**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-K**

 

**(Mark One)**

 
| ý | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|--------|------------------------------------------------------------------------------------------------|
|   | **For the  Fiscal year ended: May 31, 2004**                                                   |

 

**or**

 
| o      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                     |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | **For the  transition period from                                 to                              ** |

 

**Commission File Number: 0-23996**

 

**SCHMITTINDUSTRIES, INC.**

(Exact name of registrant as specified in its charter)

 
| **Oregon**                                                       | ** ** | **93-1151989**                       |
|------------------------------------------------------------------|------------|--------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (IRS Employer Identification Number) |
|                                                             |       |                                 |
| **2765 N.W. Nicolai Street  Portland, Oregon 97210**             |
| (Address  of principal executive offices) (Zip Code)             |
|                                                             |       |                                 |
| **(503) 227-7908**                                               |
| (Registrant’s  telephone number, including area code)       |

 

Securities registeredpursuant to Section 12(b) of the Act:

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

 

Securities registeredpursuant to Section 12(g) of the Act:

 

**Common Stock - no par value**

(Titleof each class)

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes ý     No o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 of RegulationS-K is not contained herein, and will not be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendmentto this Form 10-K.  ý

 

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

 

Asof June 30, 2004, the aggregate market value of the registrant’s CommonStock held by nonaffiliates of the registrant was $9,576,164 based on theclosing sales price of the registrant’s Common Stock on the Nasdaq SmallCapMarket.  On that date, there were2,474,461 shares of Common Stock outstanding.

 

Documents Incorporated by Reference

 

Portionsof the registrant’s definitive Proxy Statement for its 2004 Annual Meeting ofShareholders are incorporated by reference into Part III hereof.

 

 

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**PART I**

 

**Item1.  Business**

 

***Introduction***

 

The Company(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,the Company designs, manufactures and markets precision laser measurementsystems (the Measurement Segment). The Company also sells and markets itsproducts in Europe through its wholly owned subsidiaries, Schmitt Europe Ltd.(“SEL”), located in the United Kingdom and Schmitt Europa GmbH (“SEG”), locatedin Germany.  The Company’s executiveoffices are located at 2765 N.W. Nicolai Street, Portland, Oregon97210, and its telephone number is (503) 227-7908.

 

***Balancer Segment***

 

The Company’sprincipal product is the Schmitt Dynamic Balance System (the “SBS System”),consisting of a computer control unit, sensor, spindle-mounting adapter, andbalance head.  It is designed to be aninexpensive, yet highly accurate, permanent installation on grinding machines.The Company acquired its original balancing equipment technology pursuant to aseries of agreements from 1987 through 1991 and substantially enhanced andadvanced the patented technology since that time.  Since inception the targeted customer basehas been operators of grinding machines.

 

The SBS Systemis fully automated, eliminating the need to pre-balance such devices asgrinding wheels.  This reduces machinesetup 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 balance cycle is complete when the weights arepositioned to achieve the lowest vibration 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.

 

Benefits tothe 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 all 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. Precisiongrinding has an established worldwide presence in all industrialized countriesand is expanding as a method of material removal and processing.  Therefore, the Company believes there may bean increase in market growth and the need for automatic balancing. Within theindustry there are three major market segments:

 

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

 

Examples of some well-known worldwide machine tool builders who haveoffered and/or installed the SBS System include ANCA (Australia), BlohmIncorporated (U.S.), Blohm GmbH (Germany),

 

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

 

***Machine Tool Rebuilders –***These customers, found in all industrial nations, develop their business byoffering to completely update and refurbish older grinding machines. Theserebuilders typically tear the old machine apart and install new components,such as the SBS System.  The Companycurrently sells its products directly to major machine rebuilders in the U.S.and Western Europe.

 

***Grinding Machine Users -***These end users become aware of the SBS System through trade shows, trademagazine advertising, distributors, field representatives, referrals and newmachine suppliers.  The Company’sbusiness is conducted worldwide with some better known customers including:Black & Decker, Briggs and Stratton, Caterpillar Inc., DaewooInternational Corp., Eaton Corporation, Ford Motor Company, General ElectricCorp., General Motors, Ingersoll Rand, Sumitomo Heavy Industries, TexasInstruments, The Timken Company, Torrington, TRW Automotive Components and WestinghouseElectric Corp.

 

Theacquisition of SEG added other technology and designs, including the internalspindle, ring and water balancer designs to the Company’s product line (the SEGsystems).  These proven designs allowSchmitt to provide products to a broad range of machine applications.

 

In Fiscal2004, 2003 and 2002, net sales of the Company’s balancing products totaled$5,924,854, $5,481,010 and $5,275,556 respectively.  Net sales of balancing products accounted for75% of the Company’s revenue in Fiscal 2004, 74% in Fiscal 2003 and77% in Fiscal 2002.  See Note 9 toConsolidated Financial Statements.

 

***Competition*:**

 

Managementbelieves the SBS System is one of few fully automatic balancing systemsmarketed in the world.  Most competitiveproducts require special setup and training or calibration to the specificmachine. The Company believes the SBS System is currently the only balancingproduct that fits all machines with wheel sizes from 6 to 48 inches indiameter and a spindle rpm of 500 through 7,500.

 

Competitiveproducts come from European companies located in Switzerland, Germany, Spainand Italy.  These competitors produceelectromechanical balancers similar to the SBS System and water balancerssimilar to the SEG system.  The Companyconsiders these companies, with their established European base, to be themajor competitors.  These balancers haveelectronic deficiencies, rendering them less effective in solving essentialbalancing requirements.  They cannotachieve the consistent low balance levels at 500-rpm (low speed) or at 7,500rpm (high speed) as the SBS system can. In addition, these balancers have inferior brush and cable assembliesthat cause down time and high maintenance. Finally, none of these companies can currently compete effectively withthe Company in providing mounting adapters for all grinding machines.

 

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

 

The SBS Systemlist price is generally $7,995 worldwide. Competitors’ electromechanical systems are priced at $8,000 to $10,000worldwide while water balancers are priced at $9,000 to $11,000 worldwide.  Management believes customers perceive thevalue of an automatic balancer to be approximately $8,000; therefore, Companypricing is geared to obtaining a dominant market position and meetingcompetitive

 

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

 

***Measurement Segment***

 

The Companymanufactures and markets a line of laser-based, precision measurement systemsand operates a precision laser light scatter measurement laboratory.  Light scatter technology involves usinglasers, optics and detectors to throw 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.

 

There are fourproduct lines: laser-based light-scatter measurement, dimensional sizing,research and other laser alignment products and a light-scatter measurementlaboratory.

 

***Laser-based light-scatter measurement:***

 

These productsuse a patented laser light scatter technology to perform rapid, accurate,repeatable and non-destructive non-contact surface measurement tests thatquantify surface micro-roughness. Products are sold to manufacturers of disk drives and silicon wafers,both industries with fabrication processes that require precise and reliablemeasurements.

 

Computer hard disks requireexact manufacturing control and a narrow tolerance band for acceptableroughness, with surface roughness outside that narrow band resulting in areduction in data density or storage capacity. The Company’s technology simultaneously measures disk surface roughnessin two directions, radially, when the read/write head is moving to another disksector and circumferentially, when the read/write head is processinginformation on the disk.  The twoseparate roughness levels are required for proper head operation.  The precise measurement methods provided bythe Company’s products are not possible through any other cost effectivemeasurement means. The following two products meet the challenges of disk drivemanufacturers and help prevent such problems from occurring:

 

•                  The originalTMS-2000 (Texture Measurement System) product, the world’s fastest and mostaccurate non-contact texture measurement system, revolutionizeddisk-manufacturing technology.  Theproduct (used on aluminum substrates) is currently used worldwide by most majordisk drive manufacturers and provides fast, accurate and repeatablemicroroughness measurements and quadruples production throughput when comparedto other testing devices.  Surface roughnesscan now be measured to levels below 0.5 Angstroms (the point of a needle is onemillion Angstroms in diameter).

 

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

 

Customers include IBM, SeagateSubstrates, Western Digital and Komag, Inc.

 

There are two products devotedto the silicon wafer industry, the TMS-2000W and TMS-3000W.  Both of these products provide fast,accurate, repeatable measurements for manufacturers of silicon wafers, computerchips and memory devices. This industry demands manufacturing precision toincrease performance and capacity and these products help achieve those goals.Silicon wafers are carefully cut and polished to provide the base upon which acomputer 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 SMS customers in this

 

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industry to quantify andcontrol their manufacturing process. The system provides measurements to a fewhundredths of an Angstrom, a level unachievable by other testing devices.

 

**Dimensional Sizing Products:**

 

These areproducts used in a wide range of industrial applications.  These include steel casting, paperproduction, medical imaging, crane control and micron-level part and surfaceinspection.  Presently, there are fourproduct lines: the AR4000 distance measurement sensor, the AR4000 Line Scannerand the AR600 and AR200 series of triangulating laser displacement sensors.

 

The AccuRange4000 is an optical distance measurement sensor 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.

 

The AR4000Line Scanner is used with the AccuRange 4000 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 AccuRange 4000. The scanner deflects the beam 90 degrees, sweeping it through a fullcircle as it rotates.  The product canscan at rates of up to 2600 lines per minute, sweeps the laser beam through afull 360 degrees and is both compact and lightweight.

 

The AR600series is a family of triangulating laser displacement sensors with excellentaccuracy and sensitivity.  The sensorprojects a beam of visible laser light that creates a spot on the targetsurface. Reflected light from the surface is viewed from an angle by a linescan camera and the target’s distance is 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 ofsurfaces at speeds up to 1250 samples/second. The product is extremely sensitive and can detect glass and liquid surfacesand also detect multiple surfaces of transparent materials, allowing greatflexibility in specialized applications.

 

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

 

**Researchand Other Measurement Products:**

 

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

 

The μScanSystem is a portable device consisting of a hand-held control unit, aninterchangeable 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

 

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conversion.From a single measurement, a user can determine RMS surface roughness,reflectance and scatter light levels (BRDF) on flat or curved surfaces underany lighting conditions.

 

**TestingLaboratory:**

 

The Companyprovides a highly advanced measurement services laboratory, using CASIScatterometers, to a wide variety of industrial and commercial businesses thatrequire precise measurements only advanced laser light scatter technology canprovide.  The true value of thelaboratory is not only its extremely precise measurement capability but alsothe test item is not altered, touched or destroyed.  Thus, the laboratory is widely used bymanufacturers of critical optical components in aerospace and defense systems,including such companies as Aerojet, AT&T Bell Labs, Eastman Kodak, GeneralElectric, IBM, NASA and dozens of other industrial companies, universities andgovernment agencies.

 

In Fiscal2004, 2003 and 2002, net sales of Measurement products totaled $1,999,912,$1,938,511 and $1,599,103 respectively and accounted for 25%, 26% and 23% ofthe Company’s total sales in Fiscal 2004, 2003 and 2002 respectively.

 

**Businessand Marketing Strategy**

 

The Companydesigns, assembles and markets all of its products with operations divided intoa number of different areas.

 

The VicePresident of Operations directs production of Balancer segment productsincluding production, assembly, purchasing, engineering and technicalservices.  Product marketing for allBalancer segment products is managed by the President/CEO.  Two Marketing Managers are responsible fordomestic sales while a third is responsible for sales in Mainland China, Taiwanand Korea.  The Company also has oneperson who performs field service/sales. The President/CEO is responsible for European sales and oversees theefforts of the European Marketing Manager who is headquartered in the UnitedKingdom.  Finally, there is a researchand development group supervised directly by the President/CEO and the VicePresident of Operations.

 

The Companymarkets and sells the Balancer segment products in a variety of ways.  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 are paid a 10% commission; distributorsare sold products at a 15% discount.

 

Second,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.

 

Third, original equipment manufacturers (OEMs) include theBalancer segment products on the machine tools they produce. Users thuspurchase the Balancer segment products concurrently with the machine tools.Conversely, end users of grinding machines that have purchased the SBS systemdirectly from the Company, and after enjoying the benefits of the products,often request that SBS products be included with the new equipment they orderfrom OEMs. The SBS Systems are often installed by machine builders prior todisplaying their own machine tools at various trade shows, becomingendorsements that prove beneficial to the Company’s sales efforts.

