** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**(Mark One)**

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

**Forthe Fiscal year ended: May 31, 2006**

**or**

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

**Forthe transition period from                                to                               **

**CommissionFile Number:  000-23996**

**SCHMITT INDUSTRIES, INC.**

(Exact name of registrantas specified in its charter)

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

 

**2765 N.W. Nicolai StreetPortland, 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** |
|------------------------------|--------|------------------------------------------------|
| Common Stock -  no par value |   | The NASDAQ Stock  Market LLC                   |

Securitiesregistered pursuant to Section 12(g) of the Act:                          None

Indicate by check mark whether the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.                             Yeso     No x

Indicate by check mark whether the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) of theExchange Act.                Yes o     No x

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

Yes x     No o

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

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

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

 

        Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).     Yes o  No x

        The aggregate market valueof the voting stock held by non-affiliates of the registrant as of November 30,2005, the last business day of the registrant’s most recently completed secondfiscal quarter, was approximately $11,129,085 based upon the closing price of$5.70 reported for such date on the NASDAQ Capital Market. For purposes of thisdisclosure, shares of Common Stock held by persons who hold more than 10% ofthe outstanding shares of Common Stock and shares held by officers anddirectors of the registrant, have been excluded because such persons may bedeemed to be affiliates.  Thisdetermination is not necessarily conclusive for other purposes.

        As of July 31, 2006, theregistrant had 2,640,045 outstanding shares of Common Stock.

Documents Incorporated by Reference

Portions of the registrant’sdefinitive Proxy Statement for its 2006 Annual Meeting of Shareholders areincorporated by reference into Part III hereof.

 

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**PART I**

**Item1.  Business**

***Introduction***

Schmitt Industries, Inc. (the Company), an Oregoncorporation, designs, assembles and markets computer-controlled balancingequipment (the Balancer Segment) primarily to the machine tool industry.  Through its wholly owned subsidiary, SchmittMeasurement Systems, Inc. (SMS), an Oregon corporation, the Company designs,manufactures and markets precision laser measurement systems (the MeasurementSegment).  The Company also sells andmarkets its products in Europe through its wholly owned subsidiary, SchmittEurope Ltd. (SEL), located in the United Kingdom.  Effective May 30, 2005, the Companyliquidated and dissolved its German subsidiary, Schmitt Europa, GmbH.  TheCompany’s executive offices are located at 2765 N.W. Nicolai Street,Portland, Oregon 97210, and its telephone number is (503) 227-7908.

***Balancer Segment***

The Company’s principal product is the Schmitt Dynamic Balance System(the SBS System), consisting of a computer control unit, sensor,spindle-mounting adapter, and balance head. It is designed as an inexpensive highly accurate permanent installationon grinding machines.  The Companyacquired its original balancing equipment technology pursuant to a series ofagreements from 1987 through 1991, substantially enhancing and advancing thepatented technology since that time.  Since inception the targeted customer base hasbeen operators of grinding machines.

The SBS System is fully automated, eliminating the need to pre-balancesuch devices as grinding wheels.  Thisreduces machine setup time and ensures a smoother and more efficientoperation.  Operating on a principle ofmass compensation for wheel imbalance, the balance head contains two movableeccentric weights, each driven by electric motors through a precision geartrain.  These weights are repositioned tooffset any imbalance in a grinding wheel or other application.  Imbalance or vibration is picked up by thesensor that feeds a signal to a controller that filters the signal byrevolutions per minute.  The controllerthen drives the balance head weights in a direction that reduces the amplitudeof the vibration signal.  The balancecycle is complete when the weights are positioned to achieve the lowestvibration level.

Notable features of the SBS System include its ability to fit almost allmachines, ease of installation, compact and modular construction, ability tobalance a wheel while on a machine, virtual elimination of wheel vibration,automatic monitoring of balancing, display in both English and metric systems,instrument grade calibration, short balance process, measurement of bothdisplacement and/or velocity and minimal user maintenance.

Benefits to the system user include improved quality of finished parts,ease of product adaptation, minimal downtime, complete and ready installation,elimination of static balancing, longer life of the grinding wheel, diamonddressings and spindle bearings, the ability to balance within 0.02 microns andits adaptability to all types of machines.

Precision grindingis necessary in major manufacturing areas including the automotive industry(camshafts, crankshafts, valves), bearings (roller and tapered types), ceramics(precision shaping), electric motors (shafts), pumps (shafts and turbines),aircraft (engine parts), and general manufacturing.  Precision grinding has an establishedworldwide presence in all industrialized countries and is expanding as a methodof material removal and processing. Therefore, the Company believes there may be an increase in marketgrowth and demand for products such as the SBS system.  Within the Company’s customer base for theSBS System, there are three major market segments:

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

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Examples of some well-known worldwide machine tool builders whohave offered and/or installed the SBS System include ANCA (Australia), CapcoMachinery (U.S.), Ecotech/SMTW (China/U.S.), Erwin Junker (U.S.), Gleason Works(U.S.), Landis Grinding (U.S.), Kellenberger (U.S.), Koyo Machinery (US,Japan), Micron Machinery Limited (Japan/U.S.), Normac Incorporated (U.S.), NTCToyama America (U.S./Japan), Okomoto (Japan), Okuma Machine (Japan), ShigiyaMachine (Japan), Sumitomo Heavy Industry (Japan), Toyoda Machine (Japan), USACHTechnologies, Tschudin (U.S.) and Weldon Machine Tool (U.S.).  The Company currently sells its productsdirectly to major machine builders in the U.S, Western Europe and Asia.

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

***Grinding Machine Users -*** These end users become aware of the SBS Systemthrough trade shows, trade magazine advertising, distributors, fieldrepresentatives, referrals and new machine suppliers.  The Company’s business is conducted worldwidewith some better known customers including: Black & Decker, Briggs andStratton, Caterpillar Inc., Daewoo International Corp., Eaton Corporation,Emerson Power Transmission, Ford Motor Company, General Electric Corp., GeneralMotors, Getrag Automotive, Ingersoll Rand, Komatsu, Lawrence Berkeley, SumitomoHeavy Industries, NSK Bearing, NTN Bearing, Oakridge National Lab, PurdueUniversity, SKF Bearing Industries, Texas Instruments, The Timken Company, TRWAutomotive Components and Universal Bearing.

In Fiscal 2006, 2005 and 2004, net sales of the Company’s balancingproducts totaled $7,818,669, $7,430,287 and $5,924,854, respectively.  Net sales of balancing products accounted for68%, 70% and 74% of the Company’s total sales in Fiscal 2006, 2005 and 2004,respectively.  See Note 10 toConsolidated Financial Statements.

***Competition*:**

Management believes the SBS System is one of only a few fully automaticbalancing systems marketed in the world. Most competitive products require special setup and training orcalibration to the specific machine.  TheCompany believes the SBS System is currently the only balancing product thatfits all machines with wheel sizes from 6 to 48 inches in diameter and aspindle rpm of 500 through 12,500.

Competitive products come from European companies located inSwitzerland, Germany, Spain and Italy. These competitors produce electromechanical and water balancers similarto the SBS Systems.  The Companyconsiders these companies, with their established European base, to be themajor competitors.  The Company believesthat these balancers have electronic deficiencies, rendering them lesseffective in solving essential balancing requirements.  The Company also believes that they cannotachieve consistent balance levels at low speed (500 rpm) or at high speed(7,500 rpm) as the SBS system can.  Inaddition, the Company also believes these balancers have inferior brush andcable assemblies that cause down time and high maintenance.  Finally, none of these companies cancurrently compete effectively with the Company in providing mounting adaptersfor all grinding machines.

Water balancers are an older European design still on the market thatcan be supplied by Schmitt when specifically requested by users.  They require expensive plumbing and waterchambers to be machined into the wheel hub while the SBS System does not.  They are currently priced about1.25 times the level of the SBS System. To install these systems, the grinding machines must be disassembled andparts remachined or replaced within the spindle assembly.  This can take two days, far longer thanrequired to install the SBS system.  Thewater system is “tuned” or “calibrated” to the machine by a factory servicetechnician while the SBS system can be installed by the operator.  Water systems work at mid- andhigh-speeds but cannot balance in low rpm environments while SBS products workin both environments.  Water systemsrequire periodic monitoring while the SBS systems require little or no operatormonitoring.

The SBS System list price is generally $7,995 worldwide.  Based on published price lists, competitors’electromechanical systems are priced at $8,000 to $10,000 worldwide while waterbalancers generally are priced at $9,000 to $11,000 worldwide.  Management believes customers perceive thevalue of an automatic

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balancer to be approximately $8,000, a sales price that has beenconstant for several years.  Companypricing is geared to obtaining a dominant market position and meetingcompetitive supplier prices.  The marketstrategy is to establish the SBS System as the foremost product with the bestquality, reliability and performance and superior economic value.

***Measurement Segment***

The Company manufactures and markets a line of laser-based,precision measurement systems and operates a precision laser light scattermeasurement laboratory.  Light scattertechnology involves using lasers, optics and detectors to direct a beam oflight on a material sample and record its reflection/transmission.  Analysis of information can determinematerial characteristics such as surface roughness, defects and dimensionalsizing without introducing contaminants and causing changes to the testedmaterial.  The principal products arelaser-based measurement products and technology applicable to bothindustrial and military markets.  TheCompany has used patents, patent applications, trademarks and other proprietarytechnology to focus marketing efforts on industrial markets includingelectronics, computer disk and silicon wafer manufacturers.

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

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

These products usea 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 harddisks require exact manufacturing control and a narrow tolerance band foracceptable roughness, with surface roughness outside that narrow band resultingin a reduction in data density or storage capacity.  The Company’s technology simultaneouslymeasures disk surface roughness in two directions, radially, when theread/write head is moving to another disk sector, and circumferentially, whenthe read/write head is processing information on the disk.  The two separate roughness levels arerequired for proper head operation.  The Company believes the precisemeasurement methods provided by its products are not possible through any othercost effective measurement means.  Thefollowing two products meet the challenges of disk drive manufacturers:

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

·                  TheTMS-2000-DUV-RC product measures the surface microroughness of ceramic/glassrather than aluminum substrates.  Manufacturersrequire the technology and products to measure surface roughness of theseceramic/glass substrates to the same exact levels as those that measurealuminum.  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 0.5Angstroms.

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

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

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to quantify andcontrol their manufacturing process.  Thesystem provides measurements to a few hundredths of an Angstrom, a levelunachievable by competing devices.

