligations if market interest ratesfluctuate and does not expect any change in the interest rates to have amaterial effect on the Company’s results from operations.

16

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**Foreign Currency Risk**

TheCompany markets and sells its products worldwide and international sales haveaccounted for and are expected to continue to account for a significant portionof future revenue.  The Company operatesa subsidiary in the United Kingdom and acquires certain materials and servicesfrom vendors transacted in foreign currencies. Therefore, the Company’s business and financial condition is sensitiveto currency exchange rates or any other restrictions imposed on theircurrencies.  For the years ended May 31,2007, 2006 and 2005, results of operations included gains (losses) on foreigncurrency translation of $20,774, $(9,757) and $(184,106), respectively.  The foreign exchange loss in Fiscal 2005 wasdirectly attributable to the closure, liquidation and pending dissolution ofthe Company’s German subsidiary, Schmitt Europa, GmbH.  In the fourth quarter of Fiscal 2005,management chose to terminate the only two employees in that country,eliminating the need for a separate German company.  As there will be no future activity in thatsubsidiary, the accumulated foreign exchange loss, included in othercomprehensive income on the balance sheet in prior periods, was recognized inthe fourth quarter of Fiscal 2005.  The foreignexchange gains or losses in Fiscal 2007 and 2006 are primarily attributable toCompany’s United Kingdom subsidiary, Schmitt Europe, Ltd.

 

17

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**Item 8.            Financial Statements andSupplementary Data**

##### **SCHMITT INDUSTRIES, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                            | ** ** | **May 31, 2007** | ** ** | **May 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                            | ** ** |
| **Current assets**                                                                                                                                                    | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Cash and cash  equivalents                                                                                                                                            |       | $                          | 1,513,061  |                       | $          | 1,552,072 |   |
| Short-term  investments                                                                                                                                               |       | 3,964,650                  |       | 1,985,940                  |       |
| Accounts  receivable, net                                                                                                                                             |       | 1,454,179                  |       | 1,983,090                  |       |
| Inventories                                                                                                                                                           |       | 3,690,363                  |       | 3,241,590                  |       |
| Prepaid expenses                                                                                                                                                      |       | 71,331                     |       | 77,626                     |       |
| Deferred tax  asset                                                                                                                                                   |       | 144,957                    |       | 116,080                    |       |
| ** **                                                                                                                                                            |       | 10,838,541                 |       | 8,956,398                  |       |
| **Property and equipment**                                                                                                                                            | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Land                                                                                                                                                                  |       | 299,000                    |       | 299,000                    |       |
| Buildings and  improvements                                                                                                                                           |       | 1,336,181                  |       | 1,275,922                  |       |
| Furniture,  fixtures and equipment                                                                                                                                    |       | 826,380                    |       | 1,180,648                  |       |
| Vehicles                                                                                                                                                              |       | 97,955                     |       | 96,849                     |       |
|                                                                                                                                                                  |       | 2,559,516                  |       | 2,852,419                  |       |
| Less accumulated  depreciation and amortization                                                                                                                       |       | (1,333,738                 | )          | (1,643,047                 | )          |
| ** **                                                                                                                                                            |       | 1,225,778                  |       | 1,209,372                  |       |
| **Other assets**                                                                                                                                                      | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Long-term  deferred tax asset                                                                                                                                         |       | 32,780                     |       | 552,380                    |       |
| Other assets                                                                                                                                                          |       | 373,797                    |       | 208,405                    |       |
|                                                                                                                                                                  |       | 406,577                    |       | 760,785                    |       |
| **TOTAL ASSETS**                                                                                                                                                      |       | $                          | 12,470,896 |                       | $          | 10,926,555 |   |
| ** **                                                                                                                                                            | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| **LIABILITIES & STOCKHOLDERS’ EQUITY**                                                                                                                       | ** ** |
| **Current liabilities**                                                                                                                                               | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Accounts payable                                                                                                                                                      |       | $                          | 335,820    |                       | $          | 403,490 |   |
| Accrued  commissions                                                                                                                                                  |       | 225,782                    |       | 250,835                    |       |
| Accrued payroll  liabilities                                                                                                                                          |       | 83,365                     |       | 138,801                    |       |
| Other accrued  liabilities                                                                                                                                            |       | 319,289                    |       | 237,149                    |       |
| Income taxes  payable                                                                                                                                                 |       | 142,108                    |       | 60,237                     |       |
| Current portion  of long-term obligations                                                                                                                             |       | —                     |       | 15,204                     |       |
| **Total current liabilities**                                                                                                                                         |       | 1,106,364                  |       | 1,105,716                  |       |
| **Long-term obligations**                                                                                                                                             |       | —                     |       | 6,408                      |       |
| **Stockholders’ equity**                                                                                                                                         | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Common stock, no  par value, 20,000,000 shares authorized, 2,664,419 and 2,625,045 shares  issued and outstanding at May 31, 2007 and May 31, 2006, respectively |       | 8,114,251                  |       | 7,946,976                  |       |
| Accumulated  other comprehensive loss                                                                                                                                 |       | (122,050                   | )          | (220,051                   | )          |
| Retained  earnings                                                                                                                                                    |       | 3,372,331                  |       | 2,087,506                  |       |
| **Total stockholders’ equity**                                                                                                                                   |       | 11,364,532                 |       | 9,814,431                  |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                   |       | $                          | 12,470,896 |                       | $          | 10,926,555 |   |

 

##### *The accompanying notes are an integral partof these consolidated financial statements*

 

18

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##### ** **

##### **SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                         | ** ** | **Year Ended May 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                               |       |                                  |       |   |   |   |   |
| **Net sales**                                      |       | $                                     | 11,882,076 |   | $ | 11,503,360 |   | $ | 10,591,229 |   |
| Cost of sales                                      |       | 5,254,205                             |       | 5,029,714 |   | 4,460,769 |   |
| **Gross  profit**                                  |       | 6,627,871                             |       | 6,473,646 |   | 6,130,460 |   |
|                                               |       |                                  |       |   |   |   |   |
| Operating expenses:                                |       |                                  |       |   |   |   |   |
| General,  administration and sales                 |       | 4,770,996                             |       | 4,658,235 |   | 4,871,605 |   |
| Research and  development                          |       | 88,425                                |       | 81,815 |   | 42,395 |   |
| Total operating  expenses                          |       | 4,859,421                             |       | 4,740,050 |   | 4,914,000 |   |
|                                               |       |                                  |       |   |   |   |   |
| **Operating income**                               |       | 1,768,450                             |       | 1,733,596 |   | 1,216,460 |   |
| Other income  (expense)                            |       | 226,375                               |       | 50,076 |   | (214,320 |   |
|                                               |       |                                  |       |   |   |   |   |
| **Income before income taxes**                     |       | 1,994,825                             |       | 1,783,672 |   | 1,002,140 |   |
| Provision  (benefit) for income taxes              |       | 710,000                               |       | 433,543 |   | (606,000 | ) |
|                                               |       |                                  |       |   |   |   |   |
| **Net income**                                     |       | $                                     | 1,284,825  |   | $ | 1,350,129 |   | $ | 1,608,140 |   |
|                                               |       |                                  |       |   |   |   |   |
| **Net  income per common share, basic**            |       | $                                     | 0.49       |   | $ | 0.52 |   | $ | 0.64 |   |
| Weighted average  number of common shares, basic   |       | 2,649,284                             |       | 2,606,039 |   | 2,527,665 |   |
|                                               |       |                                  |       |   |   |   |   |
| **Net  income per common share, diluted**          |       | $                                     | 0.47       |   | $ | 0.49 |   | $ | 0.59 |   |
| Weighted average number  of common shares, diluted |       | 2,763,061                             |       | 2,746,402 |   | 2,708,797 |   |

 