 

**In the United States, most products are shipped directly tocustomers from the Company’s distribution center in Portland, Oregon.  Where the Company has distributors, theproduct is shipped to the distributor, who in turn pays the Company directlyand then delivers and installs the product for the end user.  European distribution to customers is handledby shipping the product directly from the Company’s Portland headquarters tothe European subsidiary in the United Kingdom, who in turn sells anddistributes the products.**

 

The VicePresident of Operations directs production of all Measurement segment productsincluding production, assembly, purchasing, engineering and technicalservices.  Similar to the parent company,the

 

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Measurementsegment uses a variety of methods to market and sell its products.  First, a Marketing Manager, under thedirection of the President/CEO, directs the overall worldwide marketing effortsfor surface measurement products. Second, both a marketing and a sales manager, again under the directionof the President/CEO, direct the overall worldwide marketing and sales effortsfor dimensional sizing products.  Third,the Company has a nonexclusive distribution agreement with a company in Japanfor the promotion and sale of Measurement segment products in Japan, Korea,Malaysia, Singapore, the Philippines and Taiwan. Fourth, trade shows representa significant amount of marketing/sales effort. The President/CEO attends these events along with various Companyrepresentatives.  These individualsoperate a display booth featuring demonstrations of Measurement segmentproducts along with product and technical literature.  Representatives from all facets of the marketto which the Company directs its sales efforts attend these trade shows.  Finally, one of the best marketing channelsis the testing laboratory.  Oncecustomers see the capabilities of the technology, it can lead to orders for theCompany’s laser based light scatter measurement products.

 

**All Measurement segment products are assembled in thePortland, Oregon facility and shipped worldwide directly to customers.**

 

**The Balancer and Measurement segment customer bases eachconsist of over 250 companies respectively.**

 

**Manufacturing**

 

There are nounique sources of supply or raw materials in any product lines.  Essential electronic components, available inlarge quantities from various suppliers, are assembled into the Balancing andMeasurement electronic control units under the Company’s quality and assemblystandards.  Company-owned software andfirmware are coupled with the electronic components to provide the basis of theCompany’s various 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 Forest Electronics.

 

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; OEM Manufacturing of Corvallis,Oregon; Eagle Industries of Newberg, Oregon; and Forest City Gear of Roscoe,Illinois.

 

The Companyuses in-house skilled assemblers to construct and test vendor-suppliedcomponents. Component inventory of finished vendor-supplied parts is held onCompany property to assure adequate flow of parts to meet customer orderrequirements.  Inventory is monitored bya computer control system designed to assure timely re-ordering of components.

 

In-housepersonnel assemble various products and test all finished components beforeplacing them in the finished goods inventory. Finished goods inventory is maintained via computer to assure timelyshipment and service to customers.  Allcustomer shipments are from the finished goods inventory.

 

InNovember 1996, the Company’s Quality Control Program received fullISO-9001 certification.  The Company ispresently transitioning its certification to the new ISO-2000 requirements.

 

**ProprietaryTechnology**

 

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

 

The Company has U.S. patentscovering both Balancer and Measurement products, processes and methods whichthe Company believes provide it with a competitive advantage.  The Company has a policy of seeking patentswhere appropriate on inventions concerning new products and improvementsdeveloped as part of its ongoing research, development and manufacturingactivities.  While patents providecertain legal rights of enforceability, there can be no assurance the historiclegal standards surrounding questions of validity and enforceability willcontinue to be applied or that current defenses as to issued patents will, in

 

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fact, be considered substantialin the future.  There can be no assuranceas to the degree and range of protection any patent will afford and whetherpatents will be issued or the extent to which the Company may inadvertentlyinfringe upon patents granted to others.

 

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

 

The Company manufactures itsBalancer segment products under copyright protection in the U.S. for electronicboard designs.  Encapsulation of thefinished product further protects the Company’s technologies includingsoftware.

 

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

 

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.

 

**ProductDevelopment**

 

In Fiscal1997, the Company began an ongoing research and development program to expandthe product lines and capabilities of both product segments.  The goal of this program is to expand theproduct base in historic markets and to enter new market areas so as to reducereliance on historic market segments. Since that Fiscal year, the Company has continued to develop thefollowing new balancing and laser measurement products.

 

**The SB-4500 controller is now a multi-function unitproviding the versatility to control several activities including all balancerproducts.  It controls balancing inapplications with speeds ranging from 300 to 30,000 rpm compared to a range of500 to 10,000 rpm with the prior Schmitt product.  Vibrations are measured to 0.02 microns or0.75 millionths of an inch, a ten-fold performance improvement over the priorcontrol unit.  It also allows customersto balance their grinding machines faster, reducing costly down time andincreasing factory throughput. This generation of computer control allows thefuture addition of new products.**

 

TheAcoustical Emissions Monitoring System (AEMS) is controlled by the SB-4500controller and monitors the customers’ dressing and grinding processes bydirect measurement of machine-generated acoustic signals.  By monitoring the high frequency sound signalgenerated by contact between the wheel and work piece, the system automaticallydetermines when wheel contact is made. Users can eliminate the “gap” time from their grinding process and alsoautomatically detect the beginning of a wheel “crash” and immediately signal thegrinding machine to stop before real damage occurs.  The benefits of the AEMS product to thecustomer include time savings from quick and easy setups, improved dressing andgrinding processes, and elimination of expensive part and machine damage.

 

The disk drive industrypresented the Company with the challenge of developing the technology andproducts to measure the surface roughness of glass substrates. Existinglaser-based light-scatter technology was modified to produce the required lightscatter information to provide the necessary measurements.  The engineering staff developed the DUV (DeepUltra-violet light) technology to measure surface microroughness of glasssubstrates to the same precise levels as existing products and at levelsrequired by the industry. This technology compliments existing products andprovides the Company the ability to supply solutions for all media used by thedisk drive industry.

 

**During Fiscal 2004, 2003 and 2002, the Company’sresearch and development expense totaled $30,370, $192,686 and $217,444respectively.  The Fiscal 2004 levelswere lower than in prior years as the Company devoted much of its internallabor efforts (most R&D costs are internal labor costs) to expanding productionlevels and the transition of engineering and production of dimensional sizingproducts from**

** **

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**Menlo Park, CA to Portland, OR.  Management expects amounts expended forR&D in Fiscal 2005 to return to levels approximating those experienced inFiscal 2003 and 2002.**

 

**BusinessRisks**

 

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

 

•                  Demand forcompany products may change.

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

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

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

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

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

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

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

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

•                  The Companyfaces risks from international sales and currency fluctuations.

 

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

 

*Demand forCompany products may change:*

 

For several months prior toMarch 2004, the Company experienced soft market demand for its Balancerproducts.  While specific reasons aredifficult to pinpoint, the low demand was attributed to worldwide economicconditions, specifically those in the grinding machine industry, the primarymarket for the Company’s Balancer products. Based upon analysis by management and the sales staff, the decline insales did not appear to arise from the customer base shifting to competitorproducts.  From March 2004 forward,the Company has seen increasing activity in the industry and as a resultgrowing demand and sales of its Balancer segment products.  Despite this increase in activity, there canbe no assurances as to the duration or strength of this increasing demand.

 

Historically, management hasresponded to soft market conditions in several ways.  First, it appears there is a significantportion of the marketplace that is not using the automatic balancing productsof the Company or any of its competitors. The Company will therefore continue to devote its future R&D effortstoward developing products that will both broaden the scope of products offeredto the current customer base plus offer products for new markets therebyreducing the reliance on historic markets. Second, in order to increase worldwide operating efficiency, managementconsolidated all engineering design and manufacturing operations in its mainlocation in Portland, Oregon, a step that reduced operating costs.   Management continues to evaluate productionmethods for the most efficient and cost effective methods.    Finally, management continuously evaluatesall operating costs and seeks to reduce costs where necessary.

 

The Measurementsegment has historically relied heavily upon sales to disk drive and siliconwafer manufacturers.  Conditions in thosemarkets adversely affected sales beginning in Fiscal 1999 and those poorconditions continued into Fiscal 2003. Disk drive demand is largely tied to anddependent upon demand for personal computers. In Fiscal 2001, personal computer manufacturers warned of lower sales

 

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expectationsand many initiated actions to significantly reduce costs.  These soft market conditions continued intoFiscal Years 2002 and 2003.  In Fiscal2004, improving conditions have occurred in the disk drive market, although thefuture impact on sales of these improving economic conditions is unknown atthis time.

 

Thesemiconductor industry also faced a down cycle beginning in Fiscal 2002 as theindustry experienced backlog cancellations, resulting in slower revenuegrowth.  The result is similar to diskdrive manufacturers in that capital spending declined significantly andconsequently so did demand for and sales of the Company’s wafer products inFiscal 2002 through 2004.  Forecasts forthat industry are for improvements in market conditions although similar to thedisk drive market, the future impact of these improving economic conditions isunknown at this time.

 

Management will continue tomarket these products to these historic markets as it appears no othertechnology has been introduced that would make the laser light-scatter productstechnologically obsolete.  There is thebelief that once market conditions improve in the disk drive and silicon wafermarkets, 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.

 

*Newproducts may not be developed to satisfy changes in consumer demands:*

 

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

 

*Failure 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.

 

*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 operatingfluctuations, it is important to realize quarter-to-quarter comparisons ofoperating results are not necessarily meaningful and should not be relied uponas indicators of future performance

 

*The Companymay not be able to reduce operating costs quickly enough if sales decline:*

 

Operating expenses aregenerally fixed in nature and largely based on anticipated sales.  During the second quarter of Fiscal 2002,Management responded to declining sales by instituting an expense reductionprogram that significantly reduced the break-even sales point.  However, should sales decline significantlyand rapidly, there is no guarantee management could take actions that wouldfurther reduce operating expenses in either a timely manner or without seriouslyimpacting the operations of the Company.

 

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

 

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

 

*The lack ofa line of credit agreement could impact future liquidity:*

 

The Company had a short-termcredit line that expired on April 30, 2003 and the commercial bank chosenot to renew the arrangement.  Whilemanagement believes it could secure credit from another source, there is no guaranteethis can be accomplished or, if it is accomplished, the terms may not be asfavorable as those under the expired line of credit.

 

***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. Theinability to retain key personnel could adversely impact the business,financial condition and results of operations.

 

***TheCompany faces risks from international sales and currency fluctuations:***

 

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.  International salesare subject to a number of risks, including: the imposition of governmentalcontrols; trade restrictions; difficulty in collecting receivables; changes intariffs and taxes; difficulties in staffing and managing internationaloperations; political and economic instability; general economic conditions;and fluctuations in foreign currencies. No assurances can be given these factors will not have a materialadverse effect on future international sales and operations and, consequently,on business, financial condition and results of operations.

 

**InternationalSales**

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

 
| ** **  | ** ** | **North America** | ** ** | **Europe** | ** ** | **Asia**  | ** ** | **Others** | ** ** |
|-------------|------------|-------------------|------------|------------|------------|-----------|------------|------------|------------|
| Fiscal 2004 |       | $                 | 4,520,940  |       | $          | 1,777,250 |       | $          | 1,365,840  |   | $ | 260,736 |   |
| Fiscal 2003 |       | $                 | 4,150,797  |       | $          | 2,348,102 |       | $          | 849,940    |   | $ | 70,682 |   |
| Fiscal 2002 |       | $                 | 4,337,917  |       | $          | 1,627,203 |       | $          | 887,093    |   | $ | 22,446 |   |

 

**Backlog**

 

The Companydoes not generally track backlog. Normally, orders are shipped within a few days after receipt unless thecustomer requests otherwise.

 

**Employees**

 

**As of July 9, 2004, the Company employed37 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.**

 

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**Item 2.  Properties**

 

The Company’sdesign and assembly facilities and executive offices are located in Portland,Oregon in three company-owned buildings with total approximate square footageof 40,500 square feet.  SEL occupies a1,893-square foot facility in Coventry, England pursuant to a three-year leasebeginning June 1, 2002 with a basic monthly rent of £1,875 (approximately$3,400 as of July 9, 2004).  SEGoccupies a 620 square foot facility in Pfungstadt, Germany pursuant to afive-year lease beginning December 1, 2001 with a basic monthly rent of658 Euros (approximately $800 as of July 9, 2004).