***Dimensional sizing products:***

These products are used in a wide range of industrial applicationsincluding steel casting, paper production, medical imaging, crane control andmicron-level part and surface inspection. Presently, there are four AccuRange (AR) product lines: the AR4000 distance measurement sensor, the AR4000Line Scanner and the AR600 and AR200 series of triangulating laser displacementsensors.

The AR4000 optical distance measurement sensor is used for most diffusereflective surfaces, but is ideally suited to level and position measurement,machine vision, 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 atightly collimated output beam for small spot size.  There are three output beam configurationsavailable: visible infrared, eye safe infrared and reflective tape targets.

The AR4000 Line Scanner is used with the AR4000 to scan and collectdistance data over a full circle.  Thescanner consists of a balanced, rotating mirror and motor with position encoderand mounting hardware for use with the AR4000. 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 AR600 series is a family of triangulating laser displacement sensorswith excellent accuracy and sensitivity. The sensor projects a beam of visible laser light that creates a spot onthe target surface.  Reflected light fromthe surface is viewed from an angle by a line scan camera and the target’sdistance 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 of surfaces at speeds up to 1250samples/second.  The product is extremelysensitive and can detect glass and liquid surfaces and also detect multiplesurfaces of transparent materials, allowing great flexibility in specializedapplications.

The AR200 line is the most compact series oftriangulating laser displacement sensors. Four models cover metric measurement ranges from six to fiftymillimeters.  All models boast a 1/500accuracy rating for measurements within twelve microns.  The AR200 sensor is the only sensor of its kindto feature pushbutton selection of output signals.  All models are standard with analog, limitswitch and serial outputs.  The AR200sensors, much like the longer-range AR600 sensors, project a beam of visiblelaser light that creates a spot on the target surface.  Reflected light from the surface is viewedfrom an angle by a line scan camera and the target’s distance is computed fromthe image pixel data.  The AR200-6M,-12M, -25M and -50M have ranges in millimeters that match their modelnumber.  The AR200 displacement sensorcannot be overloaded and measures accurately even when a mirror reflects theentire light beam back to the detector.

***Research and other measurement products:***

**The Company’s CASI Scatterometers are sold to companies andinstitutions involved in research efforts. The CASI Scatterometer uses visiable, ultraviolet or infrared laserlight as a nondestructive probe to measure surface quality, opticalperformance, smoothness, appearance, defects and contamination on a widevariety of materials.  These products aremeasurement instruments providing customers with precise roughness measurementsof optical surfaces, diffuse materials, semiconductor wafers, magnetic storagemedia and precision-machined surfaces, as well as surfaces affecting thecosmetic appearance of consumer products. Customers include Pratt & Whitney, Boeing, the U.S. Navy andRockwell Collins North America.**

The μScan System is a portable device consisting of a hand-heldcontrol unit, an interchangeable measurement head and a separate chargingunit.  To perform a measurement, theoperator places the measurement head on the objective area and presses abutton.  Each measurement takes less thanfive seconds with 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 singlemeasurement, a user can determine RMS surface roughness, reflectance andscatter light levels (BRDF) on flat or curved surfaces under any lightingconditions.

***Light-scatter measurementlaboratory:***

The Company provides a highly advanced measurement services laboratory,using CASI Scatterometers, to a wide variety of industrial and commercialbusinesses that require precise measurements only advanced laser light scattertechnology can provide.  The true valueof the laboratory is not only its extremely precise measurement capability butalso the test item is not altered, touched or destroyed.  Thus, the laboratory is widely used bymanufacturers of critical optical components in aerospace and defense systems,including such companies as Aerojet, AT&T Bell Labs, Eastman Kodak, GeneralElectric, IBM, NASA and other industrial companies, universities and governmentagencies.

In Fiscal 2006, 2005 and 2004, net sales of Measurement products totaled$3,684,691, $3,160,942 and $1,999,912 respectively and accounted for 32%, 30%and 25% of the Company’s total sales in Fiscal 2006, 2005 and 2004respectively.  See Note 10 toConsolidated Financial Statements.

***Sales by Geographic Area***

In Fiscal 2006, 2005 and 2004, the Company recorded net sales of itsproducts in the United States, its country of domicile, of $5,709,044,$5,610,274 and $4,320,421, respectively. Sales in the last three Fiscal years by geographic areas are:

|             | ** ** | **North America** | ** ** | **Europe** | ** ** | **Asia**  | ** ** | **Others** | ** ** |
|-------------|------------|------------------------|------------|------------|------------|-----------|------------|------------|------------|
| Fiscal 2006 |       | $                      | 5,878,538  |       | $          | 1,764,347 |       | $          | 2,919,556  |   | $ | 940,919 |   |
| Fiscal 2005 |       | $                      | 5,872,740  |       | $          | 2,076,089 |       | $          | 2,122,384  |   | $ | 520,016 |   |
| Fiscal 2004 |       | $                      | 4,520,940  |       | $          | 1,777,250 |       | $          | 1,365,840  |   | $ | 260,736 |   |

***Business and Marketing Strategy***

The Company designs, assembles and markets all of its products withoperations divided into a number of different areas.

***Balancer Segment Products:***

The Vice President of Operations directs production of Balancer segmentproducts including production, assembly, and purchasing, engineering andtechnical services.  Product marketingfor all Balancer segment products is managed by the President/CEO.  Two marketing managers are responsible fordomestic sales , one marketing manager is responsible for sales in Europe andanother is responsible for sales in mainland China, Taiwan and Korea.  The Company also has one person who performsfield service/sales.  Finally, researchand development efforts are supervised directly by the President/CEO and theVice President of Operations.

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

Second, OEMs include the Balancer segment products on themachine tools they produce.  Users thuspurchase the Balancer segment products concurrently with the machinetools.  Conversely, end users of grindingmachines that have purchased the SBS system directly from the Company, andafter enjoying the benefits of the products, often request that SBS products beincluded with the new equipment they order from OEMs.  The SBS Systems are often installed bymachine builders prior to displaying their own machine tools at various tradeshows, becoming endorsements that prove beneficial to the Company’s salesefforts.

Third, worldwide trade shows have proven to be an excellent source ofbusiness.  Company representatives,usually one or more of the marketing managers and/or the President/CEO, attendthese events along with local Company representatives.  These individuals operate a display boothfeaturing an SBS System demonstration stand and product and technicalliterature.  Representatives from allfacets of the Company’s target markets attend these trade shows.

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

***Measurement Segment Products:***

The Vice President of Operations directs production of all Measurementsegment products including production, assembly, and purchasing, engineeringand technical services.

Similar to the Balancer segment, the Measurement segment uses a varietyof methods to market and sell its products. First, a Marketing Manager, under the direction of the President/CEO,directs the overall worldwide marketing efforts for surface measurementproducts.  Second, both a marketing and asales manager, again under the direction of the President/CEO, direct theoverall worldwide marketing and sales efforts for dimensional sizingproducts.  Third, the Company has anexclusive distribution agreement with a company in Asia for the promotion andsale of surface measurement products in China, Taiwan, Malaysia, Singapore,Thailand and the Philippines.  Inaddition, there are distribution agreements with one company in Japan and twoin Korea.  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.**

***Backlog***

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

# ***Manufacturing***

There are no unique sources of supply or raw materials in any productlines.  Essential electronic components,available in large quantities from various suppliers, are assembled into theBalancing and Measurement electronic control units under the Company’s qualityand assembly standards.  Company-ownedsoftware and firmware are coupled with the electronic components to provide thebasis of the Company’s various electronic control units.  Management believes several supply sourcesexist for all electronic components and assembly work incorporated into itselectronic control systems.  The primaryoutside supplier of electronic assemblies is Silicon Forest Electronics ofVancouver, Washington, a custom supplier of assembled electronic products forseveral Pacific Northwest companies.  Inthe event of supply problems, the Company believes that two or threealternatives could be developed within thirty days to supplement or replaceSilicon Forest Electronics.

Mechanical parts for the Company’s products are produced by high qualityCNC machine shops.  The Company is notdependent on any one supplier of mechanical components.  Principal suppliers of components for theCompany’s products include MacKay Manufacturing of Spokane, Washington; OEMManufacturing of Corvallis, Oregon; Davis Tool of Portland, Oregon; and ForestCity Gear of Roscoe, Illinois.

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

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In-house personnel assemble various products and test all finishedcomponents before placing them in the finished goods inventory.  Finished goods inventory is maintained viacomputer to assure timely shipment and service to customers.  All customer shipments are from the finishedgoods inventory.

The Company’s Quality Control Program first received full ISO 9001certification in 1996.  On November 4,2005, the Company received its certification to the newer ISO 9001:2000requirements.

***ProprietaryTechnology***

The Company’s success depends in part on itsproprietary technology, which the Company attempts to protect through patents,copyrights, trademarks, trade secrets and other measures.  The Company has U.S. patents covering bothBalancer and Measurement products, processes and methods that the Companybelieves 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, infact, be considered substantial in the future. There can be no assurance as to the degree and range of protection anypatent will afford and whether patents will be issued or the extent to whichthe Company may inadvertently infringe upon patents granted to others.

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

The Companymanufactures its Balancer segment products under copyright protection in theU.S. for electronic board designs. Encapsulation of the finished product further protects the Company’stechnologies including software.

The Company alsorelies upon trade secret protection for its confidential and proprietaryinformation.  There can be no assurancethat others will not independently develop substantially equivalent proprietaryinformation and techniques or otherwise gain access to the Company’s tradesecrets or disclose such technology or that the Company can meaningfullyprotect its trade secrets.

While the Company pursues patent, trademark, trade secret andcopyright protection for products and various marks, it also relies on know-howand continuing technology advancement, manufacturing capabilities, affordablehigh-quality products, new product introduction and direct marketing efforts todevelop and maintain its competitive position.