#### *The accompanying notes are an integral partof these consolidated financial statements*

* *

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**SchmittIndustries, Inc.Consolidated Statements of Cash Flows**
| ** **                                                                         | ** ** | **Year Ended May 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Cash flows relating to  operating activities**                                   | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                     | 1,284,825  |   | $ | 1,350,129 |   | $ | 1,608,140 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                  |       |   |   |   |   |
| Depreciation and  amortization                                                     |       | 205,911                               |       | 210,606 |   | 214,933 |   |
| Loss on disposal  of property and equipment                                        |       | 5,235                                 |       | — |   | — |   |
| Deferred taxes                                                                     |       | 490,723                               |       | (28,460 | ) | (640,000 | ) |
| Stock based  compensation                                                          |       | 46,423                                |       | — |   | — |   |
| Tax benefit  related to stock options                                              |       | 36,124                                |       | 335,238 |   | — |   |
| Excess tax  benefit from stock based compensation                                  |       | (56,843                               | )          | — |   | — |   |
| (Increase)  decrease in:                                                           |       |                                  |       |   |   |   |   |
| Accounts  receivable                                                               |       | 549,186                               |       | 126,053 |   | (293,726 | ) |
| Inventories                                                                        |       | (441,984                              | )          | 291,723 |   | (618,220 | ) |
| Prepaid expenses                                                                   |       | 6,489                                 |       | 26,666 |   | 20,056 |   |
| Income taxes  receivable                                                           |       | —                                |       | — |   | 35,894 |   |
| Increase(decrease)  in:                                                            |       |                                  |       |   |   |   |   |
| Accounts payable                                                                   |       | (73,013                               | )          | (93,716 | ) | (68,340 | ) |
| Accrued  liabilities and customer deposits                                         |       | (4,200                                | )          | 106,607 |   | 166,131 |   |
| Income taxes  payable                                                              |       | 81,871                                |       | 34,090 |   | 26,147 |   |
| Net cash  provided by operating activities                                         |       | 2,130,747                             |       | 2,358,936 |   | 451,015 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Cash flows relating to  investing activities**                                   | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchase of  short-term investments                                                |       | (11,478,710                           | )          | (1,985,940 | ) | — |   |
| Maturities of  short-term investments                                              |       | 9,500,000                             |       | — |   | — |   |
| Purchase of  property and equipment                                                |       | (197,235                              | )          | (116,868 | ) | (93,060 | ) |
| Proceeds from  sale of property and equipment                                      |       | 5,000                                 |       | — |   | — |   |
| Advance on  convertible promissory note                                            |       | (200,000                              | )          | — |   | — |   |
| Net cash used in  investing activities                                             |       | (2,370,945                            | )          | (2,102,808 | ) | (93,060 | ) |
|                                                                               |       |                                  |       |   |   |   |   |
| **Cash flows relating to  financing activities**                                   | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Repayments on  long-term obligations                                               |       | (21,612                               | )          | (31,258 | ) | (42,064 | ) |
| Common stock  issued on exercise of stock options                                  |       | 84,728                                |       | 115,640 |   | 135,279 |   |
| Excess tax  benefit from stock based compensation                                  |       | 56,843                                |       | — |   | — |   |
| Net cash  provided by financing activities                                         |       | 119,959                               |       | 84,382 |   | 93,215 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Effect of foreign exchange  translation on cash**                                |       | 81,228                                |       | 34,603 |   | 121,595 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Increase (decrease) in cash and  cash equivalents**                              |       | (39,011                               | )          | 375,113 |   | 572,765 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Cash and cash equivalents,  beginning of period**                                |       | 1,552,072                             |       | 1,176,959 |   | 604,194 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Cash and cash equivalents, end  of period**                                      |       | $                                     | 1,513,061  |   | $ | 1,552,072 |   | $ | 1,176,959 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Supplemental Disclosure of Cash  Flow Information**                              | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the period for interest                                          |       | $                                     | 340        |   | $ | 872 |   | $ | 1,083 |   |
| Cash paid during  the period for income taxes                                      |       | $                                     | 143,734    |   | $ | 139,065 |   | $ | 7,853 |   |
|                                                                               |       |                                  |       |   |   |   |   |
| **Supplemental Schedule of  Noncash Investing and Financing Activities**           | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fixed assets financed                                                              |       | $                                     | —     |   | $ | — |   | $ | 27,861 |   |

#####  

##### *Theaccompanying notes are an integral part of these consolidated financialstatements*

 

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**SCHMITT INDUSTRIES, INC.Consolidated Statements of Changes in Stockholders’ EquityAnd Comprehensive Income**

 
| ** **                                                   | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Accumulated  other  comprehensive  loss** | ** ** | **Retained  earnings** | ** ** | **Total** | ** ** | **Total  comprehensive  income** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|----------------------------------|------------|
| **Balance, May 31, 2004**                                    |       | 2,474,461  |       | $          | 7,360,819  |                                        | $          | (376,249               | )          | $         | (870,763   | )                                | $          | 6,113,807 |   |   |   |
| Stock options  exercised                                     |       | 85,226     |       | 135,279    |       | —                                      |       | —                 |       | 135,279   |       |                             |       |
| Net income                                                   |       | —     |       | —     |       | —                                      |       | 1,608,140              |       | 1,608,140 |       | $                                | 1,608,140  |   |
| Other  comprehensive income                                  |       | —     |       | —     |       | 121,595                                     |       | —                 |       | 121,595   |       | 121,595                          |       |
| **Balance, May 31, 2005**                                    |       | 2,559,687  |       | $          | 7,496,098  |                                        | $          | (254,654               | )          | $         | 737,377    |                             | $          | 7,978,821 |   |   |   |
| ** **                                                   |       |       |       |       |       |                                        |       |                   |       |      |       |                             |       |
| **Comprehensive  income, year ended May 31, 2005**           |       |       |       |       |       |                                        |       |                   |       |      |       | $                                | 1,729,735  |   |
| Stock options  exercised and related tax benefit of $335,238 |       | 65,358     |       | 450,878    |       | —                                      |       | —                 |       | 450,878   |       |                             |       |
| Net income                                                   |       | —     |       | —     |       | —                                      |       | 1,350,129              |       | 1,350,129 |       | $                                | 1,350,129  |   |
| Other  comprehensive income                                  |       | —     |       | —     |       | 34,603                                      |       | —                 |       | 34,603    |       | 34,603                           |       |
| **Balance, May 31, 2006**                                    |       | 2,625,045  |       | $          | 7,946,976  |                                        | $          | (220,051               | )          | $         | 2,087,506  |                             | $          | 9,814,431 |   |   |   |
| ** **                                                   |       |       |       |       |       |                                        |       |                   |       |      |       |                             |       |
| **Comprehensive  income, year ended May 31, 2006**           |       |       |       |       |       |                                        |       |                   |       |      |       | $                                | 1,384,732  |   |
| Stock options  exercised and related tax benefit of $36,124  |       | 39,374     |       | 120,852    |       | —                                      |       | —                 |       | 120,852   |       |                             |       |
| Stock based  compensation                                    |       |       |       | 46,423     |       | —                                      |       | —                 |       | 46,423    |       |                             |       |
| Net income                                                   |       | —     |       | —     |       | —                                      |       | 1,284,825              |       | 1,284,825 |       | $                                | 1,284,825  |   |
| Other  comprehensive income                                  |       | —     |       | —     |       | 98,001                                      |       | —                 |       | 98,001    |       | 98,001                           |       |
| **Balance, May 31, 2007**                                    |       | 2,664,419  |       | 8,114,251  |       | $                                           | (122,050   | )                      | $          | 3,372,331 |       | $                                | 11,364,532 |   |   |   |
| ** **                                                   |       |       |       |       |       |                                        |       |                   |       |      |       |                             |       |
| **Comprehensive income, year  ended May 31, 2007**           |       |       |       |       |       |                                        |       |                   |       |      |       | $                                | 1,382,826  |   |

 

#### *The accompanying notes are an integral partof these consolidated statements*

21

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**SchmittIndustries, Inc.Notes to Consolidated Financial StatementsFor The Years Ended May 31, 2007, 2006 and 2005**

**NOTE 1SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

**Nature of Operations**

Schmitt Industries, Inc. (the Company) designs,assembles, markets and distributes electronic and mechanical components formachine tool products and laser measurement systems worldwide.