 

**Item 3.  Legal Proceedings**

 

There are nomaterial legal proceedings currently pending against the Company.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

No matterswere submitted to a vote of the security holders of the Company during thefourth quarter ended May 31, 2004.

 

**PART II**

 

**Item5.  Market for Registrant’s Common Equityand Related Stockholder Matters**

 

The Company’sCommon Stock is traded on the Nasdaq SmallCap Market under the symbol “SMIT.”

 

**The following tables set forth the high and low salesprices of the Company’s Common Stock as reported on the The Nasdaq SmallcapMarket for the periods indicated.**

** **
| **Year Ended May 31, 2004** | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------|------------|----------|------------|---------|------------|
| First Quarter               |       | $        | 1.80       |    | $          | 1.24 |   |
| Second Quarter              |       | $        | 2.52       |    | $          | 1.60 |   |
| Third Quarter               |       | $        | 2.60       |    | $          | 1.91 |   |
| Fourth Quarter              |       | $        | 2.58       |    | $          | 1.75 |   |

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

 

As ofJune 30, 2004, there were 2,474,461 shares of Common Stock outstandingheld by approximately 130 holders of record.  The number of holders does not includeindividual participants in security position listings; the Company believes thatthere are more than 2,500 individual holders of shares of Common Stock.

 

The Companyhas 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 financial condition,results of operations, current and anticipated cash requirements, acquisitionplans and plans for expansion and any other factors that the Company’s Board ofDirectors deems relevant.  The Companyhas no present intention of paying dividends on its Common Stock in theforeseeable future.

 

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**Item6.  Selected Financial Data**

 

***In thousands, except per shareinformation***

 
| **Year Ended**                                    | ** ** | **5/31/04** | ** ** | **5/31/03** | ** ** | **5/3102** | ** ** | **5/31/01** | ** ** | **5/31/00** | *** *** |
|---------------------------------------------------|------------|-------------|------------|-------------|------------|------------|------------|-------------|------------|-------------|--------------|
|  Sales                                       |       | $           | 7,925      |        | $          | 7,420      |       | $           | 6,875      |        | $            | 7,580 |   | $ | 8,854 |   |
|  Net  Income (Loss)                          |       | $           | 517        |        | $          | (1,487     | )          | $           | (1,599     | )           | $            | (2,367 | ) | $ | 561 |   |
|  Net  Income (Loss) Per Share, Basic         |       | $           | .21        |        | $          | (.60       | )          | $           | (.64       | )           | $            | (.90 | ) | $ | 0.21 |   |
|  Weighted  Average No. Shares, Basic         |       | 2,439       |       | 2,468       |       | 2,488      |       | 2,635       |       | 2,701       |         |
|  Net  Income (Loss) Per Share, Diluted       |       | $           | .20        |        | $          | (.60       | )          | $           | (.64       | )           | $            | (.90 | ) | $ | 0.21 |   |
|  Weighted  Average No. Shares, Diluted       |       | 2,524       |       | 2,468       |       | 2,488      |       | 2,635       |       | 2,869       |         |
|  Stockholders’  Equity                  |       | $           | 6,114      |        | $          | 5,665      |       | $           | 7,251      |        | $            | 8,930 |   | $ | 10,128 |   |
|  Total Assets                                |       | $           | 7,100      |        | $          | 6,272      |       | $           | 8,161      |        | $            | 10,291 |   | $ | 10,953 |   |
|  Long-term  debt (including current portion) |       | $           | 67         |        | $          | 24         |       | $           | 280        |        | $            | 353 |   | $ | — |   |

 

**Item7.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

** **

**The following information contains certain forward-lookingstatements that anticipate future trends or events.  These statements are based on certainassumptions that may prove to be erroneous and are subject to certain risksincluding but not limited to the uncertainties of the Company’s new productintroductions, the risks of increased competition and technological change inthe Company’s industries and other factors detailed in the Company’s SECfilings.  Accordingly, actual results maydiffer, possibly materially, from the predictions contained herein.**

 

**RESULTSOF OPERATIONS**

 

**Overview**

 

Balancersegment sales focus throughout the world on end-users, rebuilders and originalequipment manufacturers of grinding machines. Beginning in Fiscal 2001, the global economic slowdown impacted Balancersegment sales through soft market demand in North America and Europe andtherefore lower sales of Balancer products. However, starting in March 2004 improving economic conditions inNorth America resulted in increasing sales in that geographic market.  Sales people, representatives anddistributors throughout these geographic areas spend a large amount of timewith targeted customers.  They arefinding many of the customers in the automotive, bearing and aircraftindustries refer to improving economic conditions and its impact on the machinetool industry in North America as the reason for their recent increase inordering activity.  However, while thosecustomers are optimistic regarding short term demand for Balancer products,they continue to remain uncertain as to the strength and duration of theimproving business conditions in North America for their products.  Market demand in Asia for the Balancersegment products continue to be strong with the expanding market and customerbase believed to be the reasons for the continued growth in sales.  The European market remains soft withcustomers seeing a lack of demand for their products and therefore their demandfor Balancer products has been soft, with recent sales decreasing accordingly.  The timing of the recovery in those marketsis uncertain at this time.

 

TheMeasurement segment product line consists of both laser light-scatter anddimensional sizing products.    Thebusiness operations and prospects for these two product lines are summarized asfollows:

 

•                  Laser light-scatterproducts for disk drive and silicon wafer manufacturers – Until the acquisitionof the Acuity Research subsidiary in Fiscal 2001, the primary target marketsfor Measurement products were disk drive and silicon wafer manufacturers andcompanies and organizations involved in research efforts.  Management and the sales staff monitorindustry publications and public financial information in order to judge thepotential demand for products by the targeted industries.  Over the past several months, thisinformation has indicated improving demand for

 

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and sales of the products of thosetwo industries.  Also, frequentdiscussions with customers have confirmed the information presented in thepublic information.  Sales to customersin these industries can be very cyclical and therefore the impact of thisrecovery on sales to the Company’s laser light-scatter products is unknown atthis time, although sales personnel have seen increasing interest and inquiriesregarding the Company’s products.

 

•                  Laser light-scatterproducts for research organizations – Historically the Company has sold two tothree of these systems in each fiscal year and expects to do the same in Fiscal2005.

 

•                  Dimensional sizingproducts – Historically these have been marketed and sold into market segmentsdifferent from the laser-light scatter products.  Until the most recent fiscal year, most saleswere realized through repeat business and inquiries received through theCompany’s web site.  Because of themarket potential of these products, Management hired a marketing manager whojoined the Company in mid-Fiscal 2003 and a sales manager in the first quarterof the current fiscal year.  These twopeople have built a North America sales representative network that is seekingbusiness rather than responding to inquiries. To date, sales representative organizations have been retained thatcover most of the fifty states.  Duringthe fourth quarter of Fiscal 2003, Management made the decision to consolidatethe operations of Acuity Research (which had been located in Menlo Park,California) into the Measurement segment operations in Portland, Oregon.  This action reduced the engineering andadministrative staff at Acuity by four people and, beginning inNovember 2003, reduced monthly rental costs by $7,500.   As a result of the physical relocation ofthe Acuity business in the first fiscal quarter of the current year, operationswere suspended for a period of time and served to dampen the sales volume ofAcuity products in that period.  Therelocation was completed as of August 31, 2003.  Management believes these recent actions willresult in increased sales.

 

**CriticalAccounting Policies**

 

RevenueRecognition – The Company recognizes revenue when persuasive evidence of anarrangement exists, delivery has occurred, the sales price is fixed ordeterminable and collectibility is probable. For sales to all customers, including manufacturer representatives,distributors or their third-party customers, these criteria are met at the timeproduct is shipped.  When othersignificant obligations remain after products are delivered, revenue isrecognized only after such obligations are fulfilled.

 

 Accounts Receivable – The Company maintainscredit limits for all customers that are developed based upon several factors,included but not limited to payment history, published credit reports and useof credit references.  On a monthly basis,Management performs various analyses to evaluate accounts receivable balancesto ensure recorded amounts reflect estimated net realizable value.  This review includes accounts receivableagings, other operating trends and relevant business conditions, includinggeneral economic factors, as they relate to each of the Company’s domestic andinternational customers. If these analyses lead Management to the conclusionthat potential significant accounts are uncollectible, a reserve will beprovided.  The Company has had nosignificant bad debt write-offs since its inception in 1986. As of May 31,2004, Management established a reserve of $32,550 to cover potential doubtfulaccounts.

 

Inventories– These assets are stated at the lower of cost or market on an average costbasis. Each Fiscal quarter, Management utilizes various analyses based on salesforecasts, historical sales and inventory levels to ensure the current carryingvalue of inventory accurately reflects current and expected requirements withina reasonable timeframe. As a result of this analysis at May 31, 2004,Management believes the inventory levels are sufficient based upon the expectedrequirements in Fiscal 2004 and beyond. Based upon the same analysis in Fiscal 2003, Management determined$401,673 of inventories were in excess of expected requirements and thereforethese amounts were written off.

 

Long-termDeferred Tax Asset– 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 avaluation allowance is established if it is more likely than not that all or aportion of the deferred tax asset will not be realized. During the year endedMay 31, 2003, and based upon the losses in the prior two Fiscal years,Management believed it was prudent for the Company to increase the valuationreserve to fully offset the estimated value

 

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ofthe deferred tax assets.   Managementcontinues to review the level of the valuation allowance on a quarterly basis.

 

IntangibleAssets – There is a periodic review of intangible and other long-lived assetsfor impairment.  This review consists ofthe analysis of events or changes in circumstances that would indicate thecarrying amount of the asset may not be recoverable. Recoverability isdetermined by comparing the forecasted future net cash flows from theoperations to which the assets relate, based on management’s best estimatesusing the appropriate assumptions and projections at the time, to the carryingamount of the assets.  If the carryingvalue is determined to be in excess of future operating cash flows, the assetis considered impaired and a loss is recognized equal to the amount by whichthe carrying amount exceeds the estimated fair value of the assets.   As of May 31, 2004, Management does notbelieve impairment, as defined above, exists.

 

**Discussionof operating results:**

 
| ** **                                      | ** ** | **Year ended May 31, 2004** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **Consolidated**            | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **                                      | ** ** | **Dollars**                 | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales                                           |       | $                           | 7,924,766  |   | 100.0 | % | $ | 5,924,854 |   | 100.0 | % | $ | 1,999,912 |   | 100.0 | % |
| Cost of sales:                                  |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Operations, exclusive of inventory  write-downs |       | 3,405,761                   |       | 43.0 | % | 2,727,405 |   | 46.0 | % | 678,356 |   | 33.9 | % |
| Inventory write-downs                           |       | —                      |       | — |   | — |   | — |   | — |   | — |   |
| Cost of sales                                   |       | 3,405,761                   |       | 43.0 | % | 2,727,405 |   | 46.0 | % | 678,356 |   | 33.9 | % |
| Gross profit                                    |       | 4,519,005                   |       | 57.0 | % | $ | 3,197,449 |   | 54.0 | % | $ | 1,321,556 |   | 66.1 | % |
| Operating expenses                              |       | 4,081,739                   |       | 51.5 | % |   |   |   |   |   |   |   |   |
| Income from operations                          |       | $                           | 437,266    |   | 5.5 | % |   |   |   |   |   |   |   |   |

 
| ** **                                      | ** ** | **Year Ended May 31, 2003** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **Consolidated**            | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **                                      | ** ** | **Dollars**                 | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales                                           |       | $                           | 7,419,521  |   | 100.0 | % | $ | 5,481,010 |   | 100.0 | % | $ | 1,938,511 |   | 100.0 | % |
| Cost of sales:                                  |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Operations, exclusive of inventory  write-downs |       | 3,188,566                   |       | 43.0 | % | 2,661,510 |   | 48.6 | % | 527,056 |   | 27.2 | % |
| Inventory write-downs                           |       | 401,673                     |       | 5.4 | % | 18,561 |   | 0.3 | % | 383,112 |   | 19.8 | % |
| Cost of sales                                   |       | 3,590,239                   |       | 48.4 | % | 2,680,071 |   | 48.9 | % | 910,168 |   | 47.0 | % |
| Gross profit                                    |       | 3,829,282                   |       | 51.6 | % | $ | 2,800,939 |   | 51.1 | % | $ | 1,028,343 |   | 53.0 | % |
| Operating expenses                              |       | 4,231,699                   |       | 57.0 | % |   |   |   |   |   |   |   |   |
| Loss from operations                            |       | $                           | (402,417   | ) | (5.4 | )% |   |   |   |   |   |   |   |   |

 
| ** **                                      | ** ** | **Year Ended May 31, 2002** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **Consolidated**            | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **                                      | ** ** | **Dollars**                 | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales                                           |       | $                           | 6,874,659  |   | 100.0 | % | $ | 5,275,556 |   | 100.0 | % | $ | 1,599,103 |   | 100.0 | % |
| Cost of sales:                                  |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Operations, exclusive of inventory  write-downs |       | 2,944,937                   |       | 42.8 | % | 2,446,049 |   | 46.4 | % | 498,888 |   | 31.2 | % |
| Inventory write-downs                           |       | —                      |       | — |   | — |   |   |   | — |   |   |   |
| Cost of sales                                   |       | 2,944,937                   |       | 42.8 | % | 2,446,049 |   | 46.4 | % | 498,888 |   | 31.2 | % |
| Gross profit                                    |       | 3,929,722                   |       | 57.2 | % | $ | 2,829,507 |   | 53.6 | % | $ | 1,100,215 |   | 68.8 | % |
| Operating expenses                              |       | 3,973,798                   |       | 57.8 | % |   |   |   |   |   |   |   |   |
| Loss from operations                            |       | $                           | (44,076    | ) | (0.6 | )% |   |   |   |   |   |   |   |   |