***Product Development***

The Company maintains an ongoing research and development program toexpand the 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.  Inthe past few fiscal years, the Company has developed the following newbalancing and laser measurement products:

**The SB-4500 controller is a multi-function unit providingthe 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 12,500 rpm with the prior Schmitt product.  Vibrations are measured to 0.02 microns or0.75 millionths of an inch.  It alsoallows customers to balance their grinding machines faster, reducing costlydown time and increasing factory throughput. This computer controller allows the future addition of new products.**

The Acoustical Emissions Monitoring System (AEMS) iscontrolled by the SB-4500 controller and monitors the customers’ dressing andgrinding processes by direct measurement of machine-generated acousticsignals.  By monitoring the highfrequency sound signal generated by contact between the wheel and work piece,the system automatically determines when wheel contact is made.  Users can eliminate the “gap” time from theirgrinding process and also automatically detect the beginning of a wheel “crash”and immediately signal the grinding machine to stop before real damageoccurs.  The benefits of the AEMS productto the customer include time savings from quick and easy setups, improveddressing and grinding processes, and elimination of expensive part and machinedamage.

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The disk drive industry presented the Company with the challenge ofdeveloping the technology and products to measure the surface roughness ofglass substrates.  Existing laser-basedlight-scatter technology was modified to produce the required light scatterinformation 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 levels requiredby the industry.  This technology complimentsexisting products and provides the Company the ability to supply solutions forall media used by the disk drive industry.

 

During Fiscal 2006, 2005 and 2004, the Company’sresearch and development expense totaled $81,815, $42,395 and $30,370, respectively.  The Fiscal 2006 levels are higher than inprior years as the Company devoted much of its 2005 and 2004 internal laborefforts (most R&D costs are internal labor costs) to expanding productionlevels and the transition of engineering and production of dimensional sizingproducts from Menlo Park, CA to Portland, OR. Management expects amounts expended for R&D in Fiscal 2007 toincrease over the levels experienced in Fiscal 2006.

***Employees***

**As of July 19, 2006, the Company employed38 individuals worldwide on a full-time basis.  There were no regular part-timeemployees.  None of the Company’semployees is covered by a collective bargaining agreement.**

**Item1A.  Risk Factors**

**BusinessRisks**

Thisreport includes “forward-looking statements” as that term is defined in Section21E of the Securities 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 comparable terminology, or bydiscussions of strategy, plans or intentions. For example, this section contains numerous forward-looking statements.  All forward-looking statements in this reportare made based on management’s current expectations and estimates, whichinvolve risks and uncertainties, including those described in the followingparagraphs.  Among these factors are thefollowing:

·                  *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.*

·                  *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 uncertainties could cause actual results to bematerially different from those in the forward-looking statements.  Readers are cautioned not to place undue relianceon the forward-looking statements in this report.  We assume no obligation to update suchinformation.

*Demand for Company products may change:*

Over the past eight fiscal quarters, the Company hasexperienced increased demand for its Balancer products in North America.  These increases are attributed primarily toan improving economy in North America. The conditions and circumstances could change in future periods and as aresult demand for the Company’s products could decline.  Management is responding to these risks intwo ways.  First, it appears there is asignificant portion of the marketplace that is not using the automaticbalancing products of the Company or any of its competitors.  The Company will therefore continue to devotepart of its future R&D efforts toward developing products that will bothbroaden the scope of Balancing products offered to the

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current customer base. Second, there are uses for the Company’s Balancer products in industriesother than those in the Company’s historic customer base.  Management is devoting a significant portionof its time to identify these markets and educate those markets on the value ofthose products within their operations.

The laser light-scatter products of the Measurement segmenthave relied heavily upon sales to disk drive and silicon wafermanufacturers.  Conditions in thosemarkets adversely affected sales beginning in Fiscal 1999 and those poorconditions continued into Fiscal 2004 and consequently, demand for drives fellover these periods.  As the operations ofthose companies suffered, they in turn reduced capital spending resulting inminimal demand for and sporadic sales of the Company’s laser light-scatterproducts.  Industry forecasts are forimproving conditions, and the Company experienced increasing sales in Fiscal2005 and 2006 to those industries. However, the long-term impact on demand for the Company’s surfaceMeasurement products cannot be predicted with any certainty.

The semiconductor industry has also faced a down cycle over thepast few fiscal years.  Beginning inFiscal 2002, the semiconductor industry experienced backlog cancellations,resulting in slower revenue growth and these conditions continued into Fiscal2004.  The result is similar to diskdrive manufacturers in that capital spending has declined significantly andconsequently so has demand for and sales of the Company’s wafer products.  The Company experienced increasing sales inFiscal 2006 to those industries. However, the long-term impact on demand for the Company’s wafer productscannot be predicted with any certainty.

Management will continue to market these products to thesehistoric markets as it appears no other technology has been introduced thatwould make the laser light-scatter products technologically obsolete.  There is the belief that once marketconditions improve in the disk drive and silicon wafer markets, demand for theCompany’s products and technology will increase although most likely not tohistoric levels.  Also, managementbelieves there are other uses for the Company’s laser light scatter technologyand continues to evaluate R&D efforts to develop new products and introducethem to the marketplace.

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

The failure to develop new technologies, or react to changesin existing technologies, could materially delay development of new products,which could result in decreased revenues and a loss of market share tocompetitors.  Financial performancedepends on the ability to design, develop, manufacture, assemble, test, marketand support new products and enhancements on a timely and cost-effectivebasis.  New product opportunities may notbe identified and developed and brought to market in a timely andcost-effective manner.  Products ortechnologies developed by other companies may render products or technologiesobsolete or noncompetitive, or a fundamental shift in technologies in theproduct markets could have a material adverse effect on the Company’scompetitive position within historic industries.

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

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

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

Manufacturing operations depend upon obtaining adequatesupplies of raw materials on a timely basis. The results of operations could be adversely affected if adequatesupplies of raw materials cannot be obtained in a timely manner or if the costsof raw materials increased significantly.

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

Quarterly and annual operating results are likely tofluctuate in the future due to a variety of factors, some of which are beyondmanagement’s control.  As a result ofquarterly operating fluctuations, it is important to realize quarter-to-quartercomparisons of operating results are not necessarily meaningful and should notbe relied upon as indicators of future performance.

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

Operating expenses are generally fixed in nature and largelybased on anticipated sales.  However,should future sales decline significantly and rapidly, there is no guaranteemanagement could take actions that would further reduce operating expenses ineither a timely manner or without seriously impacting the operations of theCompany.

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

The Company believes it maintains a competitive advantage byshipping product to its customers more rapidly than its competitors.  As a result, the Company has a significantinvestment in inventories.  These inventoriesare recorded using the lower-of-cost or market method, which requiresmanagement to make certain estimates. Management evaluates the recorded inventory values based on customerdemand, market trends and expected future sales and changes these estimatesaccordingly.  A significant shortfall ofsales may result in carrying higher levels of inventories of finished goods andraw materials thereby increasing the risk of inventory obsolescence andcorresponding inventory write-downs.  Asa result, the Company may not carry adequate reserves to offset suchwrite-downs.

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

Future success depends on the efforts and continued servicesof key management, technical and sales personnel.  Significant competition exists for suchpersonnel and there is no assurance key technical and sales personnel can beretained nor assurances there will be the ability to attract, assimilate andretain other highly qualified technical and sales personnel as required.  There is also no guarantee key employees willnot leave and subsequently compete against the Company.  The inability to retain key personnel couldadversely impact the business, financial condition and results of operations.

*The Company faces risks from international salesand currency fluctuations:*

The Company markets and sells its products worldwide andinternational sales have accounted for and are expected to continue to accountfor a significant portion of future revenue. International sales are subject to a number of risks, including: theimposition of governmental controls; trade restrictions; difficulty incollecting receivables; changes in tariffs and taxes; difficulties in staffingand managing international operations; political and economic instability;general economic conditions; and fluctuations in foreign currencies.  No assurances can be given these factors willnot have a material adverse effect on future international sales and operationsand, consequently, on business, financial condition and results of operations.

**Item1B.  Unresolved Staff Comments**

Not applicable.

**Item 2.    Properties**

The Company’s design and assembly facilities and executive offices arelocated in Portland, Oregon in three company-owned buildings with totalapproximate square footage of 40,500 square feet.  SEL occupies a 1,893-square footfacility in Coventry, England pursuant to a three-year lease beginning June 1,2005 with a basic monthly rent of £1,875 (approximately $3,512 as of May 31,2006).

**Item 3.    Legal Proceedings**

There are no material legal proceedings currently pending against theCompany.

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

No matters were submitted to a vote of the security holders of theCompany during the fourth quarter ended May 31, 2006.

 

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**PART II**

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

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

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

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

 

| Year Ended May 31, 2005 | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                               |       | $        | 8.16       |    | $          | 2.20 |   |
| Second Quarter                              |       | $        | 9.54       |    | $          | 5.65 |   |
| Third Quarter                               |       | $        | 9.71       |    | $          | 5.82 |   |
| Fourth Quarter                              |       | $        | 9.70       |    | $          | 6.23 |   |

 

As of July 31, 2006, there were2,640,045 shares of Common Stock outstanding held by approximately175 holders of record.  The numberof holders does not include individual participants in security positionlistings; the Company believes that there are more than 2,000 individualholders of shares of Common Stock.

The Company has not paid any dividends on its Common Stock since1994.  The Company’s current policy is toretain earnings to finance the Company’s business.  Future dividends will be dependent upon theCompany’s financial condition, results of operations, current and anticipatedcash requirements, acquisition plans and plans for expansion and any otherfactors that the Company’s Board of Directors deems relevant.  The Company has no present intention ofpaying dividends on its Common Stock in the foreseeable future.