**Principles ofConsolidation**

These consolidated financial statements include thoseof the Company and its wholly owned subsidiaries: Schmitt Measurement Systems,Inc. (SMS), Schmitt Europe, Ltd. (SEL) and Schmitt Europa GmbH (SEG).  Effective May 31, 2005 SEG has beenliquidated.  All significant intercompany accounts and transactions have beeneliminated in the preparation of the consolidated financial statements.

**RevenueRecognition**

The Company recognizes revenue when persuasiveevidence of an arrangement exists, delivery has occurred, the sales price isfixed or determinable and collectibility is reasonably assured.  For sales to all customers, includingmanufacturer representatives, distributors or their third-party customers,these criteria are met at the time product is shipped.  When other significant obligations remainafter products are delivered, revenue is recognized only after such obligationsare fulfilled.  Substantially all productsales are sold FCA (free carrier) shipping point and any related shipping and handling costs areexpensed as incurred and included in cost of sales.

**Cash Equivalentsand Short Term Investments**

The Company generally invests excess cash in moneymarket funds and investment grade highly liquid securities.  The Company considers securities that arehighly liquid, readily convertible into cash and have original maturities ofless than three months when purchased to be cash equivalents.  At May 31, 2007, short-term investments areclassified as available-for-sale.  Thecarrying amounts of cash equivalents and short term investments are stated atcost, which approximate fair market value because of their short maturities.  There were no related unrealized holdinggains or losses at May 31, 2007.

**AccountsReceivable**

The Companymaintains credit limits for all customers based upon several factors, includedbut not limited to payment history, published credit reports and use of creditreferences.  Management performs variousanalyses to evaluate accounts receivable balances to ensure recorded amountsreflect estimated net realizable value. This review includes accounts receivable agings, other operating trendsand relevant business conditions, including general economic factors, as theyrelate to each of the Company’s domestic and international customers.  If these analyses lead management to theconclusion that potential significant accounts are uncollectible, a reserve isprovided.  Changes in the Company’sallowance for doubtful accounts are as follows:

|                       | ** ** | **Year Ended May 31,** | ** ** |
|-----------------------|------------|---------------------------------------|------------|
| ** **            | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Beginning balance     |       | $                                     | 52,186     |   | $ | 41,366 |   | $ | 32,550 |   |
| Bad debt expense      |       | 39,513                                |       | 39,513 |   | 40,527 |   |
| Accounts written  off |       | (70,881                               | )          | (28,693 | ) | (31,711 | ) |
| Ending balance        |       | $                                     | 20,818     |   | $ | 52,186 |   | $ | 41,366 |   |

 

**Inventory**

Inventory is valued at the lower of cost or marketwith cost determined on the average cost basis. As of May 31, 2007 and 2006, inventories consisted of:

|                 | ** ** | **May 31, 2007** | ** ** | **May 31, 2006** | ** ** |
|-----------------|------------|----------------------------|------------|----------------------------|------------|
| Raw materials   |       | $                          | 1,638,256  |                       | $          | 1,578,767 |   |
| Work-in-process |       | 530,415                    |       | 368,592                    |       |
| Finished goods  |       | 1,521,692                  |       | 1,294,231                  |       |
|            |       | $                          | 3,690,363  |                       | $          | 3,241,590 |   |

 

22

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Managementperforms various analyses to evaluate inventory balances to ensure recordedamounts reflect estimated net realizable value. Changes in the Company’sallowance for slow moving inventories are as follows:

|                                       | ** ** | **Year Ended May 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Beginning balance                     |       | $                                     | 172,945    |   | $ | 163,414 |   | $ | 172,696 |   |
| Items added to  allowance             |       | 151,866                               |       | 18,777 |   | 94,664 |   |
| Items disposed  or used in production |       | (49,438                               | )          | (9,246 | ) | (103,946 | ) |
| Ending balance                        |       | $                                     | 275,373    |   | $ | 172,945 |   | $ | 163,414 |   |

 

**Property andEquipment**

Property and equipment are stated at cost.  Depreciation is computed using thestraight-line method over estimated useful lives of three to seven years forfurniture fixtures, and equipment; three years for vehicles; and twenty-fiveyears for buildings and improvements.

**Foreign CurrencyTranslation**

Financial statements for the Company’s subsidiariesoutside the United States are translated into U.S. dollars at year-end exchangerates for assets and liabilities and weighted average exchange rates for incomeand expenses.  The resulting translationadjustments are included as a separate component of stockholders’ equity titled“Accumulated Other Comprehensive Loss.”

**Advertising**

Advertising costs included in general, administrativeand selling, are expensed when the advertising first takes place.  Advertising expense was $112,562, $82,322 and$87,853 for the fiscal years ended May 31, 2007, 2006 and 2005, respectively.

**Research andDevelopment Costs**

Research and development costs, predominately internallabor costs, are charged to expense when incurred.

**Stock-BasedCompensation**

Stock-based compensation includes expense charges forall stock-based awards to employees and directors granted under the Company’sstock option plan.  On June 1, 2006, theCompany adopted SFAS No. 123(R), “Share-Based Payment (Revised 2004)”, whichrequires the measurement and recognition of compensation for all stock-basedawards made to employees and directors including stock options based onestimated fair values.  SFAS 123(R)supersedes previous accounting under Accounting Principles Board Opinion No.25, “Accounting for Stock Issued to Employees” (APB 25), for periods beginningin Fiscal 2007. In March 2005, the Securities and Exchange Commission issuedStaff Accounting Bulletin No. 107 relating to application of SFAS 123(R).  The Company has applied the provisions of SAB107 in our adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modifiedprospective transition method, which requires the application of the accountingstandard as of June 1, 2006, the first day of our 2007 fiscal year. Inaccordance with the modified prospective transition method, the Company’sConsolidated Financial Statements for periods prior to the first quarter ofFiscal 2007 have not been restated to reflect this change.  Stock-based compensation recognized duringthe period is based on the value of the portion of the stock-based award thatwill vest during the period, adjusted for expected forfeitures.  The compensation cost for awards grantedprior to May 31, 2006 is based on the grant date fair value estimated inaccordance with the pro forma provisions of SFAS 123 while awards granted on orafter June 1, 2006 follow the provisions of SFAS 123(R) to determine the grantdate fair value and compensation cost. Compensation cost for all stock-basedawards is recognized using the straight-line method.

**Deferred Taxes**

The Company applies the asset and liability method inrecording income taxes, under which deferred income tax assets and liabilitiesare determined, based on the differences between the financial reporting andtax bases of assets and liabilities and are measured using currently enactedtax rates and laws.  Additionally,deferred tax assets are evaluated and a valuation allowance is established ifit is more likely than not that all or a portion of the deferred tax asset willnot be realized.  In Fiscal 2005 and2006, management concluded future operations would produce

23

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sufficient earnings so that a portion of this assetcould be used in future periods to reduce federal and state taxliabilities.  Management continues toreview the level of the valuation allowance on a quarterly basis.  There can be no assurance that the Company’sfuture operations will produce sufficient earnings so that the deferred taxasset can be fully utilized.

**Intangible andOther Long Term Assets**

Other long term assets include definite-livedintangible assets and a convertible promissory note.  Amortizable intangible assets, purchasedtechnology and patents, are amortized over their estimated useful lives rangingfrom eleven to seventeen years.

During Fiscal 2007 the Company entered into aconvertible promissory note agreement with Xtero Datacom, Inc. of Vancouver,British Columbia pursuant to which the Company will loan up to $250,000 USD to Xteroto fund product development and testing of Xtero satellite measurementtechnologies.  The advances under theloan agreement are based on established milestones being achieved by Xtero inthe beta field testing of their technology. The loan is convertible into equity of Xtero at the sole option ofSchmitt Industries, Inc.  As of May 31,2007, Schmitt advanced $200,000 to Xtero.

There is a periodic review of intangible and otherlong-lived assets for impairment.  Thisreview consists of the analysis of events or changes in circumstances thatwould indicate the carrying amount of the 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 aloss is recognized equal to the amount by which the carrying amount exceeds theestimated fair value of the assets.  Asof May 31, 2007, management does not believe impairment, as defined above,exists.