 

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Worldwidesales of Balancer products in Fiscal 2004 increased from Fiscal 2003 as salesto the North American and Asian markets increased by 5% and 69% respectivelywhile they decreased in the European markets by 15%.  The increase in North America is attributedto improving economic conditions and therefore increased customer demand whilethe increase in Asia is attributed to continued strong economicconditions.  The decrease in Europe isattributed to ongoing economic weakness in the targeted customer markets.  Worldwide sales of Balancer products inFiscal 2003 increased from Fiscal 2002 as sales to the Asian and Europeanmarkets increased by 4% and 30% respectively, while they decreased in the NorthAmerican market by 8%.  The increase inAsia is attributed to strong economic conditions while the increase in Europeis attributed to more aggressive and focused sales efforts.  The decrease in North America is attributedto ongoing economic weakness in the targeted customer markets.  Measurement product sales in Fiscal 2004 werecomparable to those experienced in Fiscal 2003. Sales of Measurement products in Fiscal 2003 increased from those inFiscal 2002 as Fiscal 2003 included the sale of several large value laserlight-scatter products while in Fiscal 2002 there were no significant sales ofthose higher value products.

 

Costof sales, as a percentage of sales, for the Balancer segment (when excludingthe inventory write-down in Fiscal 2003) decreased in Fiscal 2004 when comparedto Fiscal 2003 due to the geographic sales mix. Sales to the North American markets were a higher percentage of totalBalancer segment sales in Fiscal 2004 than they were in Fiscal 2003.  Unit sales prices in North America are higherthan they are in other geographic markets and therefore the costs on thosesales are lower as a percentage of sales than in other geographic markets.  When sales to the North American market are ahigher proportion of total sales, as they were in Fiscal 2004 compared toFiscal 2003, the effect is to lower cost of sales as a percentage of sales.Cost of sales for the Balancer segment (when excluding the inventory write-downin Fiscal 2003) increased in Fiscal 2003 when compared to Fiscal 2002, againdue to the geographic sales mix.  InFiscal 2003, sales to the European markets were a higher percentage of totalBalancer segment sales than they were in Fiscal 2002.  Due to competitive pressures, unit salesprices in Europe are lower than they are in other geographic markets andtherefore the costs on those sales are higher as a percentage of sales than inother geographic markets.  When sales tothe European market are a higher proportion of total sales, as they were inFiscal 2003 compared to Fiscal 2002, the effect is to increase cost of sales asa percentage of sales.

 

Cost-of-salesin the Measurement segment (when excluding the inventory write-down in Fiscal2003) increased in Fiscal 2004 when compared to Fiscal 2003 and is attributedto the product sales mix.  Cost-of-salesin the Measurement segment (when excluding the inventory write-down in Fiscal2003) decreased in Fiscal 2003 when compared to Fiscal 2002 due to changes inthe product sales mix.

 

Thedecrease in operating expenses between Fiscal 2004 and 2003 occurred primarilydue to a decrease in payroll costs at the Acuity Research subsidiary.  The costs at Acuity decreased due to thereduction in engineering and administration staff that occurred due to theconsolidation of Acuity operations in Portland during the quarter ended August 31,2003.  These changes returned the overalloperating expenses to an amount approximating Fiscal 2002 levels.

 

Netsales outside North America accounted for approximately 43% of the Company’srevenues in Fiscal 2004, 44% in fiscal 2003 and 37% in Fiscal 2002.  Some foreign customers purchase in their owncountry’s currencies, thereby imposing on the Company a currency risk.  All North American sales (56% of total salesin Fiscal 2004) were in U.S. dollars and the remaining Fiscal 2004 sales werein currencies other 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 2004 of $516,585 ($0.20 per fully diluted share) comparesto net losses of $1,487,131 ($0.60 per share) and $1,598,619 ($0.64 per share)in Fiscal 2003 and 2002 respectively. The net loss in Fiscal 2003 included four significant items: a $612,200non-operating charge for a write-down of the Company’s long-term investment inAir Packaging Technologies, Inc, $401,673 in write-downs of excess inventoryquantities, an increase in the deferred tax asset valuation allowance of$636,006 and a $24,060 reserve for doubtful accounts.  When these items are excluded, the net incomewould have been $186,808.  The net lossin Fiscal 2002 was primarily attributable to a $1,516,000 non-operating chargefor a

 

16

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write-downof the Company’s long-term investment in Air Packaging Technologies, Inc.  When that item is excluded, the net loss inFiscal 2002 would have been $82,619.

 

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

 

For Fiscal years 2004, 2003 or2002, sales to a single customer did not exceed 10% of total revenues.

 

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

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

The Company’s ratio of currentassets to current liabilities decreased to 5.7 to 1 at May 31, 2004 compared to7.7 to 1 at May 31, 2003.  As of May 31,2004 the Company had $604,194 in cash compared to $410,245 at May 31, 2003.

 

During the year ended May 31,2004, cash provided from operating activities amounted to $408,160 with thechanges described as follows:

 

•                  The net incomefor the year ended May 31, 2004 of $516,585 plus three non-cash items:depreciation and amortization of $188,314, the increase in the provision fordoubtful accounts of $8,490 and the write-down of the long-term investment of$6,800.

 

•                  Accounts receivableused cash as the balance increased by $499,707 (exclusive of the change in theallowance for doubtful accounts) to a May 31, 2004 balance of $1,815,417compared to $1,324,200 at May 31, 2003. At May 31, 2004, $32,550 in accountsreceivable were considered as doubtful of collection and therefore a reserve inthat amount has been provided for.  TheCompany generally experiences a payment cycle of 30-90 days on invoices,depending on the geographic market. Management believes its credit and collection policies are effective andappropriate for the marketplace.  Therecan be no assurance that the Company’s collection procedures will continue tobe successful, particularly with current economic conditions.

 

•                  Inventoriesincreased $189,162 to a May 31, 2004 balance of $2,915,093 compared to$2,725,931 at May 31, 2003.  The Companymaintains levels of inventory sufficient to satisfy normal customer demandsplus an increasing short-term delivery requirement for a majority of itsBalancer products.  Management believesits ability to provide prompt delivery gives it a competitive advantage forcertain sales.

 

•                  Prepaid expensesdecreased by $42,844 due to the amortization of several items including prepaidtrade show costs, professional fees and various business and life insurancecosts.

 

•                  Trade accountspayable increased by $210,217 with the increase due to increased purchasing activitiesin both the Balancer and Measurement segments.

 

•                  Other accruedliabilities (including commission, payroll items and other accrued expenses)increased by $127,014.

 

During the year ended May 31,2004, net cash used in investing activities was $110,482 consisting of netadditions to property and equipment.  Netcash used in financing activities amounted to $7,843, which

 

17

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consists of repayments oncapitalized obligations of $35,678, common stock issued to employees exercisingstock options for $67,835 and repurchases of common stock for $40,000.

 

The following summarizescontractual obligations at May 31, 2004 and the effect on future liquidity andcash flows:

 
| **Years Ending  May 31,** | ** ** | **Capital Lease  and Purchase  Contract** | ** ** | **Operating Leases** | ** ** | **Total  Contractual  Obligations** | ** ** |
|---------------------------|------------|-------------------------------------------|------------|----------------------|------------|-------------------------------------|------------|
| 2005                      |       | $                                         | 39,831     |                 | $          | 50,841                              |       | $ | 90,672 |   |
| 2006                      |       | 22,247                                    |       | 9,625                |       | 31,872                              |       |
| 2007                      |       | 4,995                                     |       | 4,812                |       | 9,807                               |       |
| 2008                      |       | —                                    |       | —               |       | —                              |       |
| 2009                      |       | —                                    |       | —               |       | —                              |       |
| Thereafter                |       | —                                    |       | —               |       | —                              |       |
| Total                     |       | $                                         | 67,073     |                 | $          | 65,278                              |       | $ | 132,351 |   |

 

Part of the acquisition of SMSin Fiscal 1995 resulted in the acquisition of a tax net operating loss ofapproximately $5.5 million, which is available to offset domestic earningsthrough the year 2009.  As of May 31,2004, approximately $1.3 million of these losses remain.

 

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

 

Management has responded tobusiness challenges over the past few years by reducing operating expenses,developing new products and attempting to penetrate new markets for theCompany’s products.  As a result of theseefforts, Management believes its cash flows from operations and its cashposition will provide adequate funds on both a short-term and long-term basisto cover currently foreseeable debt payments, lease commitments and paymentsunder existing and anticipated supplier agreements.  Management believes that such cash flow(without the raising of external funds) is sufficient to finance currentoperations, projected capital expenditures, anticipated long-term salesagreements and other expansion-related contingencies during Fiscal 2005.However, in the event the Company fails to achieve its operating and financialgoals for Fiscal 2005, Management may be required to take certain actions tofinance operations in that time period. These actions could include, but are not limited to, implementation ofadditional cost cutting measures, increased borrowings from credit facilitiesor entering into additional borrowing arrangements collateralized by assets.

 

**Item7A.  Qualitative and QuantitativeDisclosures about Market Risk**

 

**InterestRate Risk**

 

The Company did not have anyderivative financial instruments as of May 31, 2004.  However, the Company is exposed to interestrate risk.  The Company employsestablished policies and procedures to manage its exposure to changes in themarket risk of its marketable securities.

 

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

 

The Company does not have anylines of credit or other debt whose interest rates are based on variable ratesthat may fluctuate over time based on economic changes in the environment.  Therefore, at this time, the Company is notsubject to interest rate risk if market interest rates fluctuate and does notexpect any change in the interest rates to have a material effect on theCompany’s results from operations.

 

18

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**ForeignCurrency Risk**

 

The Company operates subsidiaries in the United Kingdom andGermany.  Therefore, the Company’sbusiness and financial condition is sensitive to currency exchange rates or anyother restrictions imposed on their currencies. For the years ended May 31, 2004, 2003 and 2002, results of operationsincluded gains (losses) on foreign currency translation of $40,608, $192,010and $(15,470) respectively.