The following table summarizedinformation about equity awards under the Company’s equity compensation plansat May 31, 2006:
| **Plan Category**                                      | ** ** | **Number of  Securities to be   issued upon   exercise of  outstanding   options** | ** ** | **Weighted-average  exercise price of   outstanding options** | ** ** | **Number of Securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities   in column a)** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **a**                                                                                                                      | ** ** | **b**                                                                             | ** ** | **c**                                                                                                                                                                                             | ** ** |
| Equity  compensation plans approved by security holders     |       | 216,496                                                                                                                    |       | $                                                                                 | 2.52       |                                                                                                                                                                                              | 352,178    |   |
| Equity  compensation plans not approved by security holders |       | —                                                                                                                     |       | —                                                                            |       | —                                                                                                                                                                                            |       |
|                                                        |       | 216,496                                                                                                                    |       | $                                                                                 | 2.52       |                                                                                                                                                                                              | 352,178    |   |

 

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**Item 6.    Selected Financial Data**

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

| Year Ended                             | *** *** | **5/31/06** | ** ** | **5/31/05** | ** ** | **5/31/04** | ** ** | **5/31/03** | ** ** | **5/31/02** | *** *** |
|---------------------------------------------|--------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|--------------|
| Sales                                       |         | $           | 11,503     |        | $          | 10,591      |       | $           | 7,925      |        | $            | 7,420 |   | $ | 6,875 |   |
| Net Income  (Loss)                          |         | $           | 1,350      |        | $          | 1,608       |       | $           | 517        |        | $            | (1,487 | ) | $ | (1,599 | ) |
| Net Income  (Loss) Per Share, Basic         |         | $           | .52        |        | $          | .64         |       | $           | .21        |        | $            | (.60 | ) | $ | (.64 |   |
| Weighted Average  No. Shares, Basic         |         | 2,606       |       | 2,528       |       | 2,439       |       | 2,468       |       | 2,488       |         |
| Net Income  (Loss) Per Share, Diluted       |         | $           | .49        |        | $          | .59         |       | $           | .20        |        | $            | (.60 | ) | $ | (.64 | ) |
| Weighted Average  No. Shares, Diluted       |         | 2,746       |       | 2,709       |       | 2,524       |       | 2,468       |       | 2,488       |         |
| Stockholders’ Equity                   |         | $           | 9,814      |        | $          | 7,979       |       | $           | 6,114      |        | $            | 5,665 |   | $ | 7,251 |   |
| Total Assets                                |         | $           | 10,927     |        | $          | 9,075       |       | $           | 7,100      |        | $            | 6,272 |   | $ | 8,161 |   |
| Long-term Debt  (including current portion) |         | $           | 22         |        | $          | 53          |       | $           | 67         |        | $            | 24 |   | $ | 280 |   |

#####  

**Item 7.    Management’s Discussion and Analysis ofFinancial 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.**

# **RESULTS OF OPERATIONS**

**Overview**

Balancersegment sales focus throughout the world on end-users, rebuilders and originalequipment manufacturers of grinding machines with the target geographic marketsin North America, Asia and Europe. Combined Balancer sales increased 5.2% for the year ended May 31, 2006compared to the year ended May 31, 2005. Beginning in March 2004, improving economic conditions in North Americaresulted in increased sales in that geographic market.  Sales people, representatives anddistributors throughout these geographic areas spend a large amount of timewith targeted customers.  Many customersin the automotive, bearing and aircraft industries refer to improved economicconditions and its impact on the machine tool industry in North America as thereason for their increased orders, although the growth rate has slowed in thelast three quarters.  While those customersare optimistic regarding short term demand for Balancer products, they remainuncertain as to the strength and duration of current business conditions inNorth America for their products which incorporate the Balancer segment productline.  North American Balancer salesdecreased 0.7% in the year ended May 31, 2006 compared to the year ended May31, 2005.  Market demand in Asia for theBalancer segment products remains strong with that region showing a 49.5%increase for the year ended May 31, 2006 compared to the year ended May 31,2005.  The European market remains softas total Balancer sales into that geographic market declined 25.7% during theyear ended May 31, 2006 compared to the year ended May 31, 2005.  Sales in all Other markets increased to $845,198in the year ended May 31, 2006 compared to the $426,656 for the year ended May31, 2005, a 98.1% increase.  The largepercentage increase was predominately a result of increases in the Japan andSouth American markets.  As with theNorth American market, the duration of the strong demand in Asia, Japan andSouth American markets cannot be forecasted with any certainty.

The Measurement segment product line consists of both laserlight-scatter and dimensional sizing products. Combined Measurement salesincreased 16.6% for the year ended May 31, 2006 compared to the year ended May31, 2005.  As noted below sales can bevery cyclical in the Measurement segment. The business operations and prospects for these two product lines aresummarized as follows:

Laser light-scatter products— The primary target markets forMeasurement products have been disk drive and silicon wafer manufacturers andcompanies and organizations involved in research efforts. Certain

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segments of these targeted industries have seen consolidationinto very large international manufacturers. Sales totaled $1,948,386 for the year ended May 31, 2006 compared to the$1,396,806 for the year ended May 31, 2005. Management and the sales staff monitor industry publications and publicfinancial information in order to judge the potential demand for products bythe targeted industries.  Over the pastyear, this information has indicated improving demand for and sales of theproducts of those industries.  Sales tocustomers in these industries can be very cyclical and therefore the impact ofthis recovery on sales to the Company’s laser light-scatter products is unknownat this time.

Laser light-scatter products from research organizations —The Company continues to receive inquiries for these products and providequotes to interested parties.  However,in the current fiscal year, no sales of these products were realized.

Dimensional sizing products — These products are marketed andsold into a wide array of industries. Sales totaled $1,736,305 for the year ended May 31, 2006 compared to the$1,764,136 for the year ended May 31, 2005. In Fiscal 2004, management built a sales distribution network coveringall fifty states.  As a result of thisaction, the Company experienced increasing interest and sales in theseproducts.  During the quarter endedAugust 31, 2003, management consolidated the operations related to theseproducts (which had been located in Menlo Park, California) into theMeasurement segment operations in Portland, Oregon.  The relocation was completed as of August 31,2003.  Since relocation to Portland,sales of these products have increased from the $1,023,278 reported in Fiscal2004.

**Critical Accounting 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.

Cash Equivalents and Short Term Investments — The Companygenerally invests excess cash in money market funds and investment grade highlyliquid securities. The Company considers securities that are highly liquid,readily convertible into cash and have original maturities of less than threemonths when purchased to be cash equivalents. At May 31, 2006, short-term investments are classified asavailable-for-sale.  The carrying amountsof cash equivalents and short term investments are stated at cost, whichapproximate fair market value because of their short maturities.  There were no related unrealized holdinggains or losses at May 31, 2006.

Accounts Receivable — The Company maintains credit limits forall customers that are developed based upon several factors, including but notlimited to payment history, published credit reports and use of creditreferences.  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 the Company’s domestic andinternational customers. If these analyses lead management to the conclusionthat potential significant accounts are uncollectible, a reserve is provided.

Inventories — These assets are stated at the lower of cost ormarket on an average cost basis. Each fiscal quarter, management utilizesvarious analyses based on sales forecasts, historical sales and inventorylevels to ensure the current carrying value of inventory accurately reflectscurrent and expected requirements within a reasonable timeframe.

Deferred Tax Assets— The Company applies the asset andliability method in recording income taxes, under which deferred income taxassets and liabilities are determined, based on the differences between thefinancial reporting and tax bases of assets and liabilities and are measuredusing currently enacted tax rates and laws. Additionally, deferred tax assetsare evaluated and a valuation allowance is established if it is more likelythan not that all or a portion of the deferred tax asset will not berealized.  In Fiscal 2005 and at November30, 2005, management concluded future operations would produce sufficientearnings so that a portion of this asset could be used in future periods toreduce federal and state tax liabilities. Management continues to review the level of the valuation allowance on aquarterly basis.  There can be noassurance that the Company’s future operations will produce sufficient earningsso that the deferred tax asset can be fully utilized.

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Intangible Assets — There is a periodic review of intangibleand other long-lived assets for impairment. This review consists of the analysis of events or changes incircumstances that would indicate the carrying amount of the asset may not berecoverable. Recoverability is determined by comparing the forecasted futurenet cash flows from the operations to which the assets relate, based onmanagement’s best estimates using the appropriate assumptions and projectionsat the time, to the carrying amount of the assets.  If the carrying value is determined to be inexcess of  future operating cash flows,the asset is considered impaired and a loss is recognized equal to the amountby which the carrying amount exceeds the estimated fair value of theassets.  As of May 31, 2006, managementdoes not believe impairment, as defined above, exists.

**Recently issued accounting pronouncements:**

TheFinancial Accounting Standards Board (FASB) issued SFAS No. 151, “Inventory Costs- an Amendment to ARB No. 43, Chapter 4” in November 2004.  This Statement requires that abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage) costs be recognized as current-period charges.  In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  The Company does not expect thispronouncement to have a material impact on the financial statements.

The FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3”.  This Statement replaces APB Opinion No. 20, “AccountingChanges”, and FASB Statement No. 3, “Reporting Accounting Changes in InterimFinancial Statements”, and changes the requirements for the accounting for andreporting of a change in accounting principle. This Statement applies to allvoluntary changes in accounting principle. It also applies to changes requiredby an accounting pronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions. When a pronouncement includesspecific transition provisions, those provisions should be followed.  The Company does not expect this pronouncementto have a material impact on the financial statements.

The FASB revised SFAS No. 123R, “Share-Based Payment” inDecember 2004.  Under the revisedstandard, the Company will be required to recognize compensation cost, relatedto its stock options, beginning in the first fiscal quarter of the yearbeginning June 1, 2006.  The cost ofservices received from employees in exchange for awards of share-basedcompensation generally shall be measured based on the grant-date fair value ofthe equity instruments issued.  TheCompany expects the effect of this pronouncement to approximate the pro formaamounts disclosed in Note 2 of the Notes to Consolidated Financial Statements.

The FASB issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes” (FIN 48) in June 2006.  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in our financial statements inaccordance with SFAS No. 109, “Accounting for Income Taxes”.  The provisions of FIN 48 are effective forour fiscal year beginning June 1, 2007. We are currently evaluating the impact of the provisions of FIN 48.

**Discussion of operating results:**

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

 

 

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

 
| ** **          | ** ** | **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       |       | 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 | % |   |   |   |   |   |   |   |   |
| Operating income    |       | $                                               | 437,266    |   | 5.5 | % |   |   |   |   |   |   |   |   |

 

Worldwide sales ofBalancer products increased 5.2% in the year ended May 31, 2006 compared to theyear ended May 31, 2005 as sales to the Asian markets increased by 49.5% offsetby a decline in the North American market of 0.7%.  Sales in all Other markets increased to$845,198 in the year ended May 31, 2006 compared to the $426,656 for the yearended May 31, 2005, a 98.1% increase. These increases were offset by decreases in the European market of25.7%.  Unit sales prices of Balancerproducts are relatively stable and therefore any increases or decreases in thedollar amount of sales between fiscal periods can generally be attributed to anincrease or decrease in the number of units sold.  The Balancer product sales increase in Asiaand Other markets is attributed to expansion of the sales efforts in China andother market regions.  The decreasedunits sold in Europe are attributed to strong European competition and weakereconomic conditions in certain European markets.  The large percentage increase in Othermarkets was predominately a result of increases in the Japan and South Americanmarkets.