**Earnings Per Share**

Basic earnings per share is computed using theweighted average number of common shares outstanding.  Diluted earnings per share is computed usingthe weighted average number of common shares outstanding, adjusted for dilutiveincremental shares attributed to outstanding options to purchase common stock.

**Concentration ofCredit Risk**

Financial instruments that potentially expose theCompany to concentration of credit risk are trade accounts receivable.  Credit terms generally include a discount of1-1/2% if the invoice is paid within ten days, with the net amount payable in30 days.

**FinancialInstruments**

Based on borrowing rates currently available to theCompany for bank loans with similar terms and maturities, the fair value of theCompany’s long-term debt approximates the carrying value.  Furthermore, the carrying value of all otherfinancial instruments potentially subject to valuation risk (principallyconsisting of cash and cash equivalents, short term investments, accountsreceivable and accounts payable) also approximate fair value because of theirshort-term maturities.

**Use of Estimates**

The preparation of the consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the amounts reported in the consolidated financial statements andaccompanying notes.  Actual results coulddiffer from those estimates.

**Recently issuedaccounting pronouncements**

The Financial Accounting Standards Board (FASB) issuedFASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN48) in June 2006.  FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in our financialstatements in accordance with Statement of Financial Accounting Standard (SFAS)No. 109, “Accounting for Income Taxes”. The provisions of FIN 48 are effective for our fiscal year beginningJune 1, 2007.  The Company is currentlyevaluating the impact of the provisions of FIN 48.

24

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In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin (SAB) No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements,” which addresses how the effects of prior-yearuncorrected misstatements should be considered when quantifying misstatementsin current-year financial statements. SAB No. 108 requires companies toquantify misstatements using both the balance sheet and income statementapproaches and to evaluate whether either approach results in quantifying anerror that is material in light of relevant quantitative and qualitativefactors.  SAB No. 108 is effective forour fiscal year ending May 31, 2007.  TheCompany is not currently aware of any material misstatements and, accordingly,the implementation of SAB No. 108 did not have any effect on our financialposition or results of operations.

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements”. SFAS 157 defines fair value, establishes a framework formeasuring fair value in accordance with generally accepted accountingprinciples, and expands disclosures about fair value measurements.  The provisions of SFAS 157 are effective forthe fiscal year beginning June 1, 2008. The Company is currently evaluating the impact of the provisions of SFAS157.

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities including anAmendment of FASB Statement No. 115”. SFAS 159 permits entities to choose to measure many financial instrumentsand certain other items at fair value. The provisions of SFAS 159 are effective for the fiscal year beginningJune 1, 2008.  The Company is currentlyevaluating the impact of the provisions of SFAS 159.

**Reclassifications**

Certain reclassifications have been made to the 2006and 2005 amounts to conform to 2007 presentations.

**NOTE 2LINE OF CREDIT**

The Company has a $1.0 million bank line of creditagreement secured by U.S. accounts receivable, inventories and generalintangibles.  Interest is payable at thebank’s prime rate, 8.25% as of May 31, 2007, and the agreement expires onSeptember 1, 2007.  There were nooutstanding balances on the line of credit at May 31, 2007.

**NOTE 3INCOME TAXES**

The provision(benefit) for income taxes are as follows:

|                                                 | ** ** | **Years ended May 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **2007**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Current                                         |       | $                                      | 226,000    |   | $ | 109,100 |   | $ | 34,000 |   |
| Deferred                                        |       | 501,936                                |       | 604,666 |   | 420,167 |   |
| Decrease in valuation  allowance                |       | (17,936                                | )          | (280,223 | ) | (1,060,167 | ) |
| Total (benefit from) provision for income taxes |       | $                                      | 710,000    |   | $ | 433,543 |   | $ | (606,000 | ) |

 

Deferred tax assets (liabilities) are comprised of thefollowing components:

|                                                                                     | ** ** | **2007** | ** ** | **2006**  | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|-----------|------------|
| Depreciation                                                                        | * *   | $        | 52,177     |      | $          | 62,869 | * * |
| Net operating loss  carryforwards                                                   |       | —   |       | 197,958   | * *   |
| Deferred taxes related  to the decline in fair market value of long-term investment | * *   | 694,696  |       | 694,696   | * *   |
| Other deferred items,  net                                                          | * *   | 200,560  |       | 500,569   | * *   |
| Gross deferred tax  assets                                                          | * *   | 947,433  |       | 1,456,092 | * *   |
| Deferred tax asset  valuation allowance                                             | * *   | (769,696 | )          | (787,632  | )          |
| Net deferred tax asset                                                              | * *   | $        | 177,737    |      | $          | 668,460 | * * |

 

25

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The net deferred tax asset is classified as follows:

|                               | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Current deferred tax  asset   | * *   | $        | 144,957    |     | $          | 116,080 | * * |
| Long-term deferred tax  asset | * *   | 32,780   |       | 552,380  | * *   |
| Net deferred tax asset        | * *   | $        | 177,737    |     | $          | 668,460 | * * |

 

Deferred tax assets are evaluated and a valuationallowance is established if it is more likely than not that all or a portion ofthe deferred tax asset will not be realized. The Company has recorded a substantial deferred tax asset related to theexpected realization of net operating loss carryforwards for federal income taxpurposes and other temporary differences between book and tax bases of assetsand liabilities.  Due to the uncertaintyof utilization of the Company’s net operating losses and in consideration ofother factors, management recorded a valuation allowance on the deferred taxasset at May 31, 2003.

During Fiscal 2005 and 2006, management concludedfuture operations would produce sufficient earnings so that portions of thisasset could be used in future periods to reduce federal and state taxliabilities and the allowance was reduced to reflect the amount of the deferredtax asset management believes can be utilized in future periods.  Our effective tax rate on consolidated netincome was 35.6% for the year ended May 31, 2007.  Our effective tax rateon consolidated net income differs from the federal statutory tax rateprimarily due to certain expenses not deductible for income tax reportingoffset by lower effective tax rates on net income reported by the Company’swholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the UnitedKingdom.   The net effective tax expenseon consolidated net income in Fiscal 2006 and Fiscal 2005 differs from the federalstatutory tax rate primarily due to a reduction in the valuation allowance atNovember 30, 2005 and May 31, 2005. Management believes the effective tax rate on consolidated net income infuture periods will reflect a normal combined state and federal rate, net ofthe effect from expenses not deductible for income tax reporting and net incomeor losses reported by SEL.

The provision for income taxes differs from the amount of income taxesdetermined by applying the U.S. statutory federal tax rate to pre-tax incomedue to the following:
| ** **                                  | ** ** | **Years ended May 31,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|
| ** **                                  | ** ** | **2007**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Statutory federal tax  rate                 |       | 34.0                                   | %          | 34.0 | % | 34.0 | % |
| State taxes, net of  federal benefit        |       | 4.4                                    |       | 4.4 |   | 4.4 |   |
| Change in deferred tax  valuation allowance |       | —                                 |       | (15.7 | ) | (105.8 | ) |
| Permanent and other  differences            |       | (2.8                                   | )          | 1.6 |   | 6.9 |   |
| Effective tax rate                          |       | 35.6                                   | %          | 24.3 | % | (60.5 | )% |

 

**NOTE 4EMPLOYEE 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.  As of June1, 2005 the Company resumed matching contributions in conjunction with employeecontributions to the plan and made contributions totaling $68,662 during Fiscal2007 and $45,041 during Fiscal 2006. There were no contributions made by the Company to this Plan during theyear ended May 31, 2005.

26

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**NOTE 5LONG-TERM OBLIGATIONS**

As of May 31, 2007, there were no outstandingobligations under capital leases or purchase contracts.  During Fiscal 2005, the Company entered intoa purchase contract for $27,861.  Theagreement calls for monthly principal and interest payments of $810 and carriesinterest at 1.9%.  During Fiscal 2004,the Company entered into an equipment lease, which was treated as a capitallease, and a purchase contract totaling $78,477.  One lease expired in Fiscal 2006 and thesecond expired in Fiscal 2007.  Equipmentrecorded under the capital lease was $48,477, with related accumulateddepreciation of $37,704 at May 31, 2007.