 

19

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**Item 8.****                                                           FinancialStatements and Supplementary Data**

 

**SCHMITT INDUSTRIES,INC.**

**CONSOLIDATEDBALANCE SHEETS**

**MAY 31, 2004 AND 2003**

 
| ** **                                                                                                                                               | ** ** | **2004**  | ** ** | **2003**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|------------|------------|
| **ASSETS**                                                                                                                                               |       |      |       |       |       |
| ***Current Assets***                                                                                                                                     |       |      |       |       |       |
| Cash                                                                                                                                                     |       | $         | 604,194    |       | $          | 410,245 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $32,550 and $24,060 in 2004 and 2003 respectively                                        |       | 1,815,417 |       | 1,324,200  |       |
| Inventories                                                                                                                                              |       | 2,915,093 |       | 2,725,931  |       |
| Prepaid expenses                                                                                                                                         |       | 124,348   |       | 167,192    |       |
| Income taxes receivable                                                                                                                                  |       | 35,894    |       | 32,659     |       |
|                                                                                                                                                     |       | 5,494,946 |       | 4,660,227  |       |
|                                                                                                                                                     |       |      |       |       |       |
| ***Property and  Equipment***                                                                                                                            |       |      |       |       |       |
| Land                                                                                                                                                     |       | 299,000   |       | 299,000    |       |
| Buildings and improvements                                                                                                                               |       | 1,214,500 |       | 1,208,417  |       |
| Furniture, fixtures and equipment                                                                                                                        |       | 1,115,788 |       | 991,828    |       |
| Vehicles                                                                                                                                                 |       | 94,261    |       | 93,887     |       |
|                                                                                                                                                     |       | 2,723,549 |       | 2,593,132  |       |
| Less accumulated depreciation and  amortization                                                                                                          |       | 1,395,634 |       | 1,307,100  |       |
|                                                                                                                                                     |       | 1,327,915 |       | 1,286,032  |       |
| ***Other Assets***                                                                                                                                       |       |      |       |       |       |
| Long-term investment                                                                                                                                     |       | —    |       | 6,800      |       |
| Long-term deferred tax asset                                                                                                                             |       | —    |       | —     |       |
| Other assets                                                                                                                                             |       | 277,612   |       | 318,880    |       |
|                                                                                                                                                     |       | 277,612   |       | 325,680    |       |
| **TOTAL  ASSETS**                                                                                                                                        |       | $         | 7,100,473  |       | $          | 6,271,939 |   |
|                                                                                                                                                     | * *   | * *  | * *   | * *   | * *   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                           | * *   | * *  | * *   | * *   | * *   |
|                                                                                                                                                     | * *   | * *  | * *   | * *   | * *   |
| ***Current  Liabilities***                                                                                                                               |       |      |       |       |       |
| Accounts payable                                                                                                                                         |       | $         | 565,546    |       | $          | 355,329 |   |
| Accrued commissions                                                                                                                                      |       | 189,679   |       | 148,953    |       |
| Customer deposits                                                                                                                                        |       | 53,203    |       | 10,892     |       |
| Other accrued liabilities                                                                                                                                |       | 111,165   |       | 67,188     |       |
| Current portion of long-term  obligations                                                                                                                |       | 39,831    |       | 20,031     |       |
|                                                                                                                                                     |       | 959,424   |       | 602,393    |       |
|                                                                                                                                                     |       |      |       |       |       |
| **Long-term  Obligations**                                                                                                                               |       | 27,242    |       | 4,273      |       |
| ** **                                                                                                                                               |       |      |       |       |       |
| **Commitments  and Contingencies**                                                                                                                       |       |      |       |       |       |
|                                                                                                                                                     |       |      |       |       |       |
| ***Stockholders’  Equity***                                                                                                                         |       |      |       |       |       |
| Common stock, no par value,  20,000,000 shares authorized, 2,474,461 and 2,457,932 shares issued and  outstanding at May 31, 2004 and 2003, respectively |       | 7,360,819 |       | 7,332,984  |       |
| Accumulated other  comprehensive loss                                                                                                                    |       | (376,249  | )          | (280,363   | )          |
| Accumulated deficit                                                                                                                                      |       | (870,763  | )          | (1,387,348 | )          |
|                                                                                                                                                     |       | 6,113,807 |       | 5,665,273  |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                     |       | $         | 7,100,473  |       | $          | 6,271,939 |   |

 

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

 

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**Schmitt Industries, Inc.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**FOR THE YEARS ENDED MAY 31, 2004, 2003 AND2002**

 
| ** **                                           | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**   | ** ** |
|------------------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
| **Net Sales**                                        |       | $         | 7,924,766  |      | $          | 7,419,521  |       | $ | 6,874,659 |   |
|                                                 |       |      |       |      |       |       |       |
| **Cost of Sales**                                    |       |      |       |      |       |       |       |
| Operations, exclusive of inventory  write-downs      |       | 3,405,761 |       | 3,188,566 |       | 2,944,937  |       |
| Inventory write-downs                                |       | —    |       | 401,673   |       | —     |       |
| Total cost of sales                                  |       | 3,405,761 |       | 3,590,239 |       | 2,944,937  |       |
|                                                 |       |      |       |      |       |       |       |
| Gross profit                                         |       | 4,519,005 |       | 3,829,282 |       | 3,929,722  |       |
|                                                 |       |      |       |      |       |       |       |
| **Operating expenses:**                              |       |      |       |      |       |       |       |
| General, administrative and selling                  |       | 4,051,369 |       | 4,039,013 |       | 3,756,354  |       |
| Research and development                             |       | 30,370    |       | 192,686   |       | 217,444    |       |
| Total operating expenses                             |       | 4,081,739 |       | 4,231,699 |       | 3,973,798  |       |
|                                                 |       |      |       |      |       |       |       |
| **Operating income (loss)**                          |       | 437,266   |       | (402,417  | )          | (44,076    | )          |
|                                                 |       |      |       |      |       |       |       |
| **Other income and (expense):**                      |       |      |       |      |       |       |       |
| Interest expense                                     |       | (4,330    | )          | (22,824   | )          | (53,468    | )          |
| Interest income                                      |       | 882       |       | 558       |       | 4,665      |       |
| Loss on write-down of long-term investment           |       | (6,800    | )          | (612,200  | )          | (1,516,000 | )          |
| Gain (loss) on foreign currency exchange             |       | 40,608    |       | 192,010   |       | (15,470    | )          |
| Rental income                                        |       | 18,921    |       | 22,800    |       | 22,800     |       |
| Miscellaneous (expense) income                       |       | 30,038    |       | (29,052   | )          | 2,930      |       |
| Other income and (expense)                           |       | 79,319    |       | (448,708  | )          | (1,554,543 | )          |
|                                                 |       |      |       |      |       |       |       |
| **Income (loss) before provision for income  taxes** |       | 516,585   |       | (851,125  | )          | (1,598,619 | )          |
|                                                 |       |      |       |      |       |       |       |
| **Provision  for income taxes**                      |       | —    |       | 636,006   |       | —     |       |
|                                                 |       |      |       |      |       |       |       |
| **Net income (loss)**                                |       | $         | 516,585    |      | $          | (1,487,131 | )          | $ | (1,598,619 | ) |
|                                                 |       |      |       |      |       |       |       |
| Net income (loss) per common share, basic            |       | $         | 0.21       |      | $          | (0.60      | )          | $ | (0.64 | ) |
|                                                 |       |      |       |      |       |       |       |
| Weighted average number of common shares,  basic     |       | 2,438,895 |       | 2,467,651 |       | 2,488,458  |       |
|                                                 |       |      |       |      |       |       |       |
| Net income (loss) per common share, diluted          |       | $         | 0.20       |      | $          | (0.60      | )          | $ | (0.64 | ) |
|                                                 |       |      |       |      |       |       |       |
| Weighted average number of common shares,  diluted   |       | 2,524,050 |       | 2,467,651 |       | 2,488,458  |       |

 

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

 

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**Schmitt Industries, Inc.**

**CONSOLIDATED STATEMENTS OF CHANGES INSTOCKHOLDERS’ EQUITY**

**FOR THE YEARS ENDED MAY 31, 2004, 2003 AND2002**

 
| ** **                                         | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Accumulated  Other  Comprehensive  (Loss)** | ** ** | **Retained  Earnings  (Accumulated  Deficit)** | ** ** | **Total**  | ** ** | **Total  Comprehensive  Income (Loss)** | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|-----------------------------------------------|------------|------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
|                                               |       |       |       |       |       |                                          |       |                                           |       |       |       |                                    |       |
| **Balance, May 31, 2001**                          |       | 2,501,931  |       | $          | 7,407,476  |                                          | $          | (175,954                                       | )          | $          | 1,698,402  |                                    | $          | 8,929,924 |   |   |   |
| Common shares repurchased                          |       | (33,499    | )          | (63,855    | )          | —                                        |       | —                                         |       | (63,855    | )          |                                    |       |
| Net (loss)                                         |       | —     |       | —     |       | —                                        |       | (1,598,619                                     | )          | (1,598,619 | )          | $                                       | (1,598,619 | ) |
| Other comprehensive (loss)                         |       | —     |       | —     |       | (16,793                                       | )          | —                                         |       | (16,793    | )          | (16,793                                 | )          |
| **Balance, May 31, 2002**                          |       | 2,468,432  |       | 7,343,621  |       | (192,747                                      | )          | 99,783                                         |       | 7,250,657  |       |                                    |       |
| **Comprehensive (loss), year ended May 31,  2002** |       |       |       |       |       |                                          |       |                                           |       |       |       | (1,615,412                              | )          |
|                                               |       |       |       |       |       |                                          |       |                                           |       |       |       |                                    |       |
| Common shares repurchased                          |       | (10,500    | )          | (10,637    | )          | —                                        |       | —                                         |       | (10,637    | )          |                                    |       |
| Net (loss)                                         |       | —     |       | —     |       | —                                        |       | (1,487,131                                     | )          | (1,487,131 | )          | $                                       | (1,487,131 | ) |
| Other comprehensive (loss)                         |       | —     |       | —     |       | (87,616                                       | )          | —                                         |       | (87,616    | )          | (87,616                                 | )          |
| **Balance, May 31, 2003**                          |       | 2,457,932  |       | $          | 7,332,984  |                                          | $          | (280,363                                       | )          | $          | (1,387,348 | )                                       | $          | 5,665,273 |   |   |   |
| **Comprehensive (loss), year ended May 31,  2003** |       |       |       |       |       |                                          |       |                                           |       |       |       | $                                       | (1,574,747 | ) |
|                                               |       |       |       |       |       |                                          |       |                                           |       |       |       |                                    |       |
| Common shares repurchased                          |       | (40,000    | )          | (40,000    | )          | —                                        |       | —                                         |       | (40,000    | )          |                                    |       |
| Stock options exercised                            |       | 56,529     |       | 67,835     |       |                                          |       |                                           |       | 67,835     |       |                                    |       |
| Net income                                         |       | —     |       | —     |       | —                                        |       | 516,585                                        |       | 516,585    |       | $                                       | 516,585    |   |
| Other comprehensive (loss)                         |       | —     |       | —     |       | (95,886                                       | )          | —                                         |       | (95,886    | )          | (95,886                                 | )          |
| **Balance, May 31, 2004**                          |       | 2,474,461  |       | $          | 7,360,819  |                                          | $          | (376,249                                       | )          | $          | (870,763   | )                                       | $          | 6,113,807 |   |   |   |
| **Comprehensive income, year ended May 31,  2004** |       |       |       |       |       |                                          |       |                                           |       |       |       | $                                       | 420,699    |   |

 

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

 