Measurementproduct sales increased 16.6% in the year ended May 31, 2006 compared to theyear ended May 31, 2005 as sales of the Company’s surface measurement productsincreased by 39.5% offset by slight decrease in dimensional sizing products of1.6%.  The sales of surface measurementproducts in the year ended May 31, 2006 compared to the year ended May 31, 2005increased as they included more unit sales than in the same fiscal period inthe prior year.

Cost of sales forboth the Balancer and Measurement segments increased (as a percentage of sales)in the year ended May 31, 2006 compared to the year ended May 31, 2005primarily due to the product sales mix as production labor and overhead costswere relatively stable.  Margins werealso negatively impacted as a result of higher sales in foreign markets as alarge portion of those sales are made through distributors who receive pricingnet of commissions and other sales costs.

The decrease inoperating expenses between Fiscal 2006 and 2005 occurred primarily due to thereduction of operating expenses in the Company’s foreign operations resultingfrom the liquidation and dissolution of its the German subsidiary, SchmittEuropa, GmbH, effective May 30, 2005. The costs in the foreign operations decreased due to the reduction in salesand administration staff that occurred due to the consolidation of SchmittEuropa, GmbH operations into Schmitt Europe Ltd.  The increase in operating expenses betweenFiscal 2005 and 2004 occurred primarily due to the higher levels of sales.

Sales by SchmittEurope Ltd. totaled $1,810,377 for the year ended May 31, 2006 compared tosales of $2,119,103 in the year ended May 31, 2005.  Approximately 10.5% of the decrease was dueto lower unit sales volumes with the remainder due to the changes in foreignexchange rates between the two fiscal periods. The lower sales volumes were realized as a result of the soft sales inEuropean markets, which were partially offset by increases in other marketsprimarily located in Asia and South America.

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Net sales outsideNorth America accounted for approximately 49% of the Company’s revenues inFiscal 2006, 45% in Fiscal 2005 and 43% in Fiscal 2004.  Some foreign customers purchase in their owncountry’s currencies, thereby imposing on the Company a currency risk.  Of total sales in Fiscal 2006, 2005 and 2004,approximately 15%, 20% and 23%, respectively, were denominated in currenciesother than U.S. dollars.  To date,currency fluctuations have had minimal impact on sales.  However, significant variations in the valueof the U.S. dollar, relative to currencies of countries in which the Companyhas significant competitors, can impact future sales.  The Company does not engage in currencyhedging.  In addition, the longer paymentcycles of international sales can have a negative impact on liquidity.  The Company believes international sales willcontinue to grow in future periods.

The net income forFiscal 2006 of $1,350,129 ($0.49 per fully diluted share) compared to netincome of $1,608,140 ($0.59 per fully diluted share) and net income of $516,585($0.20 per fully diluted share) in Fiscal 2005 and 2004, respectively.  Net income in Fiscal 2006 included a $280,223reduction in the deferred tax asset valuation allowance which reduced theFiscal 2006 income tax provision.  Netincome in Fiscal 2005 included two significant items; a foreign exchange lossof $174,274 which was incurred due to the closure of the German subsidiary(Schmitt Europa, GmbH); and $640,000 income tax benefit due to the reduction inthe deferred tax asset valuation allowance.  Management believes the effective tax rate infuture periods will reflect a normal combined state and federal rate.

A substantialportion of the Company’s revenues are derived from sales to end users throughselling agents. The Company is dependent on the sales activities of its sellingagents, and there can be no assurance these agents will continue to besuccessful in their efforts to market the Company’s products.  The Company enjoys substantial repeatbusiness from a broad base of customers, but there is no assurance thesecustomers will continue to buy the Company’s products.

In Fiscal years2006, 2005 or 2004, sales to any single customer did not exceed 10% of totalrevenues.

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

# **LIQUIDITY AND CAPITAL RESOURCES**

The Company’s ratio of current assets to currentliabilities increased to 8.1 to 1 at May 31, 2006 compared to 6.5 to 1 at May31, 2005.  Cash, cash equivalents andavailable for sale short term investments totaled $3,538,012 as of May 31, 2006compared to $1,176,959 at May 31, 2005. As of May 31, 2006 the Company had $1,552,072 in cash and cashequivalents compared to $1,176,959 at May 31, 2005.  As of May 31, 2006 the Company had $1,985,940in short term investments compared to $-0- at May 31, 2005.  Short term investments consisted of highlyliquid A1-P1 rated commercial paper securities maturing through September 2006.

During the year ended May 31, 2006, cash provided byoperating activities amounted to $2,358,936 with the changes described asfollows:

•               Netincome for the year ended May 31, 2006 of $1,350,129 plus one non-cash item:depreciation and amortization of $210,606; less the non-cash increase indeferred tax assets of $28,460 net of a $335,238 tax benefit related to stockoptions.

•               Accountsreceivable generated cash as the balance decreased by $126,053 to a May 31,2006 balance of $1,983,090 compared to $2,109,143 at May 31, 2005, a 6%decrease. The Company generally experiences a payment cycle of 30-90 days oninvoices, 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.

17

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•               Inventoriesdecreased $291,723 to a May 31, 2006 balance of $3,241,590 compared to$3,533,313 at May 31, 2005, a 8.3% decrease. The Company maintains levels of inventory sufficient to satisfy normalcustomer demands plus an increasing short-term delivery requirement for amajority of its Balancer products. Management believes its ability to provide prompt delivery gives it acompetitive advantage for certain sales.

•               Prepaidexpenses decreased by $26,666 to $77,626 from a balance of $104,292 at May 31,2005 with the decrease due to prepaid fees, trade show costs and variousbusiness and insurance costs.

•               Tradeaccounts payable used cash as the balance decreased by $93,716 to $403,490 froma balance of $497,206 at May 31, 2005 primarily due to normal fluctuations in timingof payment of outstanding payable balances.

•               Otheraccrued liabilities (including customer deposits, commissions, payroll itemsand other accrued expenses) increased by $106,607 to a balance of $626,785 from$520,178 at May 31, 2005.

During the year ended May 31, 2006, net cash used ininvesting activities was $2,102,808, consisting of net additions to propertyand equipment of $116,868 and net purchases of short term investments of$1,985,940.  Net cash provided byfinancing activities amounted to $84,382 which consisted of repayments oflong-term obligations of $31,258 net of common stock issued on exercised stockoptions of $115,640.

The following summarizes contractual obligations atMay 31, 2006 and the effect on future liquidity and cash flows:

| Years ending  May 31, | ** ** | **Capital Lease   and Purchase  Contract** | ** ** | **Operating Leases** | ** ** | **Total  Contractual  Obligations** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------|------------|---------------------------|------------|-------------------------------------|------------|
| 2007                            |       | $                                                         | 15,204     |                      | $          | 63,026                              |       | $ | 78,230 |   |
| 2008                            |       | 6,408                                                     |       | 63,026                    |       | 69,434                              |       |
| 2009                            |       | —                                                    |       | 8,550                     |       | 8,550                               |       |
| Thereafter                      |       | —                                                    |       | 521                       |       | 521                                 |       |
| Total                           |       | $                                                         | 21,612     |                      | $          | 135,123                             |       | $ | 156,735 |   |

 

Management hashistorically responded to business challenges that had a negative impact onoperations and liquidity by reducing operating expenses, developing newproducts and attempting to penetrate new markets for the Company’sproducts.  As a result of these efforts,results of operations and cash flow from operations have improved.  Management believes its cash flows fromoperations, its available credit resources and its cash position will provideadequate funds on both a short-term and long-term basis to cover currentlyforeseeable debt payments, lease commitments and payments under existing andanticipated supplier agreements. Management believes that such cash flow (without the raising of externalfunds) is sufficient to finance current operations, projected capitalexpenditures, anticipated long-term sales agreements and otherexpansion-related contingencies during Fiscal 2007.  However, in the event the Company fails toachieve its operating and financial goals for Fiscal 2007, management may berequired to take certain actions to finance operations in that timeperiod.  These actions could include, butare not limited to, implementation of cost cutting measures and/or enteringinto additional borrowing arrangements collateralized by assets.

**Item7A.  Quantitative and QualitativeDisclosures about Market Risk**

**InterestRate Risk**

The Company did not have any derivative financialinstruments as of May 31, 2006.  However,the Company could be exposed to interest rate risk at any time in the futureand, therefore, employs established policies and procedures to manage itsexposure to changes in the market risk of its marketable securities.

The Company’sinterest income and expense are most sensitive to changes in the general levelof U.S. and European interest rates.  Inthis regard, changes in U.S. and European interest rates affect the interestearned on the Company’s interest bearing cash equivalents and short terminvestments.  The Company has a variablerate line of credit facility with a bank but there is no outstanding balance asof May 31, 2006.  Also, there is no otherlong-term obligation whose interest rates are based on variable rates that mayfluctuate over time based on economic changes in the environment.  Therefore, at this time, the Company is notsubject to interest rate risk on outstanding interest bearing obligations ifmarket interest rates fluctuate and does not expect any change in the interestrates to have a material effect on the Company’s results from operations.

18

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**ForeignCurrency Risk**

The Company markets and sells its products worldwideand international sales have accounted for and are expected to continue toaccount for a significant portion of future revenue.  The Company operates a subsidiary in theUnited Kingdom and acquires certain materials and services from vendorstransacted in foreign currencies. Therefore, the Company’s business and financial condition is sensitiveto currency exchange rates or any other restrictions imposed on theircurrencies.  For the years ended May 31,2006, 2005 and 2004, results of operations included gains (losses) on foreigncurrency translation of $(9,757), $(184,106) and $40,608, respectively.  The foreign exchange loss in Fiscal 2005 wasdirectly attributable to the closure, liquidation and pending dissolution ofthe Company’s German subsidiary, Schmitt Europa, GmbH.  In the fourth quarter of Fiscal 2005,management chose to terminate the only two employees in that country,eliminating the need for a separate German company.  As there will be no future activity in thatsubsidiary, the accumulated foreign exchange loss, included in othercomprehensive income on the balance sheet in prior periods, was recognized inthe fourth quarter of Fiscal 2005.  Theforeign exchange gains or losses in Fiscal 2006 and 2004 are primarilyattributable to Company’s United Kingdom subsidiary, Schmitt Europe, Ltd.