The Company leasescertain facilities and equipment to support operations under non-cancelableoperating leases and other contractualobligations.  Total rent expensefor the years ended May 31, 2007, 2006 and 2005 amounted to $64,824, $41,806and $67,133, respectively.

The approximatefuture minimum commitments under leases and contractualobligations for each of the years ending May 31 are as follows:

| Years ending May 31, | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| 2008                                |       | $          | 52,000     |   |
| 2009                                |       | $          | 38,000     |   |
| 2010                                |       | $          | 5,000      |   |
| Thereafter                          |       | $          | —     |   |

 

**NOTE 6COMMITMENTS AND CONTINGENCIES**

In a transaction related to the acquisition of SchmittMeasurement Systems, Inc., formerly TMA Technologies, Inc. (TMA), the Companyestablished a royalty pool and vested in each shareholder and debt holder ofthe acquired company an interest in the royalty pool equal to the amountinvested or loaned including interest payable through March 1995.  The royalty pool is funded at 5% of net sales(defined as gross sales less returns, allowances and sales commissions) of theCompany’s surface measurement products and future derivative products developedby Schmitt Industries, Inc., which utilize these technologies.  As part of the royalty pool agreement, eachformer shareholder and debt holder released TMA from any claims with regard tothe acquisition except their rights to future royalties.  Royalty expense applicable to the years endedMay 31, 2007, 2006 and 2005 amounted to $89,350, $87,567 and $79,268,respectively.

**NOTE 7SEGMENT INFORMATION**

The Company has two reportable business segments: thedesign and assembly of dynamic balancing systems and components for the machinetool industry (Balancer), and the design and assembly of laser measurementsystems (Measurement).  The Companyoperates in three principal geographic markets, United States, Europe and Asia.

27

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| ** **                          | ** ** | **Year Ended May 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                          | ** ** | **Balancer**                          | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| Gross sales                         |       | $                                     | 8,587,432  |   | $ | 4,077,510 |   | $ | 8,429,409 |   | $ | 3,765,191 |   | $ | 8,276,258 |   | $ | 3,188,941 |   |
| Intercompany sales                  |       | (663,805                              | )          | (119,061 | ) | (610,740 | ) | (80,500 | ) | (845,971 | ) | (27,999 | ) |
| Net sales                           |       | $                                     | 7,923,627  |   | $ | 3,958,449 |   | $ | 7,818,669 |   | $ | 3,684,691 |   | $ | 7,430,287 |   | $ | 3,160,942 |   |
| Operating income                    |       | $                                     | 697,330    |   | $ | 1,071,120 |   | $ | 674,446 |   | $ | 1,059,150 |   | $ | 274,710 |   | $ | 941,750 |   |
| Intercompany rent  expense (income) |       | $                                     | (30,000    | ) | $ | 30,000 |   | $ | (30,000 | ) | $ | 30,000 |   | $ | (30,000 | ) | $ | 30,000 |   |
| Depreciation expense                |       | $                                     | 143,569    |   | $ | 27,734 |   | $ | 139,905 |   | $ | 36,097 |   | $ | 137,184 |   | $ | 43,146 |   |
| Amortization expense                |       | $                                     | —     |   | $ | 34,608 |   | $ | — |   | $ | 34,604 |   | $ | — |   | $ | 34,603 |   |
| Advances on convertible  note       |       | $                                     | 200,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Capital expenditures                |       | $                                     | 171,207    |   | $ | 26,028 |   | $ | 54,903 |   | $ | 61,965 |   | $ | 103,658 |   | $ | 17,263 |   |

 

***GeographicInformation***

|                      | ** ** | **Year Ended May 31,** | ** ** |
|----------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| North American       |       |                                  |       |   |   |   |   |
| United States        |       | $                                     | 5,855,118  |   | $ | 5,709,044 |   | $ | 5,610,274 |   |
| Canada and Mexico    |       | 200,011                               |       | 169,494 |   | 262,466 |   |
| North American total |       | 6,055,129                             |       | 5,878,538 |   | 5,872,740 |   |
| European             |       |                                  |       |   |   |   |   |
| Germany              |       | 261,979                               |       | 313,655 |   | 552,438 |   |
| Intercompany         |       | —                                |       | (10,293 | ) |   |   |
| Germany total        |       | 261,979                               |       | 303,362 |   | 552,438 |   |
| United Kingdom       |       | 1,159,406                             |       | 1,081,981 |   | 1,276,968 |   |
| Intercompany         |       | (724,417                              | )          | (677,415 | ) | (873,970 | ) |
| United Kingdom total |       | 434,989                               |       | 404,566 |   | 402,998 |   |
| Other European       |       | 1,401,709                             |       | 1,056,419 |   | 1,120,653 |   |
| Total European       |       | 2,098,677                             |       | 1,764,347 |   | 2,076,089 |   |
| Asia                 |       | 2,702,531                             |       | 2,919,556 |   | 2,122,384 |   |
| Other markets        |       | 1,025,739                             |       | 940,919 |   | 520,016 |   |
| Total Net Sales      |       | $                                     | 11,882,076 |   | $ | 11,503,360 |   | $ | 10,591,229 |   |

 
| ** **                    | ** ** | **Year Ended May 31,** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **2007**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                    | ** ** | **United States**                | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** |
| Operating income (loss)       |       | $                                     | 1,475,710  |   | $ | 292,740 |   | $ | 1,730,712 |   | $ | 2,884 |   | $ | 1,547,349 |   | $ | (330,889 | ) |
| Depreciation expense          |       | $                                     | 159,953    |   | $ | 11,350 |   | $ | 164,394 |   | $ | 11,608 |   | $ | 172,903 |   | $ | 7,427 |   |
| Amortization expense          |       | $                                     | 34,608     |   | $ | — |   | $ | 34,604 |   | $ | — |   | $ | 34,603 |   | $ | — |   |
| Advances on convertible  note |       | $                                     | 200,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Capital expenditures          |       | $                                     | 196,787    |   | $ | 448 |   | $ | 112,101 |   | $ | 4,767 |   | $ | 120,921 |   | $ | — |   |

 

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**Segment andGeographic Assets**

|                                    | ** ** | **May 31, 2007** | ** ** | **May 31, 2006** | ** ** |
|------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Segment assets  to total assets    |       |                       |       |                       |       |
| Balancer                           |       | $                          | 5,022,717  |                       | $          | 4,659,418 |   |
| Measurement                        |       | 1,792,731                  |       | 2,060,665                  |       |
| Corporate assets                   |       | 5,655,448                  |       | 4,206,472                  |       |
| Total assets                       |       | $                          | 12,470,896 |                       | $          | 10,926,555 |   |
|                               |       |                       |       |                       |       |
| Geographic  assets to total assets |       |                       |       |                       |       |
| United States                      |       | $                          | 11,812,573 |                       | $          | 10,164,617 |   |
| Europe                             |       | 658,323                    |       | 761,938                    |       |
| Total assets                       |       | $                          | 12,470,896 |                       | $          | 10,926,555 |   |

Note — Europe isdefined as the European subsidiary, Schmitt Europe, Ltd.

**NOTE 8**

**STOCK OPTIONS ANDSTOCK BASED COMPENSATION**

The Board ofDirectors adopted the 2004 Stock Option Plan (2004 Plan) in August 2004 and the1995 Stock Option Plan (1995 Plan) in December 1995, which plan was amended inAugust 1996 and restated in August 1998. An option granted under the 2004 Plan and/or 1995 Plan (the Plans) mightbe either an incentive stock option (ISO), or a nonstatutory stock option(NSO).  ISOs may be granted only toemployees and members of the Board of Directors of the Company and are subjectto certain limitations, in addition to restrictions applicable to all stockoptions under the Plan.  Options notmeeting these limitations will be treated as NSOs.  The purchase price of ISOs is fair marketvalue on the date of grant; the purchase price of NSOs may vary from fairmarket value.  Vesting is at thediscretion of the compensation committee of the Board of Directors, but iseither 50% at grant date and 16.7% on each anniversary thereafter or 50% atgrant date and 25% on each anniversary thereafter.  The Company initially reserved 400,000 sharesfor issuance under the 1995 Plan and 300,000 shares for issuance under the 2004Plan.  The 1995 Plan expired in December2005 and no additional options may be issued under the 1995 Plan, althoughexpiration of the 1995 Plan did not affect the rights of persons who receivedstock grants under the 1995 Plan. Stock-based compensation recognized in the Company’s ConsolidatedFinancial Statements for the year ended May 31, 2007 includes compensation costfor stock-based awards granted prior to, but not fully vested as of, May 31,2006.  There were no stock-based awardsgranted subsequent to May 31, 2006.  Alloutstanding options will expire no later than 2015.