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**Schmitt Industries, Inc.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**FOR THEYEARS ENDED MAY 31, 2004, 2003 AND 2002**

 
| ** **                                                                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**   | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
| **Cash Flows Relating to Operating Activities**                                          |       |     |       |     |       |       |       |
| Net loss                                                                                 |       | $        | 516,585    |     | $          | (1,487,131 | )          | $ | (1,598,619 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities |       |     |       |     |       |       |       |
| Write-down of long-term investment                                                       |       | 6,800    |       | 612,200  |       | 1,516,000  |       |
| Write-down of excess inventory quantities                                                |       | —   |       | 401,673  |       | —     |       |
| Depreciation and amortization                                                            |       | 188,314  |       | 240,265  |       | 245,138    |       |
| Deferred taxes                                                                           |       | —   |       | 636,006  |       | 122,865    |       |
| Provision for bad debts                                                                  |       | 8,490    |       | 24,060   |       | —     |       |
| (Increase) decrease in:                                                                  |       |     |       |     |       |       |       |
| Accounts receivable                                                                      |       | (499,707 | )          | (213,224 | )          | 92,121     |       |
| Inventories                                                                              |       | (189,162 | )          | 80,518   |       | 350,916    |       |
| Prepaid expenses                                                                         |       | 42,844   |       | (5,312   | )          | 24,690     |       |
| Income taxes receivable                                                                  |       | (3,235   | )          | 123,977  |       | (122,975   | )          |
| Increase (decrease) in:                                                                  |       |     |       |     |       |       |       |
| Accounts payable                                                                         |       | 210,217  |       | 116,321  |       | (179,079   | )          |
| Accrued commissions and other accrued  liabilities                                       |       | 127,014  |       | 35,730   |       | (198,594   | )          |
| Net cash provided by operating activities                                                |       | 408,160  |       | 565,083  |       | 252,463    |       |
|                                                                                     |       |     |       |     |       |       |       |
| **Cash Flows Relating to Investing Activities**                                          |       |     |       |     |       |       |       |
| Purchase of property and equipment                                                       |       | (108,796 | )          | (74,505  | )          | (110,458   | )          |
| Disposal of property and equipment                                                       |       | (1,686   | )          | 26,399   |       | 39,377     |       |
| Net cash used in investing activities                                                    |       | (110,482 | )          | (48,106  | )          | (71,081    | )          |
|                                                                                     |       |     |       |     |       |       |       |
| **Cash Flows Relating to Financing Activities**                                          |       |     |       |     |       |       |       |
| Line of credit repayments                                                                |       | —   |       | (200,000 | )          | (400,000   | )          |
| Line of credit borrowings                                                                |       | —   |       | —   |       | 400,000    |       |
| Proceeds of long-term borrowings                                                         |       | —   |       | 38,250   |       | 33,877     |       |
| Repayment of long-term debt                                                              |       | (35,678  | )          | (294,408 | )          | (106,015   | )          |
| Common stock issued                                                                      |       | 67,835   |       | —   |       | —     |       |
| Common stock repurchased                                                                 |       | (40,000  | )          | (10,637  | )          | (63,855    | )          |
| Net cash (used in) financing activities                                                  |       | (7,843   | )          | (466,795 | )          | (135,993   | )          |
|                                                                                     |       |     |       |     |       |       |       |
| **Effect of foreign exchange translation on  cash**                                      |       | (95,886  | )          | (87,616  | )          | 111,207    |       |
|                                                                                     |       |     |       |     |       |       |       |
| **Increase (decrease) in cash**                                                          |       | 193,949  |       | (37,434  | )          | 156,596    |       |
|                                                                                     |       |     |       |     |       |       |       |
| **Cash,** beginning of  year                                                             |       | 410,245  |       | 447,679  |       | 291,083    |       |
|                                                                                     |       |     |       |     |       |       |       |
| **Cash,** end of year                                                                    |       | $        | 604,194    |     | $          | 410,245    |       | $ | 447,679 |   |
|                                                                                     |       |     |       |     |       |       |       |
| **Supplemental Disclosure of Cash Flow  Information**                                    |       |     |       |     |       |       |       |
| Cash paid during the period for interest                                                 |       | $        | 4,330      |     | $          | 22,824     |       | $ | 58,771 |   |
| Cash paid during the period for income  taxes                                            |       | $        | 4,035      |     | $          | 26,110     |       | $ | 110 |   |
|                                                                                     |       |     |       |     |       |       |       |
| **Supplemental Schedule of Noncash  Investing and Financing Activities**            |       |     |       |     |       |       |       |
| Fixed assets financed                                                                    |       | $        | 78,447     |     | $          | —     |       | $ | — |   |
| Increase (decrease) in market value of  long-term investment                             |       | $        | —     |     | $          | —     |       | $ | (273,000 | ) |
| Increase in long-term deferred tax asset                                                 |       | $        | —     |     | $          | —     |       | $ | 145,000 |   |

 

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

 

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**Schmitt Industries, Inc.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**FOR THE YEARS ENDED MAY 31, 2004, 2003 AND 2002**

 

**NOTE1**

**ORGANIZATIONAND NATURE OF OPERATIONS**

 

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

 

**NOTE2**

**SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

**Principlesof Consolidation**

 

These consolidated financialstatements include those of the Company and its wholly owned subsidiaries:Schmitt Measurement Systems, Inc. (SMS), Schmitt Europe, Ltd. (SEL) and SchmittEuropa GmbH (SEG). All significantintercompany accounts and transactions have been eliminated in the preparationof the consolidated financial statements.

 

**RevenueRecognition**

 

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

 

**Cashand Cash Equivalents**

 

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

 

**AccountsReceivable**

 

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

 

**Inventory**

 

Inventory is valued at thelower of cost or market with cost determined on the average cost basis.  As of May 31, 2004 and 2003, inventoriesconsisted of raw materials ($1,824,897 and $1,346,513, respectively),work-in-process ($68,287 and $1,527, respectively), and finished goods($1,021,909 and $1,377,891, respectively).

 

**Propertyand Equipment**

 

Property and equipment arestated at cost.  Depreciation is computedusing the straight-line method over estimated useful lives of three to sevenyears for furniture fixtures, and equipment; three years for vehicles; andtwenty-five years for buildings and improvements.

 

24

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**ForeignCurrency Translation**

 

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

 

**Advertising**

 

Advertising costs included inmarketing, general and administrative, are expensed when the advertising firsttakes place. Advertising expense was $86,648, $67,530 and $79,306 for thefiscal years ended May 31, 2004, 2003 and 2002, respectively.

 

**Researchand Development Costs**

 

Research and development costsare charged to expense when incurred.

 

**Stock-BasedCompensation**

 

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

 

The Company has adopted thedisclosure only provisions of SFAS 123. Accordingly, no compensation cost has been recognized for the stockoption plans. Adjustments are made for options forfeited prior to vesting.  No stock options were granted during the yearended May 31, 2004.  For the years endedMay 31, 2003 and 2002, total value of options granted was computed to be $7,158and $110,532, respectively, which would be amortized on the straight-line basisover the vesting period of the options. Had compensation cost for the Company’s stock option plans beendetermined based on the fair value at the grant date for the awards in 2003 and2002, consistent with the provisions of SFAS 123, the Company’s pro forma netincome (loss) for the years ended May 31, 2004, 2003 and 2002, would be$487,648, $(1,591,321) and $(1,709,151), respectively.  Pro forma basic and fully-diluted earnings(loss) per share for the years ended May 31, 2004, 2003 and 2002 would be $.20$(.64) and $(.69) respectively.

 

Pursuant to SFAS 123, the fairvalue of each option granted is estimated on the date of the grant using theBlack-Scholes option pricing model.  Theweighted average assumptions used for Fiscal 2004, 2003 and 2002 were arisk-free interest rate of 3.50% for 2004 and 2003 and 4.00% for 2002, anexpected dividend yield of 0% for all years, an expected life of four years forFiscal 2004, 2003 and 2002 and a volatility of 91%, 119% and 121%,respectively.

 

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

 

**IncomeTaxes**

 

Deferred tax assets andliabilities are recognized for the future tax consequences of differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax bases as measured by the enacted tax rateswhich are expected to be in effect when these differences reverse.   Income tax expense is the tax payable forthe period and the change during the period in net deferred tax assets and liabilities.Management establishes a valuation allowance against its net deferred taxassets to reduce the net asset to the amount that, based upon their evaluation,will more likely than not be realized.

 

25

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**EarningsPer 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.

 

**Concentrationof Credit Risk**

 

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

 

**FinancialInstruments**

 

The carrying amounts offinancial instruments approximate their fair values at May 31, 2004.

 

**Useof Estimates**

 

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

 

**NewAccounting Pronouncements**

 

In May 2003, the FASB issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity”, which establishes standards for how certain financialinstruments are classified when it has characteristics of both liabilities andequity.  SFAS No. 150 requiresinstruments which were previously classified as equity, that meet the scope ofthe pronouncement, be classified as liabilities.  The Company began applying the provisions ofthis statement in November 2003. The initial adoption of this standard did not have any effect on theCompany’s financial position, results of operations or cash flows.

 

**Reclassifications**

 

Certain reclassifications havebeen made to 2003 and 2002 amounts to conform to the 2004 presentation.

 

**NOTE 3**

 

**ACCOUNTSRECEIVABLE**

 

Changes in the Company’sallowance for doubtful accounts is as follows:

 
| ** **           | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------|------------|----------|------------|----------|------------|
| Beginning balance    |       | $        | 24,060     |     | $          | — |   |
| Bad debt expense     |       | 17,742   |       | 24,060   |       |
| Accounts written off |       | (9,252   | )          | —   |       |
| Ending balance       |       | $        | 32,550     |     | $          | 24,060 |   |

 

**NOTE4**

**LONG-TERMINVESTMENTS**

The Company owns 1,375,716shares or approximately 9% of the outstanding shares of Air PackagingTechnologies, Inc.  That company isengaged in the design, manufacture, marketing and sales of “Air Box” patentedpackaging systems used in the retail, industrial protective and promotionalpackaging markets worldwide.  Thisinvestment is classified as “Available-for-sale securities” under Statement ofFinancial

 

26

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Accounting Standards No. 115(SFAS No. 115).  As required under thatstatement, all unrealized gains and losses are reported in Accumulated OtherComprehensive Loss and included as a separate component in Other ComprehensiveLoss in Stockholders’ Equity until realized or until unrealized losses aredeemed to be “other than temporary”.

 

At May 31, 2004 Managementdetermined the decline in value of the investment from acquisition cost was“other than temporary”, and, as required under SFAS No. 115, the long-terminvestment was written down by $6,800 to its fair market value as of May 31,2004.  Fair market value was the closing priceof the stock on the over-the-counter market at May 31, 2004.  As required under SFAS No. 115, the new costbasis shall not be changed for subsequent recoveries in fair value.  Future temporary gains and losses will bereported as required under SFAS No. 115.

 

**NOTE5**

**INCOMETAXES**

 

The provision (benefit) forincome taxes was as follows

 
| ** **                                 | ** ** | **Years ended May 31,** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|
| ** **                                 | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current                                    |       | $                       | —     |   | $ | — |   | $ | — |   |
| Deferred                                   |       | 226,827                 |       | (363,021 | ) | (533,183 | ) |
| (Decrease) increase in valuation allowance |       | (226,827                | )          | 999,027 |   | 533,183 |   |
| Total provision for income taxes           |       | $                       | —     |   | $ | 636,006 |   | $ | — |   |

 

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

 
| ** **                                                                          | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Depreciation                                                                        |       | $          | —     |       | $          | 19,679 |   |
| Net operating loss carryforwards                                                    |       | 1,244,724  |       | 704,324    |       |
| Deferred taxes related to the write-off of  obsolete inventory quantities           |       | —     |       | 744,139    |       |
| Deferred taxes related to the decline in  fair market value of long-term investment |       | 819,840    |       | 817,229    |       |
| Other deferred assets                                                               |       | 83,481     |       | 89,501     |       |
| Gross deferred tax assets                                                           |       | 2,148,045  |       | 2,374,872  |       |
|                                                                                |       |       |       |       |       |
| Deferred tax asset valuation allowance                                              |       | (2,148,045 | )          | (2,374,872 | )          |
|                                                                                |       |       |       |       |       |
| Net deferred tax asset                                                              |       | $          | —     |       | $          | — |   |

 

TheCompany has approximately $1.9 million of U.S. federal net operating losscarryforwards that were acquired as part of the acquisition of SchmittMeasurement Systems, Inc.  These NOLs aresubject to limitations that restrict their use and expire in the years 2009through 2010.  The Company also hasapproximately $1.3 million of U.S. Federal and State net operating losscarryforwards, the utilization of which could be limited upon a change incontrol of the Company, and expire in the year 2024.

 

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

 

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

 

27

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| ** **                                 | ** ** | **Years Ended May 31,** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|
| ** **                                 | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
| Statutory federal tax rate                 |       | 34.0                    | %          | (34.0 | )% | (34.0 | )% |
| State taxes, net of federal benefit        |       | —                  |       | — |   | — |   |
| Change in deferred tax valuation allowance |       | (43.9                   | )          | 117.4 |   | 29.8 |   |
| Permanent and other differences            |       | 9.9                     |       | (8.7 | ) | 4.2 |   |
|                                       |       |                    |       |   |   |   |   |
| Effective tax rate                         |       | —                  | %          | 74.7 | % | — | % |

 

**NOTE 6**

**EMPLOYEEBENEFIT PLANS**

 

TheCompany adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan &Trust effective June 1, 1996. Employees must meet certain age and service requirements to beeligible.  Participants may contribute upto 15% of their eligible compensation which may be partially matched by theCompany.  The Company may further makeeither a profit sharing contribution or a discretionary contribution.  There were no contributions made by theCompany to this Plan during the years ended May 31, 2004 and 2003, while duringthe year ended May 31, 2002 contributions were $47,881.