 

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**Item 8.                    FinancialStatements and Supplementary Data**

**Schmitt Industries, Inc.**

##### **ConsolidatedBalance Sheets**

| ** **                                                                                                                                                       | ** ** | **May 31, 2006** | ** ** | **May 31, 2005** | **  ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------------|
| **ASSETS**                                                                                                                                                       | ** ** | ** **                 | ** ** | ** **                 |             |
| **Current assets**                                                                                                                                               |       |                       |       |                       |             |
| Cash and cash  equivalents                                                                                                                                       |       | $                          | 1,552,072  |                       | $                | 1,176,959 |   |
| Short-term  investments                                                                                                                                          |       | 1,985,940                  |       | —                     |             |
| Accounts  receivable, net of allowance of $52,186 and $41,366                                                                                                    |       |                       |       |                       |             |
| at May 31, 2006  and May 31, 2005, respectively                                                                                                                  |       | 1,983,090                  |       | 2,109,143                  |             |
| Inventories                                                                                                                                                      |       | 3,241,590                  |       | 3,533,313                  |             |
| Prepaid expenses                                                                                                                                                 |       | 77,626                     |       | 104,292                    |             |
| Deferred tax  asset                                                                                                                                              |       | 116,080                    |       | 92,319                     |             |
| ** **                                                                                                                                                       |       | 8,956,398                  |       | 7,016,026                  |             |
| **Property and equipment**                                                                                                                                       |       |                       |       |                       |             |
| Land                                                                                                                                                             |       | 299,000                    |       | 299,000                    |             |
| Buildings and  improvements                                                                                                                                      |       | 1,275,922                  |       | 1,214,348                  |             |
| Furniture,  fixtures and equipment                                                                                                                               |       | 1,180,648                  |       | 1,120,946                  |             |
| Vehicles                                                                                                                                                         |       | 96,849                     |       | 96,849                     |             |
|                                                                                                                                                             |       | 2,852,419                  |       | 2,731,143                  |             |
| Less accumulated  depreciation and amortization                                                                                                                  |       | (1,643,047                 | )          | (1,462,637                 | )                |
| ** **                                                                                                                                                       |       | 1,209,372                  |       | 1,268,506                  |             |
| **Other assets**                                                                                                                                                 |       |                       |       |                       |             |
| Long-term  deferred tax asset                                                                                                                                    |       | 552,380                    |       | 547,681                    |             |
| Other assets                                                                                                                                                     |       | 208,405                    |       | 243,009                    |             |
|                                                                                                                                                             |       | 760,785                    |       | 790,690                    |             |
|                                                                                                                                                             |       |                       |       |                       |             |
| **Total assets**                                                                                                                                                 |       | $                          | 10,926,555 |                       | $                | 9,075,222 |   |
| ** **                                                                                                                                                       | ** ** | ** **                 | ** ** | ** **                 |             |
| **LIABILITIES  & STOCKHOLDERS’ EQUITY**                                                                                                                 | ** ** | ** **                 | ** ** | ** **                 |             |
| **Current liabilities**                                                                                                                                          |       |                       |       |                       |             |
| Accounts payable                                                                                                                                                 |       | $                          | 403,490    |                       | $                | 497,206 |   |
| Accrued  commissions                                                                                                                                             |       | 250,835                    |       | 275,745                    |             |
| Accrued payroll  liabilities                                                                                                                                     |       | 138,801                    |       | 102,883                    |             |
| Other accrued  liabilities                                                                                                                                       |       | 237,149                    |       | 141,550                    |             |
| Income taxes  payable                                                                                                                                            |       | 60,237                     |       | 26,147                     |             |
| Current portion  of long-term obligations                                                                                                                        |       | 15,204                     |       | 32,114                     |             |
| ** **                                                                                                                                                       |       | 1,105,716                  |       | 1,075,645                  |             |
|                                                                                                                                                             |       |                       |       |                       |             |
| **Long-term obligations**                                                                                                                                        |       | 6,408                      |       | 20,756                     |             |
|                                                                                                                                                             |       |                       |       |                       |             |
| **Stockholders’ equity**                                                                                                                                    |       |                       |       |                       |             |
| Common stock, no  par value, 20,000,000 shares authorized, 2,625,045 and 2,559,687 shares  issued and outstanding at May 31, 2006 and May 31, 2005, respectively |       | 7,946,976                  |       | 7,496,098                  |             |
| Accumulated  other comprehensive loss                                                                                                                            |       | (220,051                   | )          | (254,654                   | )                |
| Retained  earnings                                                                                                                                               |       | 2,087,506                  |       | 737,377                    |             |
| ** **                                                                                                                                                       |       | 9,814,431                  |       | 7,978,821                  |             |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       | $                          | 10,926,555 |                       | $                | 9,075,222 |   |

 

#### ***The accompanying notes are anintegral part of these consolidated financial statements***

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#### **SchmittIndustries, Inc.**

##### **ConsolidatedStatements of Operations**

##### **For TheYears Ended May 31, 2006, 2005 and 2004**

| ** **                                         | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|----------------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
|                                               |       |      |       |      |       |       |       |
| Net sales                                          |       | $         | 11,503,360 |      | $          | 10,591,229 |       | $ | 7,924,766 |   |
| Cost of sales                                      |       | 5,029,714 |       | 4,460,769 |       | 3,405,761  |       |
| Gross profit                                       |       | 6,473,646 |       | 6,130,460 |       | 4,519,005  |       |
|                                               |       |      |       |      |       |       |       |
| Operating  expenses:                               |       |      |       |      |       |       |       |
| General,  administration and sales                 |       | 4,658,235 |       | 4,871,605 |       | 4,051,369  |       |
| Research and  development                          |       | 81,815    |       | 42,395    |       | 30,370     |       |
| Total operating  expenses                          |       | 4,740,050 |       | 4,914,000 |       | 4,081,739  |       |
|                                               |       |      |       |      |       |       |       |
| Operating income                                   |       | 1,733,596 |       | 1,216,460 |       | 437,266    |       |
|                                               |       |      |       |      |       |       |       |
| Other income  (expense)                            |       |      |       |      |       |       |       |
| Gain (loss) on  foreign currency exchange          |       | (9,757    |       | (184,106  | )          | 40,608     |       |
| Miscellaneous  income (expense)                    |       | 59,833    |       | (30,214   |       | 45,511     |       |
| Loss on  write-down of long-term investment        |       | —    |       | —    |       | (6,800     |       |
| Total other  income (expense)                      |       | 50,076    |       | (214,320  |       | 79,319     |       |
|                                               |       |      |       |      |       |       |       |
| Income before  income taxes                        |       | 1,783,672 |       | 1,002,140 |       | 516,585    |       |
|                                               |       |      |       |      |       |       |       |
| Provision  (benefit) for income taxes              |       | 433,543   |       | (606,000  | )          | —     |       |
|                                               |       |      |       |      |       |       |       |
| Net income                                         |       | $         | 1,350,129  |      | $          | 1,608,140  |       | $ | 516,585 |   |
|                                               |       |      |       |      |       |       |       |
|                                               |       |      |       |      |       |       |       |
|                                               |       |      |       |      |       |       |       |
| Net income per  common share, basic                |       | $         | 0.52       |      | $          | 0.64       |       | $ | 0.21 |   |
|                                               |       |      |       |      |       |       |       |
| Weighted average  number of common shares, basic   |       | 2,606,039 |       | 2,527,665 |       | 2,438,895  |       |
|                                               |       |      |       |      |       |       |       |
|                                               |       |      |       |      |       |       |       |
| Net income per  common share, diluted              |       | $         | 0.49       |      | $          | 0.59       |       | $ | 0.20 |   |
|                                               |       |      |       |      |       |       |       |
| Weighted average number  of common shares, diluted |       | 2,746,402 |       | 2,708,797 |       | 2,524,050  |       |

 

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

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##### **Schmitt Industries,Inc.**

##### **ConsolidatedStatements of Cash Flows**

## **For TheYears Ended May 31, 2006, 2005 and 2004**

| ** **                                                               | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004**  | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|----------|------------|-----------|------------|
| **Cash  flows relating to operating activities**                         |       |       |       |     |       |      |       |
| Net income                                                               |       | $          | 1,350,129  |     | $          | 1,608,140 |       | $ | 516,585 |   |
| Adjustments to reconcile net income to net cash                          |       |       |       |     |       |      |       |
| provided by  operating activities:                                       |       |       |       |     |       |      |       |
| Depreciation and amortization                                            |       | 210,606    |       | 214,933  |       | 188,314   |       |
| Deferred taxes                                                           |       | (28,460    | )          | (640,000 | )          | —    |       |
| Tax benefit related to stock options                                     |       | 335,238    |       | —   |       | —    |       |
| Write-down of long-term investment                                       |       | —     |       | —   |       | 6,800     |       |
| (Increase) decrease in:                                                  |       |       |       |     |       |      |       |
| Accounts receivable                                                      |       | 126,053    |       | (293,726 | )          | (491,217  | )          |
| Inventories                                                              |       | 291,723    |       | (618,220 | )          | (189,162  | )          |
| Prepaid expenses                                                         |       | 26,666     |       | 20,056   |       | 42,844    |       |
| Income taxes receivable                                                  |       | —     |       | 35,894   |       | (3,235    | )          |
| Increase(decrease) in:                                                   |       |       |       |     |       |      |       |
| Accounts payable                                                         |       | (93,716    | )          | (68,340  | )          | 210,217   |       |
| Accrued liabilities and customer deposits                                |       | 106,607    |       | 166,131  |       | 127,014   |       |
| Income taxes payable                                                     |       | 34,090     |       | 26,147   |       | —    |       |
| Net cash provided by operating activities                                |       | 2,358,936  |       | 451,015  |       | 408,160   |       |
| **Cash  flows relating to investing activities**                         |       |       |       |     |       |      |       |
| Purchase of short-term investments                                       |       | (1,985,940 | )          | —   |       | —    |       |
| Maturities of short-term investments                                     |       | —     |       | —   |       | —    |       |
| Purchase of property and equipment                                       |       | (116,868   | )          | (93,060  | )          | (108,796  | )          |
| Disposals of property and equipment                                      |       | —     |       | —   |       | (1,686    | )          |
| Net cash used in investing activities                                    |       | (2,102,808 | )          | (93,060  | )          | (110,482  | )          |
| **Cash  flows relating to financing activities**                         |       |       |       |     |       |      |       |
| Additions to long-term obligations                                       |       | —     |       | —   |       | —    |       |
| Repayments on long-term obligations                                      |       | (31,258    | )          | (42,064  | )          | (35,678   | )          |
| Common stock issued on exercise of stock options                         |       | 115,640    |       | 135,279  |       | 67,835    |       |
| Common stock repurchased                                                 |       | —     |       | —   |       | (40,000   | )          |
| Net cash provided by financing activities                                |       | 84,382     |       | 93,215   |       | (7,843    | )          |
|                                                                     |       |       |       |     |       |      |       |
| **Effect  of foreign exchange translation on cash**                      |       | 34,603     |       | 121,595  |       | (95,886   | )          |
|                                                                     |       |       |       |     |       |      |       |
| **Increase  in cash and cash equivalents**                               |       | 375,113    |       | 572,765  |       | 193,949   |       |
|                                                                     |       |       |       |     |       |      |       |
| **Cash  and cash equivalents, beginning of period**                      |       | 1,176,959  |       | 604,194  |       | 410,245   |       |
|                                                                     |       |       |       |     |       |      |       |
| **Cash  and cash equivalents, end of period**                            |       | $          | 1,552,072  |     | $          | 1,176,959 |       | $ | 604,194 |   |
|                                                                     |       |       |       |     |       |      |       |
| **Supplemental  Disclosure of Cash Flow Information**                    |       |       |       |     |       |      |       |
| Cash paid during the period for interest                                 |       | $          | 872        |     | $          | 1,083     |       | $ | 4,330 |   |
| Cash paid during the period for income taxes                             |       | $          | 139,065    |     | $          | 7,853     |       | $ | 4,035 |   |
|                                                                     |       |       |       |     |       |      |       |
| **Supplemental  Schedule of Noncash Investing and Financing Activities** |       |       |       |     |       |      |       |
|  Fixed assets financed                                              |       | $          | —     |     | $          | 27,861    |       | $ | 78,447 |   |