Upon adoption ofSFAS 123(R), the Company continued to use the Black-Scholes option pricingmodel as its method of valuation for stock-based awards. The Company’sdetermination of the fair value of stock-based awards on the date of grantusing an option pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.  Although the fair value of stock-based awardsis determined in accordance with SFAS 123(R) and SAB 107, the Black-Scholesoption pricing model requires the input of highly subjective assumptions, andother reasonable assumptions could provide differing results.  These variables include, but are not limitedto:

·                  *Risk-Free Interest Rate.* The Company bases the risk-free interest rate on the implied yieldcurrently available on U.S. Treasury issues with an equivalent remaining termapproximately equal to the expected life of the award.

·                  *Expected Life.*  Theexpected life of awards granted represents the period of time that they areexpected to be outstanding.  The Companydetermines the expected life based on historical experience with similarawards, giving consideration to the contractual terms, vesting schedules andpre-vesting and post-vesting forfeitures.

·                  *Expected Volatility.* The Company estimates the volatility of its common stock at the date ofgrant based on the historical volatility of its common stock. The volatilityfactor the Company uses is based on its historical stock prices over the mostrecent period commensurate with the estimated expected life of the award. Thesehistorical periods may exclude portions of time when unusual transactionsoccurred.

29

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·                  *Expected Dividend Yield.* The Company has never paid any cash dividends on its common stock anddoes not anticipate paying any cash dividends in the foreseeable future.Consequently, the Company uses an expected dividend yield of zero.

·                  *Expected Forfeitures.* The Company uses relevant historical data to estimate pre-vesting optionforfeitures. The Company records stock-based compensation only for those awardsthat are expected to vest.

The Company hascomputed, to determine stock-based compensation expense recognized for the yearended May 31, 2007 and for pro forma disclosure purposes for the years endedMay 31, 2006 and 2005, the value of all stock options granted using theBlack-Scholes option pricing model as prescribed by SFAS No. 123(R) using thefollowing assumptions:

 

| **Risk-free interest rate** |   | 3.8-4.45 %    |
|-----------------------------|--------|---------------|
| **Expected  life**          |   | 4.0-4.7 years |
| **Expected  volatility**    |   | 95-102 %      |

 

**Stock-BasedCompensation Under FAS 123(R)**

The followingtable summarizes stock-based compensation expense related to stock-based awardsunder SFAS 123(R) for the year ended May 31, 2007 and what certain operatingresults would have been without the effects of applying SFAS No. 123(R).

|                                      | ** ** | **As reported** | ** ** | **Pro Forma without  effects of applying  SFAS No. 123(R)** | ** ** |
|--------------------------------------|------------|----------------------|------------|-------------------------------------------------------------------------------------------|------------|
|                                 |       |                 |       |                                                                                      |       |
| General, administration  and sales   |       | $                    | 4,770,996  |                                                                                      | $          | 4,724,573 |   |
| Income before income  taxes          |       | $                    | 1,994,825  |                                                                                      | $          | 2,041,248 |   |
| Net income                           |       | $                    | 1,284,825  |                                                                                      | $          | 1,313,422 |   |
| Cash flow from  operating activities |       | $                    | 2,130,747  |                                                                                      | $          | 2,187,590 |   |
| Cash flow from financing  activities |       | $                    | 119,959    |                                                                                      | $          | 63,116 |   |
| Basic earnings per  share            |       | $                    | 0.49       |                                                                                      | $          | 0.50 |   |
| Diluted earnings per share           |       | $                    | 0.47       |                                                                                      | $          | 0.48 |   |

 

At May 31, 2007 the Company had a total of 175,871outstanding stock options (159,247 vested and exercisable and 16,624 non-vested)with a weighted average exercise price of $2.57.  The Company estimates that a total ofapproximately $50,517 will be recorded as additional stock-based compensationexpense over the period beginning with the year ending May 31, 2008 through thefiscal year ending May 31, 2009, for all options which are outstanding as ofMay 31, 2007, but which were not yet vested.

 

| Outstanding Options   | ** ** | **Exercisable Options**               | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life (yrs)** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| 76,247                     |       | $                                          | 1.20       |   | 4.8 |   | 76,247 |   | $ | 1.20 |   |
| 68,124                     |       | 2.30                                       |       | 6.8 |   | 65,625 |   | 2.30 |   |
| 5,000                      |       | 5.80                                       |       | 8.4 |   | 3,750 |   | 5.80 |   |
| 26,500                     |       | 6.58                                       |       | 8.3 |   | 13,625 |   | 6.58 |   |
| 175,871                    |       | $                                          | 2.57       |   | 6.2 |   | 159,247 |   | $ | 2.22 |   |

 

30

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Options granted, exercised, canceled and expired underthe Company’s stock option plan during the years ended May 31, 2007, 2006 and2005 are summarized as follows:

|                                     | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Options outstanding -  May 31, 2004 |       | 170,516                    |       | $                                          | 1.20       |   |
| Options granted                     |       | 165,500                    |       | 2.30                                       |       |
| Options  exercised                  |       | (85,226                    | )          | 1.59                                       |       |
| Options  forfeited/cancelled        |       | —                     |       |                                       |       |
| Options outstanding -  May 31, 2005 |       | 250,790                    |       | $                                          | 1.79       |   |
|                                |       |                       |       |                                       |       |
| Options granted                     |       | 34,000                     |       | 6.47                                       |       |
| Options exercised                   |       | (63,294                    | )          | 1.83                                       |       |
| Options  forfeited/cancelled        |       | (5,000                     | )          | 2.30                                       |       |
| Options outstanding -  May 31, 2006 |       | 216,496                    |       | $                                          | 2.52       |   |
|                                |       |                       |       |                                       |       |
| Options granted                     |       | —                     |       | —                                     |       |
| Options  exercised                  |       | (39,374                    | )          | 2.15                                       |       |
| Options  forfeited/cancelled        |       | (1,251                     | )          | 6.58                                       |       |
| Options outstanding - May 31, 2007  |       | 175,871                    |       | $                                          | 2.57       |   |

 

The total intrinsic value of outstanding andexercisable options at May 31, 2007 was $922,001 and $889,883,respectively.   The total intrinsic valueof options exercised during the years ended May 31, 2007, 2006 and 2005was $198,207, $402,122 and $428,106, respectively.

**Pro FormaInformation under SFAS 123 and APB 25**

Prior to June 1,2006, the Company elected to follow the accounting provisions of APB 25 forstock-based compensation and to furnish the pro forma disclosures requiredunder SFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure.”  No stock-based employeecompensation cost was reflected in net income because all options granted underthe Company’s stock option plan had an exercise price equal to the market valueof the underlying common stock on the date of the grant.