 

**NOTE7**

**LONG-TERMOBLIGATIONS**

 

During Fiscal 2004, the Companyentered into an equipment lease and a purchase contract for $78,477.  The agreements call for monthly principalpayments of $832 and $2,131 and both carry no interest.  One lease expires in Fiscal 2006 and thesecond in Fiscal 2007.  Equipmentrecorded under the equipment lease was $48,477, with related accumulateddepreciation of $4,386.

 

As of May 31, 2004, futurecapital lease payments are:

 
| **Year Ending May 31,** | ** ** |
|-------------------------|------------|
| 2005                    |       |   | $ | 39,831 |   |
| 2006                    |       |   | $ | 22,247 |   |
| 2007                    |       |   | $ | 4,995 |   |

 

**NOTE8**

**COMMITMENTSAND CONTINGENCIES**

 

In a transaction related to theacquisition of Schmitt Measurement Systems, Inc., formerly TMA Technologies,Inc. (TMA), the Company established a royalty pool and vested in eachshareholder and debt holder of the acquired company an interest in the royaltypool equal to the amount invested or loaned including interest payable throughMarch 1995.  The royalty pool willbe funded at 5% of net sales (defined as gross sales less returns, allowancesand sales commissions) of Schmitt Measurement Systems, Inc.’s products andfuture derivative products developed by Schmitt Industries, Inc., which utilizethese technologies.  As part of theroyalty pool agreement, each former shareholder and debt holder released TMAfrom any claims with regard to the acquisition except their rights to futureroyalties.  Royalty expense applicable tothe years ended May 31, 2004, 2003 and 2002 amounted to $41,430, $48,517 and$27,763, respectively.

 

28

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The Company has entered intovarious non-cancelable leases for facilities used to support operations in theUnited Kingdom, Germany and California. Rent expense for the years ended May 31, 2004, 2003 and 2002 amounted to$78,062, $136,953 and $136,374 respectively.

 

Lease commitments

 
| **Year Ending May 31,** | ** ** |
|-------------------------|------------|
| 2005                    |       |   | $ | 50,841 |   |
| 2006                    |       |   | $ | 9,625 |   |
| 2007                    |       |   | $ | 4,812 |   |
| 2008                    |       |   | $ | — |   |
| 2009                    |       |   | $ | — |   |
| Thereafter              |       |   | $ | — |   |

 

Specific business challengesfaced by the Company over the past few years have had a negative impact onoperations and liquidity.  Management hasresponded to these challenges by reducing operating expenses, developing newproducts and penetrating new markets for the Company’s products.  As a result of these efforts, Managementbelieves its cash flows from operations and its cash position will provideadequate funds on both a short-term and long-term basis to cover currentlyforeseeable debt payments, lease commitments and payments under existing andanticipated supplier agreements. Management believes that such cash flow (without the raising of externalfunds) is sufficient to finance current operations, projected capitalexpenditures, anticipated long-term sales agreements and otherexpansion-related contingencies during Fiscal 2005. However, in the event theCompany fails to achieve its operating and financials goals in for Fiscal 2005,management may be required to take certain actions to finance operations inthat time period.  These actions couldinclude, but are not limited to, implementation of additional cost cuttingmeasures or entering into additional borrowing arrangements that arecollateralized by assets.

 

**NOTE9**

**SEGMENTSOF BUSINESS**

 

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

 

***Segment Information***

 
| ** **                    | ** ** | **Year Ended May 31,** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **2004**               | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                    | ** ** | **Balancer**           | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| Gross sales                   |       | $                      | 6,644,781  |   | $ | 2,017,494 |   | $ | 6,283,987 |   | $ | 1,961,086 |   | $ | 6,197,649 |   | $ | 1,605,288 |   |
| Intercompany sales            |       | $                      | 719,927    |   | $ | 17,582 |   | $ | 802,977 |   | $ | 22,575 |   | $ | 922,093 |   | $ | 6,185 |   |
| Net sales                     |       | $                      | 5,924,854  |   | $ | 1,999,912 |   | $ | 5,481,010 |   | $ | 1,938,511 |   | $ | 5,275,556 |   | $ | 1,599,103 |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from operations |       | $                      | 2,674      |   | $ | 434,592 |   | $ | (281,900 | ) | $ | (120,517 | ) | $ | (270,416 | ) | $ | 226,340 |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Intercompany rent             |       | $                      | —     |   | $ | 30,000 |   | $ | — |   | $ | 30,000 |   | $ | — |   | $ | 30,000 |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation expense          |       | $                      | 111,282    |   | $ | 35,764 |   | $ | 119,331 |   | $ | 60,486 |   | $ | 136,864 |   | $ | 53,671 |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Amortization expense          |       | $                      | 6,665      |   | $ | 34,603 |   | $ | 20,002 |   | $ | 40,446 |   | $ | 20,000 |   | $ | 34,603 |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures          |       | $                      | 90,848     |   | $ | 17,948 |   | $ | 38,970 |   | $ | 35,535 |   | $ | 80,491 |   | $ | 29,967 |   |

 

29

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***Geographic Information***

GeographicSales

 
| ** **           | ** ** | **Year Ended May 31,** | ** ** |
|----------------------|------------|------------------------|------------|
| ** **           | ** ** | **2004**               | ** ** | **2003** | ** ** | **2002** | ** ** |
| North American Sales |       |                   |       |   |   |   |   |
| United States        |       | $                      | 4,320,421  |   | $ | 3,985,882 |   | $ | 4,230,818 |   |
| Intercompany         |       | $                      | —     |   | $ | 22,134 |   | $ | 72,319 |   |
|                 |       | $                      | 4,320,421  |   | $ | 3,963,748 |   | $ | 4,158,499 |   |
| Canada               |       | $                      | 154,738    |   | $ | 153,022 |   | $ | 151,732 |   |
| Mexico               |       | $                      | 45,781     |   | $ | 34,027 |   | $ | 27,686 |   |
| North America total  |       | $                      | 4,520,940  |   | $ | 4,150,797 |   | $ | 4,337,917 |   |
|                 |       |                   |       |   |   |   |   |
| European Sales       |       |                   |       |   |   |   |   |
| Germany              |       | $                      | 469,342    |   | $ | 781,375 |   | $ | 897,670 |   |
| Intercompany         |       | $                      | —     |   | $ | — |   | $ | 206,824 |   |
| Germany total        |       | $                      | 469,342    |   | $ | 781,375 |   | $ | 690,846 |   |
|                 |       |                   |       |   |   |   |   |
| United Kingdom       |       | $                      | 1,136,035  |   | $ | 1,253,639 |   | $ | 1,065,416 |   |
| Intercompany         |       | $                      | 737,509    |   | $ | 803,418 |   | $ | 649,135 |   |
| United Kingdom total |       | $                      | 398,526    |   | $ | 450,221 |   | $ | 416,281 |   |
|                 |       |                   |       |   |   |   |   |
| Other European Sales |       | $                      | 909,382    |   | $ | 1,116,506 |   | $ | 520,076 |   |
|                 |       |                   |       |   |   |   |   |
| Total Europe         |       | $                      | 1,777,250  |   | $ | 2,348,102 |   | $ | 1,627,203 |   |
|                 |       |                   |       |   |   |   |   |
| Asia                 |       | $                      | 1,365,840  |   | $ | 849,940 |   | $ | 887,093 |   |
| Others               |       | $                      | 260,736    |   | $ | 70,682 |   | $ | 22,446 |   |
|                 |       | $                      | 7,924,766  |   | $ | 7,419,521 |   | $ | 6,874,659 |   |

 
| ** **                    | ** ** | **Year Ended May 31,** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **2004**               | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                    | ** ** | **United States**      | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** |
| Income (loss) from operations |       | $                      | 623,887    |   | $ | (186,621 | ) | $ | (292,905 | ) | $ | (109,512 | ) | $ | 113,812 |   | $ | (157,888 | ) |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation expense          |       | $                      | 137,606    |   | $ | 9,440 |   | $ | 164,877 |   | $ | 14,940 |   | $ | 177,851 |   | $ | 12,684 |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Amortization expense          |       | $                      | 41,268     |   | $ | — |   | $ | 60,448 |   | $ | — |   | $ | 54,603 |   | $ | — |   |
|                          |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures          |       | $                      | 103,647    |   | $ | 5,149 |   | $ | 68,363 |   | $ | 6,142 |   | $ | 107,388 |   | $ | 3,070 |   |

 

***Long-term Assets***

 
| ** **    | ** ** | **May 31, 2004** | ** ** | **May 31, 2003** | ** ** |
|---------------|------------|------------------|------------|------------------|------------|
| Segment:      |       |             |       |             |       |
| Balancer      |       | $                | 1,041,032  |             | $          | 994,798 |   |
| Measurement   |       | $                | 564,495    |             | $          | 616,914 |   |
|          |       |             |       |             |       |
| Geographic:   |       |             |       |             |       |
| United States |       | $                | 1,585,021  |             | $          | 1,588,599 |   |
| Europe        |       | $                | 20,506     |             | $          | 23,113 |   |

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

 

**NOTE 10**

**STOCKOPTIONS**

 

The Board of Directors adopted aStock Option Plan in December 1995, which plan was amended inAugust 1996 and restated in August 1998.  An option granted under the Amended andRestated Stock Option Plan might be either an incentive stock option (ISO), ora nonstatutory stock option (NSO).  ISOsmay be granted only to employees and members of the Board of Directors of theCompany and are subject to certain limitations, in addition to restrictionsapplicable to all stock options under the Plan. Options not meeting 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 the discretionof the option committee of the Board of Directors, but is either 50% at grantdate and 16.7% on each anniversary thereafter or 50% at grant date and 25% oneach anniversary thereafter.  The Companyinitially reserved 400,000 shares for issuance under the stock option plan.  All outstanding options will expire no laterthan 2014.

 

30

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The following summarizes theoptions outstanding as of May 31, 2004:

 
| ** **                        | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-----------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|
| Options outstanding, May 31, 2001 |       | 225,666    |       | $                                      | 4.32       |                                                |       |   |
| Options granted                   |       | 287,334    |       | $                                      | 1.44       |                                                |       |   |
| Options forfeited/cancelled       |       | (269,000   | )          | $                                      | 4.08       |                                                |       |   |
|                              |       |       |       |                                   |       |                                                |       |
| Options outstanding May 31, 2002  |       | 244,000    |       | $                                      | 1.20       |                                                |       |   |
|                              |       |       |       |                                   |       |                                                |       |
| Options granted                   |       | 6,666      |       | $                                      | 1.20       |                                                |       |   |
| Options forfeited/cancelled       |       | (6,677     | )          | $                                      | 1.20       |                                                |       |   |
|                              |       |       |       |                                   |       |                                                |       |
| Options outstanding May 31, 2003  |       | 243,989    |       | $                                      | 1.20       |                                                |       |   |
| Options granted                   |       | —     |       | $                                      | —     |                                                |       |   |
| Options exercised                 |       | (56,529    | )          | $                                      | 1.20       |                                                |       |   |
| Options forfeited/cancelled       |       | (16,944    | )          | $                                      | 1.20       |                                                |       |   |
|                              |       |       |       |                                   |       |                                                |       |
| Options outstanding May 31, 2004  |       | 170,516    |       | $                                      | 1.20       |                                                | 6.60 Years |   |
|                              |       |       |       |                                   |       |                                                |       |
| Options vested at May 31, 2004    |       | 138,051    |       | $                                      | 1.20       |                                                | 6.60 Years |   |

 

**NOTE 11**

 