##### *** ***

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

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#####  

##### **Schmitt Industries, Inc.CONSOLIDATED STATEMENTS OF CHANGES INSTOCKHOLDERS’ EQUITYFOR THE YEARS ENDED MAY 31, 2006, 2005 AND 2004**

** **
| ** **                                        | ** ** | **Common Stock** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Retained ** | ** ** | ** **   | ** ** | **Total  comprehensive** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|--------------------|------------|--------------|------------|--------------------------|------------|
| ** **                                        | ** ** | **Shares**            | ** ** | **Amount**                            | ** ** | **loss**           | ** ** | **earnings** | ** ** | **Total**                | ** ** | **income (loss)** | ** ** |
| ** **                                        | ** ** | ** **            | ** ** | ** **                            | ** ** | ** **         | ** ** | ** **   | ** ** | ** **               | ** ** | ** ** | ** ** |
| **Balance,  May 31, 2003**                        |       | 2,457,932             |       | $                                     | 7,332,984  |               | $          | (280,363     | )          | $                        | (1,387,348 | ) | $ | 5,665,273 |   |   |   |
| ** **                                        |       |                  |       |                                  |       |               |       |         |       |                     |       |   |   |
| Common stock 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 |   |
| ** **                                        | ** ** | ** **            | ** ** | ** **                            | ** ** | ** **         | ** ** | ** **   | ** ** | ** **               | ** ** | ** ** | ** ** |
| Stock options exercised                           |       | 85,226                |       | 135,279                               |       | —             |       | —       |       | 135,279                  |       |   |   |
| Net income                                        |       | —                |       | —                                |       | —             |       | 1,608,140    |       | 1,608,140                |       | $ | 1,608,140 |   |
| Other comprehensive income                        |       | —                |       | —                                |       | 121,595            |       | —       |       | 121,595                  |       | 121,595 |   |
| **Balance,  May 31, 2005**                        |       | 2,559,687             |       | 7,496,098                             |       | (254,654           | )          | 737,377      |       | 7,978,821                |       |   |   |
| ** **                                        | ** ** | ** **            | ** ** | ** **                            | ** ** | ** **         | ** ** | ** **   | ** ** | ** **               | ** ** | ** ** | ** ** |
| **Comprehensive income, year ended May 31, 2005** |       |                  |       |                                  |       |               |       |         |       |                     |       | $ | 1,729,735 |   |
|                                              |       |                  |       |                                  |       |               |       |         |       |                     |       |   |   |
| Stock options  exercised and related              |       |                  |       |                                  |       |               |       |         |       |                     |       |   |   |
| tax benefit of $335,238                           |       | 65,358                |       | 450,878                               |       | —             |       | —       |       | 450,878                  |       |   |   |
| Net income                                        |       | —                |       | —                                |       | —             |       | 1,350,129    |       | 1,350,129                |       | $ | 1,350,129 |   |
| Other comprehensive income                        |       | —                |       | —                                |       | 34,603             |       | —       |       | 34,603                   |       | 34,603 |   |
| **Balance,  May 31, 2006**                        |       | 2,625,045             |       | $                                     | 7,946,976  |               | $          | (220,051     | )          | $                        | 2,087,506  |   | $ | 9,814,431 |   |   |   |
| ** **                                        | ** ** | ** **            | ** ** | ** **                            | ** ** | ** **         | ** ** | ** **   | ** ** | ** **               | ** ** | ** ** | ** ** |
| **Comprehensive income, year ended May 31, 2006** |       |                  |       |                                  |       |               |       |         |       |                     |       | $ | 1,384,732 |   |
|                                              |       |                  |       |                                  |       |               |       |         |       |                     |       |   |   |

 

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

 

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##### **Schmitt Industries, Inc.Notes to Consolidated FinancialStatementsFor The Years Ended May 31, 2006, 2005 and 2004**

# **NOTE 1**

# **ORGANIZATIONAND NATURE OF OPERATIONS**

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

# **NOTE 2**

# **SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

# **Principles of Consolidation**

# These consolidatedfinancial statements include those of the Company and its wholly ownedsubsidiaries: Schmitt Measurement Systems, Inc. (SMS), Schmitt Europe, Ltd.(SEL) and Schmitt Europa GmbH (SEG). Effective May 31, 2005 SEG has been liquidated.  Allsignificant intercompany accounts and transactions have been eliminated in thepreparation of the consolidated financial statements.

**Revenue Recognition**

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

# **Cash Equivalents and Short Term Investments**

The Companygenerally invests excess cash in money market funds and investment grade highlyliquid securities.  The Company considerssecurities that are highly liquid, readily convertible into cash and haveoriginal maturities of less than three months when purchased to be cashequivalents.  At May 31, 2006, short-terminvestments are classified as available-for-sale.  The carrying amounts of cash equivalents andshort term investments are stated at cost, which approximate fair market valuebecause of their short maturities.  Therewere no related unrealized holding gains or losses at May 31, 2006.

# **Accounts Receivable**

The Companymaintains credit limits for all customers based upon several factors, includedbut not limited to payment history, published credit reports and use of creditreferences.  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 theseanalyses lead management to the conclusion that potential significant accountsare uncollectible, a reserve is provided.

# **Inventory**

Inventory isvalued at the lower of cost or market with cost determined on the average costbasis.  As of May 31, 2006 and 2005,inventories consisted of raw materials ($1,578,767 and $1,830,748,respectively), work-in-process ($368,592 and $127,001, respectively), andfinished goods ($1,294,231 and $1,575,564, respectively).

# **Property and Equipment**

Property andequipment are stated at cost. Depreciation is computed using the straight-line method over estimateduseful lives of three to seven years for furniture fixtures, and equipment;three years for vehicles; and twenty-five years for buildings and improvements.

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# **Foreign Currency Translation**

Financialstatements for the Company’s subsidiaries outside the United States aretranslated into U.S. dollars at year-end exchange rates for assets andliabilities and weighted average exchange rates for income and expenses.  The resulting translation adjustments areincluded as a separate component of stockholders’ equity titled “AccumulatedOther Comprehensive Loss.”

# **Advertising**

Advertising costsincluded in general, administrative and selling, are expensed when theadvertising first takes place. Advertising expense was $82,322, $87,853 and $86,648 for the fiscalyears ended May 31, 2006, 2005 and 2004, respectively.

# **Research and Development Costs**

Research anddevelopment costs, which are predominately internal labor costs, are charged toexpense when incurred.

# **Stock-Based Compensation**

The Company has elected to follow the accounting provisionsof Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for StockIssued to Employees”, for stock-based compensation and to furnish the pro formadisclosures required under Statement of Financial Accounting Standards (SFAS)No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.”  No stock-based employee compensation cost isreflected in net income because all options granted under those plans had anexercise price equal to the market value of the underlying common stock on thedate of the grant.

The following table illustrates the effect on net income andearnings per share if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based compensation:
| ** **                                                                                                                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Net income, as  reported                                                                                                     |       | $        | 1,350,129  |     | $          | 1,608,140 |       | $ | 516,585 |   |
| Add: Stock-based employee compensation expense  included in reported net income, net of tax                                  |       | —   |       | —   |       | —    |       |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of tax |       | (120,411 | )          | (230,865 | )          | (28,937   | )          |
| Pro forma net  income                                                                                                        |       | $        | 1,229,718  |     | $          | 1,377,275 |       | $ | 487,648 |   |
|                                                                                                                         |       |     |       |     |       |      |       |
| Earnings per  share — basic                                                                                             |       |     |       |     |       |      |       |
| As reported                                                                                                                  |       | $        | 0.52       |     | $          | 0.64      |       | $ | 0.21 |   |
| Pro forma                                                                                                                    |       | $        | 0.47       |     | $          | 0.54      |       | $ | 0.20 |   |
| Earnings per  share — diluted                                                                                           |       |     |       |     |       |      |       |
| As reported                                                                                                                  |       | $        | 0.49       |     | $          | 0.59      |       | $ | 0.20 |   |
| Pro forma                                                                                                                    |       | $        | 0.45       |     | $          | 0.51      |       | $ | 0.19 |   |

 

The effects of applying SFAS No. 123 in this pro formadisclosure are not necessarily indicative of future amounts.

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# **Deferred Tax Assets**

The Companyapplies the asset and liability method in recording income taxes, under whichdeferred income tax assets and liabilities are determined, based on thedifferences between the financial reporting and tax bases of assets andliabilities and are measured using currently enacted tax rates and laws.  Additionally, deferred tax assets areevaluated and a valuation allowance is established if it is more likely thannot that all or a portion of the deferred tax asset will not be realized.  In Fiscal 2005 and at November 30, 2005,management concluded future operations would produce sufficient earnings sothat a portion of this asset could be used in future periods to reduce federaland state tax liabilities.  Managementcontinues to review the level of the valuation allowance on a quarterlybasis.  There can be no assurance thatthe Company’s future operations will produce sufficient earnings so that thedeferred tax asset can be fully utilized.