The followingtable illustrates the effect on the Company’s net income and basic and dilutednet income per share for the years ended May 31, 2006 and 2005 had compensationcost for the plans been determined based on the fair value at the grant datesfor awards under those plans consistent with the method of SFAS 123.

|                                                                                                                               | ** ** | **Year Ended May 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Net income, as reported                                                                                                       |       | $                                     | 1,350,129  |   | $ | 1,608,140 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of tax |       | (120,411                              | )          | (230,865 | ) |
| Pro forma net income                                                                                                          |       | $                                     | 1,229,718  |   | $ | 1,377,275 |   |
| Earnings per share —  basic                                                                                              |       |                                  |       |   |   |
| As reported                                                                                                                   |       | $                                     | 0.52       |   | $ | 0.64 |   |
| Pro forma                                                                                                                     |       | $                                     | 0.47       |   | $ | 0.54 |   |
| Earnings per share —  diluted                                                                                            |       |                                  |       |   |   |
| As reported                                                                                                                   |       | $                                     | 0.49       |   | $ | 0.59 |   |
| Pro forma                                                                                                                     |       | $                                     | 0.45       |   | $ | 0.51 |   |

 

31

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**NOTE 9**

**EARNINGS PER SHARE**

Basicearnings per share is computed using the weighted average number of sharesoutstanding.  Diluted earnings per shareis computed using the weighted average number of shares outstanding, adjustedfor dilutive incremental shares attributed to outstanding options to purchasecommon stock.  The following table is areconciliation of the numerators and denominators of the basic and diluted pershare computations for each of the three years in the period ended May 31,2007:

|                                              | ** ** | **Income  (Numerator)** | ** ** | **Weighted  Average Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|--------------------------------------------------|------------|----------------------------|------------|
| **Year ended May 31, 2007**                  | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **                 | ** ** |
| Basic earnings  per share                    |       |                    |       |                                             |       |                       |       |
| Income available  to common stockholders     |       | $                       | 1,284,825  |                                             | 2,649,284  |                       | $          | 0.49 |   |
| Effect of  dilutive securities stock options |       | —                  |       | 113,777                                          |       |                       |       |
| Diluted earnings  per share                  |       |                    |       |                                             |       |                       |       |
| Income available  to common stockholders     |       | $                       | 1,284,825  |                                             | 2,763,061  |                       | $          | 0.47 |   |
| ** **                                   | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **                 | ** ** |
| **Year ended May 31, 2006**                  | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **                 | ** ** |
| Basic earnings  per share                    |       |                    |       |                                             |       |                       |       |
| Income available  to common stockholders     |       | $                       | 1,350,129  |                                             | 2,606,039  |                       | $          | 0.52 |   |
| Effect of  dilutive securities stock options |       | —                  |       | 140,363                                          |       |                       |       |
| Diluted earnings  per share                  |       |                    |       |                                             |       |                       |       |
| Income available  to common stockholders     |       | $                       | 1,350,129  |                                             | 2,746,402  |                       | $          | 0.49 |   |
| ** **                                   | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **                 | ** ** |
| **Year ended May 31, 2005**                  | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **                 | ** ** |
| Basic earnings  per share                    |       |                    |       |                                             |       |                       |       |
| Income available  to common stockholders     |       | $                       | 1,608,140  |                                             | 2,527,665  |                       | $          | 0.64 |   |
| Effect of dilutive  securities stock options |       | —                  |       | 181,132                                          |       |                       |       |
| Diluted earnings  per share                  |       |                    |       |                                             |       |                       |       |
| Income available to  common stockholders     |       | $                       | 1,608,140  |                                             | 2,708,797  |                       | $          | 0.59 |   |

 

**NOTE 10**

**RELATED PARTYTRANSACTIONS**

EffectiveJune 1, 2004, the Company entered into a contract to provide consultingservices to PulverDryer USA, Inc., (“PulverDryer”) pursuant to whichPulverDryer paid the Company $8,000 a month from June 2004 through October2004.  PulverDryer also buys certainproducts from the Company at normal prevailing rates.  The Company and PulverDryer extended thecontract from November 1, 2004 forward at that same monthly fee of $8,000.  Product sales to PulverDryer during thefiscal years ended May 31, 2007, 2006 and 2005 totaled $35,300, $152,305 and$88,873, respectively.

In connection withthe contract, the Board authorized Wayne Case, the Company’s Chief ExecutiveOfficer, to provide advisory services to PulverDryer, and permitted Mr. Case toreceive as compensation the total consulting fees paid by PulverDryer from June2004 through October 2004.  EffectiveNovember 1, 2004, Mr. Case receives 40% of the ongoing consulting fee fromPulverDryer, which percentage was determined by the Compensation Committee.  Mr. Case also serves on the board ofdirectors of PulverDryer.

32

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**NOTE 11**

**QUARTERLYFINANCIAL DATA**

***Inthousands, except per share information (unaudited)***

 

| 2007 Quarter Ended   | ** ** | **August  31** | ** ** | **November  30** | ** ** | **February  28** | ** ** | **May  31** | ** ** |
|--------------------------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|
| Sales                          |       | $              | 3,073      |             | $          | 2,930            |       | $           | 2,971      |   | $ | 2,909 |   |
| Gross profit                   |       | $              | 1,598      |             | $          | 1,642            |       | $           | 1,250      |   | $ | 1,667 |   |
| Net income                     |       | $              | 271        |             | $          | 271              | (1)        | $           | 388        |   | $ | 355 |   |
| Net income per share,  basic   |       | $              | .10        |             | $          | .10              | (1)        | $           | .15        |   | $ | .13 |   |
| Net income per share,  diluted |       | $              | .10        |             | $          | .10              | (1)        | $           | .14        |   | $ | .13 |   |
| Market Price of Common  Stock  |       |           |       |             |       |             |       |        |       |
| High                           |       | $              | 7.99       |             | $          | 7.86             |       | $           | 7.98       |   | $ | 8.20 |   |
| Low                            |       | $              | 6.58       |             | $          | 6.27             |       | $           | 7.04       |   | $ | 7.20 |   |

 

| 2006 Quarter Ended   | ** ** | **August  31** | ** ** | **November  30** | ** ** | **February  28** | ** ** | **May  31** | ** ** |
|--------------------------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|
| Sales                          |       | $              | 2,665      |             | $          | 2,606            |       | $           | 2,707      |   | $ | 3,525 |   |
| Gross profit                   |       | $              | 1,428      |             | $          | 1,506            |       | $           | 1,414      |   | $ | 2,126 |   |
| Net income                     |       | $              | 243        |             | $          | 395              |       | $           | 198        |   | $ | 514 |   |
| Net income per share,  basic   |       | $              | .09        |             | $          | .15              |       | $           | .08        |   | $ | .20 |   |
| Net income per share,  diluted |       | $              | .09        |             | $          | .14              |       | $           | .07        |   | $ | .19 |   |
| Market Price of Common  Stock  |       |           |       |             |       |             |       |        |       |
| High                           |       | $              | 11.95      |             | $          | 9.10             |       | $           | 7.47       |   | $ | 8.39 |   |
| Low                            |       | $              | 7.69       |             | $          | 5.40             |       | $           | 5.47       |   | $ | 5.78 |   |

----

(1)             Asreported in our Quarterly Report on Form 10-Q for the three and ninemonths ended February 28, 2007, net income as previously reported in ourQuarterly Report on Form 10-Q for the three and six months endedNovember 30, 2006 was restated as the provision for income taxes did notconsider certain income taxes on a portion of net income from the Company’swholly owned subsidiary located in the United Kingdom.

33

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***Report of IndependentRegistered Public Accounting Firm***

Board of Directors andShareholders

Schmitt Industries, Inc.

We have audited theaccompanying consolidated balance sheets of Schmitt Industries, Inc. and itssubsidiaries as of May 31, 2007 and 2006, and the related consolidatedstatements of operations, changes in stockholders’ equity and comprehensiveincome and cash flows for each of the three years in the period ended May 31,2007.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform an audit of its internal control over financialreporting. Our audit included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

As discussed in Note 1 tothe consolidated financial statements, the Company changed its method ofaccounting for stock-based compensation as a result of adopting Statement ofFinancial Accounting Standards No. 123(R), Share-Based Payment (Revised 2004),effective June 1, 2006.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Schmitt Industries, Inc. as of May 31, 2007and 2006 and the results of its operations and its cash flows for each of thethree years in the period ended May 31, 2007 in conformity with accountingprinciples generally accepted in the United States of America.

/s/ GRANT THORNTONLLP

Portland, OregonJuly 30, 2007

34

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**Item 9.****                                   Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

None.

**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 Rules 13a-15(e) and 15d — 15(e) promulgated under the Securities ExchangeAct of 1934, as amended, as of the end of the period covered by thisreport.  Based on their evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures are effective as of the end of the periodcovered by this 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.

**Item 9B.         Other Information**

None.