**OTHERCOMPREHENSIVE INCOME (LOSS)**

 
| ** **                                                                                                                                                         | ** ** | **Years ended May 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
| Significant components of net (loss)  income:                                                                                                                      |       |                    |       |   |   |   |   |
| Write-down of long-term investment to fair  market value                                                                                                           |       | $                       | (6,800     | ) | $ | (612,200 | ) | $ | (1,516,000 | ) |
| Inventory write-downs                                                                                                                                              |       | —                  |       | (401,673 | ) | — |   |
| Increase in reserve for deferred tax asset                                                                                                                         |       | —                  |       | (636,006 | ) | — |   |
| Reserve for doubtful accounts                                                                                                                                      |       | (8,490                  | )          | (24,060 | ) | — |   |
| Income (loss) from operations exclusive of  inventory write-downs, restructure costs increase in reserve for deferred tax  asset and reserve for doubtful accounts |       | 531,875                 |       | 186,808 |   | (82,619 | ) |
| Net income (loss)                                                                                                                                                  |       | 516,585                 |       | (1,487,131 | ) | (1,598,619 | ) |
|                                                                                                                                                               |       |                    |       |   |   |   |   |
| Other comprehensive (loss) income:                                                                                                                                 |       |                    |       |   |   |   |   |
| (Decrease) in fair market value of  long-term investment, net of taxes                                                                                             |       | —                  |       | — |   | (128,000 | ) |
| Foreign currency translation adjustment                                                                                                                            |       | (95,886                 | )          | (87,616 | ) | 111,207 |   |
|                                                                                                                                                               |       |                    |       |   |   |   |   |
| Total comprehensive income (loss)                                                                                                                                  |       | $                       | 420,699    |   | $ | (1,574,747 | ) | $ | (1,615,412 | ) |

 

**The long-term investment is considered an“Available-for-sale security”.  Asrequired under Statement of Financial Accounting Standards No. 115, allunrealized gains and losses, net of tax benefits, are reported in AccumulatedOther Comprehensive (Loss) Income and included as a separate component of OtherComprehensive (Loss) Income in Stockholders’ Equity until realized or untilunrealized losses are deemed to be “other than temporary”.  The cumulative translation adjustmentconsists of unrealized gains/losses from translation adjustments onintercompany foreign currency transactions that are of a long-term investmentnature.**

 

31

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**NOTE 12**

 

**EARNINGSPER 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 31,2004:

 

| ** **                                                              | ** ** | **Income  (Numerator)** | ** ** | **Weighted  Average  Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------------------------|------------|------------------------|------------|
| **Year ended May 31, 2004**                                             |       |                    |       |                                         |       |                   |       |
| Basic earnings per share  Income available to common stockholders       |       | $                       | 516,585    |                                         | 2,438,895  |                   | $          | 0.21 |   |
|                                                                    |       |                    |       |                                         |       |                   |       |
| Effect of dilutive securities stock options                             |       | —                  |       | 85,155                                       |       |                   |       |
|                                                                    |       |                    |       |                                         |       |                   |       |
| Diluted earnings per share  Income available to common stockholders     |       | $                       | 516,585    |                                         | 2,524,050  |                   | 0.20       |   |
|                                                                    |       |                    |       |                                         |       |                   |       |
| **Year ended May 31, 2003**                                             |       |                    |       |                                         |       |                   |       |
| Basic and diluted loss per share  Loss available to common stockholders |       | $                       | (1,487,131 | )                                            | 2,467,651  |                   | $          | (0.60 | ) |
|                                                                    |       |                    |       |                                         |       |                   |       |
| **Year ended May 31, 2002**                                             |       |                    |       |                                         |       |                   |       |
| Basic and diluted loss per share  Loss available to common stockholders |       | $                       | (1,598,619 | )                                            | 2,488,458  |                   | $          | (0.64 | ) |

 

InFiscal 2003 and 2002, 243,290 and 380,142 incremental shares were excluded fromthe diluted loss per share calculation, as their effect was anti-dilutive.

 

32

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**SUMMARIZEDQUARTERLY FINANCIAL DATA**

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

***(unaudited)***

 
| **2004 Quarter Ended**               | ** ** | **August  31** | ** ** | **November  30** | ** ** | **February  29** | ** ** | **May  31** | ** ** |
|--------------------------------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|
| Sales                                |       | $              | 1,648      |             | $          | 1,736            |       | $           | 1,773      |   | $ | 2,768 |   |
| Gross Profit                         |       | $              | 884        |             | $          | 930              |       | $           | 979        |   | $ | 1,726 |   |
| Net (Loss) income                    |       | $              | (67        | )                | $          | 47               |       | $           | 1          |   | $ | 536 |   |
| Net (Loss) income Per Share, Basic   |       | $              | (.03       | )                | $          | .02              |       | $           | .00        |   | $ | .22 |   |
| Net (Loss) income Per Share, Diluted |       | $              | (.03       | )                | $          | .02              |       | $           | .00        |   | $ | .22 |   |
| Market Price of Common Stock         |       |           |       |             |       |             |       |        |       |
| High                                 |       | $              | 1.80       |             | $          | 2.52             |       | $           | 2.60       |   | $ | 2.58 |   |
| Low                                  |       | $              | 1.24       |             | $          | 1.60             |       | $           | 1.91       |   | $ | 1.75 |   |

 
| **2003 Quarter Ended**               | ** ** | **August  31** | ** ** | **November  30** | ** ** | **February  28** | ** ** | **May  31** | ** ** |
|--------------------------------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|
| Sales                                |       | $              | 2,001      |             | $          | 1,794            |       | $           | 1,621      |   | $ | 2,004 |   |
| Gross Profit                         |       | $              | 1,153      |             | $          | 1,049            |       | $           | 462        |   | $ | 1,165 |   |
| Net (Loss) income                    |       | $              | 55         |             | $          | 33               |       | $           | (1,715     | ) | $ | 140 |   |
| Net (Loss) income Per Share, Basic   |       | $              | .03        |             | $          | .01              |       | $           | (.69       | ) | $ | .05 |   |
| Net (Loss) income Per Share, Diluted |       | $              | .03        |             | $          | .01              |       | $           | (.69       | ) | $ | .05 |   |
| Market Price of Common Stock         |       |           |       |             |       |             |       |        |       |
| High                                 |       | $              | 1.65       |             | $          | 1.95             |       | $           | 1.50       |   | $ | 1.60 |   |
| Low                                  |       | $              | 1.05       |             | $          | 1.11             |       | $           | 1.07       |   | $ | 0.80 |   |

 

***Report******of Independent Registered PublicAccounting Firm:***

 

Board of Directors and Shareholders

Schmitt Industries, Inc.

 

We have audited the accompanying consolidatedbalance sheet of Schmitt Industries, Inc. and its subsidiaries as of May 31,2004 and 2003, and the related consolidated statements of operations, changesin stockholders’ equity and cash flows for each of the two years in the periodended May 31, 2004.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovide a reasonable basis for our opinion.

 

In our opinion, the financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of Schmitt Industries, Inc. and its subsidiaries as of May31, 2004 and 2003, and the consolidated results of their operations and theirconsolidated cash flows for each of the two years in the period ended May 31, 2004,in conformity with accounting principles generally accepted in the UnitedStates of America.

 

 
|                | /s/ GRANT  THORNTON LLP |   |
|---------------------|-------------------------|--------|
|                |
|                |
| Portland,  Oregon   |
| July 27,  2004 |

 

33

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***Report of Independent Registered Public AccountingFirm:***

 

To the Board of Directors andShareholders of

Schmitt Industries, Inc.

 

In our opinion, theaccompanying consolidated statements of operations, of changes in shareholders’equity and of cash flows present fairly, in all material respects, the resultsof Schmitt Industries, Inc. (The “Company”) and its subsidiaries**’**operations and cash flows for the year ended May 31, 2002,in conformity with accounting principles generally accepted in the UnitedStates of America.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.  We conducted our audits of these statementsin accordance with auditing standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

PricewaterhouseCoopers LLP

 

Portland, Oregon

July 3, 2002

 

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

 

**PARTIII**

 

Certain information required byPart III is included in the Company’s definitive Proxy Statement for its 2004Annual Meeting of Shareholders (“Proxy Statement”) and is incorporated hereinby reference. The Proxy Statement will be filed pursuant to Regulation 14A ofthe Securities Exchange Act of 1934 not later than 120 days after the end ofthe Fiscal year covered by this Report.

 

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

 

Theinformation required by these items is included in the Proxy Statement underthe headings “Management”, “Equity Compensation Plan,” “ExecutiveCompensation,” “Summary Compensation Table,” “Options Grants in Fiscal 2004,”“Aggregated Option Expenses in Fiscal 2004 and Fiscal Year-End Option Values,”and “Section 16(a) Beneficial Ownership Reporting Compliance” and “Code ofEthics” and is incorporated herein by reference.

 

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

 

Theinformation required by this item is included in the Proxy Statement under theheading “Security Ownership of Certain Beneficial Owners” and is incorporatedherein by reference.

 

34

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

 

Theinformation required by this item is included in the Proxy Statement under theheading “Certain Relationships and Related Transactions” and is incorporatedherein by reference.

 

**Item 14****                                                       PrincipalAccounting Fees and Services**

 

Theinformation required by this item is included in the Proxy Statement under theheading “Independent Public Accountants” and is incorporated herein byreference.

 

**PART IV**

 

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

*(a)**                               FinancialStatements:*

 
| (1)    | Consolidated Balance Sheets as of May 31, 2004 and 2003                                                                                                                                                                      |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                         |
|   | Consolidated Statements of Operations for  the years ended May 31, 2004, 2003 and 2002                                                                                                                                       |
|   |                                                                                                                                                                                                                         |
|   | Consolidated Statements of Changes in  Stockholders’ Equity for the years ended May 31, 2004, 2003 and 2002                                                                                                        |
|   |                                                                                                                                                                                                                         |
|   | Consolidated Statements of Cash Flows for  the years ended May 31, 2004, 2003 and 2002                                                                                                                                       |
|   |                                                                                                                                                                                                                         |
|   | Notes to Consolidated Financial Statements                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                         |
|   | Report of Registered Public  Accounting Firms                                                                                                                                                                                |
|   |                                                                                                                                                                                                                         |
| (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 37 of the Exhibits filed with this report.                                                                                                                     |

 

35

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**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|     | **SCHMITT  INDUSTRIES, INC.**    |
|----------|----------------------------------|
|     |                             |
|     |                             |
|     | By:                              |   | /s/ Wayne A.  Case |   |
|     |                             | Wayne A.  Case |
| * * | * *                         |   | *Chairman  of the Board, President  and Chief Executive Officer* |
|     |                             |
|     | Date:  August 11, 2004 |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities indicated on August 11, 2004.

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

 

36

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**INDEX TO EXHIBITS**

 

| **Exhibits** | ** ** | **Description**                                                                                                                                                                                                                              |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                                                                                         |
| 3(i)         |       | Second  Restated Articles of Incorporation of Schmitt Industries, Inc. (the  “Company”).  Incorporated by reference  to Exhibit 3(i) to the Company’s Annual Report on Form 10-K for the Fiscal  year ended May 31, 1999 |
|         |       |                                                                                                                                                                                                                                         |
| 3(ii)        |       | Second  Restated Bylaws of the Company Incorporated by reference to Exhibit 3(ii) to  the Company’s Annual Report on Form 10-K for the Fiscal year ended May 31,  1999                                                                  |
|         |       |                                                                                                                                                                                                                                         |
| *10.1        |       | Schmitt  Industries, Inc. Amended & Restated Stock Option Plan.  Incorporated by reference to Exhibit 10.1  to the Company’s Annual Report on Form 10-K for the Fiscal year ended May 31,  1999                                |
|         |       |                                                                                                                                                                                                                                         |
| **14.1       |       | Code of  Ethics and Business Conduct of Schmitt Industries, Inc.                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                                                         |
| **21.1       |       | Subsidiaries  of Schmitt Industries, Inc.                                                                                                                                                                                                    |
|         |       |                                                                                                                                                                                                                                         |
| **23.1       |       | Consent of  Grant Thornton LLP                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                         |
| **23.2       |       | Consent of  PricewaterhouseCoopers LLP                                                                                                                                                                                                       |
|         |       |                                                                                                                                                                                                                                         |
| **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                                           |

 

----

*Managementcontract or compensatory plan.

 

**Filedherewith

 

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