**PARTIII**

Certaininformation required by Part III is included in the Company’s definitive ProxyStatement for its 2007 Annual Meeting of Shareholders (“Proxy Statement”) andis incorporated herein by reference.  TheProxy Statement will be filed pursuant to Regulation 14A of the SecuritiesExchange Act of 1934 not later than 120 days after the end of the fiscal yearcovered by this Report.

**Item 10.         Directors, Executive Officers andCorporate Governance**

The information required by this item is included in the Company’s ProxyStatement relating to the 2007 Annual Meeting of Shareholders and isincorporated herein by reference.

**Item 11.         Executive Compensation**

The information required by this item is includedin the Company’s Proxy Statement relating to the 2007 Annual Meeting ofShareholders and is incorporated herein by reference.

**Item 12.****                            Security Ownership of Certain Beneficial Ownersand Management and Related Stockholder Matters**

The information required by this item is included in the Company’s ProxyStatement relating to the 2007 Annual Meeting of Shareholders and isincorporated herein by reference.

Thistable shows information about equity awards under the Company’s equitycompensation plans at May 31, 2007:

| Plan Category                                          | ** ** | **Number of  Securities to be  issued upon  exercise of  outstanding  options** | ** ** | **Weighted-average  exercise price of  outstanding options** | ** ** | **Number of Securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities  in column a)** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **a**                                                                                                    | ** ** | **b**                                                                       | ** ** | **c**                                                                                                                                                                                       | ** ** |
| Equity compensation  plans approved by security holders     |       | 175,871                                                                                                  |       | $                                                                           | 2.57       |                                                                                                                                                                                        | 275,000    |   |
|                                                        |       |                                                                                                     |       |                                                                        |       |                                                                                                                                                                                        |       |
| Equity compensation  plans not approved by security holders |       | —                                                                                                   |       | —                                                                      |       | —                                                                                                                                                                                      |       |
|                                                        |       | 175,871                                                                                                  |       | $                                                                           | 2.57       |                                                                                                                                                                                        | 275,000    |   |

** **

35

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**Item 13.         CertainRelationships and Related Transactions and Director Independence**

The information required by this item is included in the Company’s ProxyStatement relating to the 2007 Annual Meeting of Shareholders and isincorporated herein by reference.

**Item 14.         PrincipalAccounting Fees and Services**

The information required by this item is included in the Company’s ProxyStatement relating to the 2007 Annual Meeting of Shareholders and isincorporated herein by reference.

**PART IV**

**Item 15.         Exhibits and Financial StatementSchedules**

*(a)          Financial Statements:*
|        | (1)    |     | Consolidated Balance Sheets as of May 31, 2007 and  2006                                                                                                                                                                      |
|--------|--------|----------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |     |                                                                                                                                                                                                                          |
|   |   |     | Consolidated Statements of Operations for the years  ended May 31, 2007, 2006 and 2005                                                                                                                                        |
|   |   |     |                                                                                                                                                                                                                          |
|   |   |     | Consolidated Statements of Cash Flows for the years  ended May 31, 2007, 2006 and 2005                                                                                                                                        |
|   |   |     |                                                                                                                                                                                                                          |
|   |   |     | Consolidated Statements of Changes in Stockholders’  Equity and Comprehensive Income for the years ended May 31, 2007, 2006 and  2005                                                                                    |
|   |   |     |                                                                                                                                                                                                                          |
|   |   |     | Notes to Consolidated Financial Statements for the  years ended May 31, 2007, 2006 and 2005                                                                                                                                   |
|   |   |     |                                                                                                                                                                                                                          |
|   |   |     | Report of Independent Registered Public Accounting  Firm                                                                                                                                                                      |
|   |   |     |                                                                                                                                                                                                                          |
|   | (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 38 of the Exhibits filed with this report.                                                                                                                                  |

 

36

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|            | **SCHMITT INDUSTRIES, INC.** |
|------------|------------------------------|
| ** ** | ** **                   |
| ** ** | ** **                   |
|       | By:                          | /s/ Wayne A. Case |
|       |                         | Wayne A. Case |
| * *   |                         | *Chairman of the Board, President* |
| * *   |                         | *and Chief Executive Officer* |
| * *   |                         | * * |
|       | Date: July 31, 2007          |

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities indicated on July 31, 2007.

 
| **Signature**             | ** ** | **Title**                                                     |
|---------------------------|------------|---------------------------------------------------------------|
|                      |       |                                                          |
| /s/ Wayne A. Case         |       | Chairman of the Board, President and Chief Executive  Officer |
|  Wayne A. Case       |       | (Principal Executive Officer)                                 |
|                      |       |                                                          |
| /s/ Michael S. McAfee     |       | Chief Financial Officer/Treasurer                             |
|  Michael S.  McAfee  |       | (Principal Financial and Accounting Officer)                  |
|                      |       |                                                          |
| /s/ Maynard Brown         |       | Director                                                      |
| Maynard Brown             |       |                                                          |
|                      |       |                                                          |
| /s/ Timothy D.J. Hennessy |       | Director                                                      |
| Timothy D.J. Hennessy     |       |                                                          |
|                      |       |                                                          |
| /s/ David M. Hudson       |       | Director                                                      |
| David M. Hudson           |       |                                                          |
|                      |       |                                                          |
| /s/ Michael J. Ellsworth  |       | Director                                                      |
| Michael J. Ellsworth      |       |                                                          |

 

37

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**INDEX TO EXHIBITS**
| Exhibits                                                                                                                                                                                                                                         | ** ** | **Description**                                                                                                                                                                          |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibits marked with an asterisk (*) are  incorporated by reference to exhibits or appendices previously filed with the  Securities and Exchange Commission, as indicated by the references in brackets.  All other exhibits are filed herewith. |
|                                                                                                                                                                                                                                             |       |                                                                                                                                                                                     |
| *3.1                                                                                                                                                                                                                                             |       | Second Restated Articles of Incorporation of Schmitt  Industries, Inc. (the Company).**[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 3(i)]**                                |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| *3.2                                                                                                                                                                                                                                             |       | Second Restated Bylaws of the Company.**[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 3(ii)]**                                                                              |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| *4.1                                                                                                                                                                                                                                             |       | See exhibits 3.1 and 3.2 for provisions of the  Articles of Incorporation and Bylaws defining the rights of security holders.                                                            |
|                                                                                                                                                                                                                                             |       |                                                                                                                                                                                     |
| *10.1†                                                                                                                                                                                                                                      |       | Schmitt Industries, Inc. Amended & Restated Stock  Option Plan (the 1995 Plan).**[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 10.1]**                                  |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| *10.2†                                                                                                                                                                                                                                      |       | Employment Agreement of Wayne A. Case dated January  1, 2004.**[Form 10-Q for the fiscal quarter ended February 29, 2004, Exhibit 10.1]**                                                |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| *10.3†                                                                                                                                                                                                                                      |       | Schmitt Industries, Inc. 2004 Stock Option Plan.**[Appendix B to Schedule 14A filed on August 23,  2004]**                                                                               |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| *10.4†                                                                                                                                                                                                                                      |       | Employment Agreement of Michael S. McAfee dated  September 21, 2005.**[Form 8-K filed on September 23, 2005, Exhibit 10.1]**                                                             |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| *14.1                                                                                                                                                                                                                                            |       | Code of Ethics and Business Conduct.**[Form 10-K for the fiscal year ended May 31, 2004, Exhibit 14.1]**                                                                                 |
|                                                                                                                                                                                                                                             |       | ** **                                                                                                                                                                               |
| 21.1                                                                                                                                                                                                                                             |       | Subsidiaries of Schmitt Industries, Inc. as of May  31, 2007.                                                                                                                            |
|                                                                                                                                                                                                                                             |       |                                                                                                                                                                                     |
| 23.1                                                                                                                                                                                                                                             |       | Consent of Independent Registered Public Accounting  Firm.                                                                                                                               |
|                                                                                                                                                                                                                                             |       |                                                                                                                                                                                     |
| 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. |

 

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†                     Managementcontract or compensatory plan or arrangement required to be filed as an exhibitto this Form 10-K..

38

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