# **Intangible Assets**

There is aperiodic review of intangible and other long-lived assets for impairment.  This review consists of the analysis ofevents or changes in circumstances that would indicate the carrying amount ofthe asset may not be recoverable. Recoverability is determined by comparing the forecasted future net cashflows from the operations to which the assets relate, based on management’sbest estimates using the appropriate assumptions and projections at the time,to the carrying amount of the assets.  Ifthe carrying value is determined to be in excess of  future operating cash flows, the asset isconsidered impaired and a loss is recognized equal to the amount by which thecarrying amount exceeds the estimated fair value of the assets.  As of May 31, 2006, management does notbelieve impairment, as defined above, exists.

# **Earnings Per Share**

Basic earnings per share is computed using the weightedaverage number of common shares outstanding. Diluted earnings per share is computed using the weighted average numberof common shares outstanding, adjusted for dilutive incremental sharesattributed to outstanding options to purchase common stock.

# **Concentration of Credit Risk**

Financialinstruments that potentially expose the Company to concentration of credit riskare trade accounts receivable.  Creditterms generally include a discount of 1-1/2% if the invoice is paid within tendays, with the net amount payable in 30 days.

# **Financial Instruments**

Based on borrowingrates currently available to the Company for bank loans with similar terms andmaturities, the fair value of the Company’s long-term debt approximates thecarrying value.  Furthermore, thecarrying value of all other financial instruments potentially subject tovaluation risk (principally consisting of cash and cash equivalents, short terminvestments, accounts receivable and accounts payable) also approximate fairvalue because of their short-term maturities.

# **Use of Estimates**

The preparation ofthe consolidated 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.

# **Recently issued accounting pronouncements:**

The FinancialAccounting Standards Board (FASB) issued SFAS No. 151, “Inventory Costs - anAmendment to ARB No. 43, Chapter 4” in November 2004.  This Statement requires that abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage) costs be recognized as current-period charges.  In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  The Company does not expect thispronouncement to have a material impact on the financial statements.

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The FASB issuedSFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APBOpinion No. 20 and FASB Statement No. 3”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, andFASB Statement No. 3, “Reporting Accounting Changes in Interim FinancialStatements”, and changes the requirements for the accounting for and reportingof a change in accounting principle. This Statement applies to all voluntary changes in accountingprinciple.  It also applies to changesrequired by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions.  When a pronouncement includes specifictransition provisions, those provisions should be followed.  The Company does not expect thispronouncement to have a material impact on the financial statements.

The FASB issuedSFAS No. 123R, “Share-Based Payment” in December 2004.  Under the revised standard, the Company willbe required to recognize compensation cost, related to its stock options,beginning in the first fiscal quarter of the year beginning June 1, 2006.  The cost of services received from employeesin exchange for awards of share-based compensation generally shall be measuredbased on the grant-date fair value of the equity instruments issued.  The Company will use the modified prospectivetransition method and will continue to value stock-based compensation utilizingthe Black-Scholes valuation model.  TheCompany has evaluated the provisions of SFAS No. 123R and expects its adoptionwill have a material impact on the Company’s consolidated results of operationsand earnings per share, as the stock-based compensation expense will be chargeddirectly against the Company’s reported earnings. The amount of expense thatwill be recognized is largely dependent on several variables, including thelevel of share-based payments that will be granted during the fiscal year inaddition to the assumptions used in the valuation model.  The Company estimates that a total ofapproximately $90,000 will be recorded as additional compensation expense overthe period beginning with the quarter ending August 31, 2006 through the fiscalyear ending May 31, 2009, for all options which are outstanding as of May 31,2006, but which were not yet vested.  Theadoption of SFAS No. 123R will not have any effect on the Company’s cash flowsor liquidity as stock-based compensation is a non-cash expense.  See Stock-Based Compensation in Note 2 andNote 11.

The FASB issuedFASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN48) in June 2006.  FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in our financialstatements in accordance with SFAS No. 109, “Accounting for Income Taxes”.  The provisions of FIN 48 are effective forour fiscal year beginning June 1, 2007. We are currently evaluating the impact of the provisions of FIN 48.

# **Reclassifications**

Certain reclassifications have been made to the 2005 and 2004amounts to conform to 2006 presentations.

**NOTE 3**

**ACCOUNTS RECEIVABLE**

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

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

 

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**NOTE 4**

**INVENTORIES**

Changes in the Company’sallowance for slow moving inventories are as follows:

|                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Beginning  balance       |       | $        | 163,414    |     | $          | 172,696 |   |
| Items added to allowance |       | 18,777   |       | 94,664   |       |
| Items used in production |       | (9,246   | )          | (103,946 | )          |
| Ending balance           |       | $        | 172,945    |     | $          | 163,414 |   |

 

# **NOTE 5**

**LINE OFCREDIT**

The Company has a $1.0 million bank line of credit agreementsecured by U.S. accounts receivable, inventories and general intangibles.  Interest is payable at the bank’s prime rate,8% as of May 31, 2006, and the agreement expires on September 1, 2007. Therewere no outstanding balances on the line of credit at May 31, 2006.

# **NOTE 6**

**INCOMETAXES**

The provision(benefit) for income taxes was as follows:
| ** **                                       | ** ** | **Years ended May 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current                                          |       | $                                      | 109,100    |   | $ | 34,000 |   | $ | — |   |
| Deferred                                         |       | 604,666                                |       | 420,167 |   | 226,827 |   |
| Decrease in  valuation allowance                 |       | (280,223                               | )          | (1,060,167 | ) | (226,827 | ) |
| Total (benefit from)  provision for income taxes |       | $                                      | 433,543    |   | $ | (606,000 | ) | $ | — |   |

 

Deferred taxassets (liabilities) are comprised of the following components:

|                                                | ** ** | **2006**  | ** ** | **2005**   | ** ** |
|------------------------------------------------|------------|-----------|------------|------------|------------|
| Depreciation                                   |       | $         | 62,869     |       | $          | 65,749 |   |
| Net operating  loss carryforwards              |       | 197,958   |       | 637,258    |       |
| Deferred taxes  related to the decline in fair |       |      |       |       |       |
| market value of  long-term investment          |       | 694,696   |       | 694,696    |       |
| Other deferred  items, net                     |       | 500,569   |       | 330,175    |       |
| Gross deferred  tax assets                     |       | 1,456,092 |       | 1,727,878  |       |
| Deferred tax  asset valuation allowance        |       | (787,632  | )          | (1,087,878 | )          |
| Net deferred tax asset                         |       | $         | 668,460    |       | $          | 640,000 |   |

 

The Net deferredtax asset is classified as follows:

|                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Current deferred  tax asset   |       | $        | 116,080    |     | $          | 92,319 |   |
| Long-term  deferred tax asset |       | 552,380  |       | 547,681  |       |
| Net deferred tax asset        |       | $        | 668,460    |     | $          | 640,000 |   |

 

The Company’s U.S. federal and state net operating loss carryforwardsexpire through Fiscal 2025.

 

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The Company applies the asset and liability method in recording incometaxes, under which deferred income tax assets and liabilities are determined,based on the differences between the financial reporting and tax bases ofassets and liabilities and are measured using currently enacted tax rates andlaws.  Deferred tax assets are evaluatedand a valuation allowance is established if it is more likely than not that allor a portion of the deferred tax asset will not be realized.  The Company has recorded a substantialdeferred tax asset related to the expected realization of net operating losscarryforwards for federal income tax purposes and other temporary differencesbetween book and tax bases of assets and liabilities.  Due to the uncertainty of utilization of theCompany’s net operating losses and in consideration of other factors,management recorded a valuation allowance on the deferred tax asset at May 31,2003.

In Fiscal 2005, management concluded future operations would producesufficient earnings so that a portion of the net deferred tax asset could beused in future periods to reduce federal and state tax liabilities.  As a result, the valuation reserve for thisasset was reduced as of May 31, 2005 to reflect the amount of the assetmanagement expected to utilize in future fiscal periods.  During Fiscal 2006, management concludedfuture operations would produce sufficient earnings so that additional portionsof this asset could be used in future periods to reduce federal and state taxliabilities and the allowance was reduced to reflect the amount of the deferredtax asset management believes can be utilized in Fiscal 2006 and beyond.  Management believes the effective tax rate infuture periods will reflect a normal combined state and federal rate.

The provision for income taxes differs from the amount of income taxesdetermined by applying the U.S. statutory federal tax rate to pre-tax (loss)income due to the following:
| ** **                                  | ** ** | **Years ended May 31,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|
| ** **                                  | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Statutory  federal tax rate                 |       | 34.0                                   | %          | 34.0 | % | 34.0 | % |
| State taxes, net  of federal benefit        |       | 4.4                                    |       | 4.4 |   | — |   |
| Change in  deferred tax valuation allowance |       | (15.7                                  | )          | (105.8 | ) | (43.9 | ) |
| Permanent and  other differences            |       | 1.6                                    |       | 6.9 |   | 9.9 |   |
| Effective tax rate                          |       | 24.3                                   | %          | (60.5 | )% | — | % |

 

**NOTE 7**

**EMPLOYEEBENEFIT PLANS**

The Company adopted the Schmitt Industries, Inc. 401(k)Profit Sharing Plan & Trust effective June 1, 1996.  Employees must meet certain age and servicerequirements to be eligible. Participants may contribute up to 15% of their eligible compensationwhich may be partially matched by the Company. The Company may further make either a profit sharing contribution or adiscretionary contribution.  As of June1, 2005 the Company resumed matching contributions in conjunction with employeecontributions to the plan and made contributions totaling $45,041 during Fiscal2006.  There were no contributions madeby the Company to this Plan during the years ended May 31, 2005 and 2004.

# **NOTE 8**

**LONG-TERM OBLIGATIONS**

During Fiscal2005, the Company entered into a purchase contract for $27,861.  The agreement calls for monthly principal andinterest payments of $810 and carries interest at 1.9%.  During Fiscal 2004, the Company entered intoan equipment lease, which was treated as a capital lease, and a purchase contracttotaling $78,477.  The agreements callfor monthly principal payments of $832 and $2,131 and both carry nointerest.  One lease expired in Fiscal2006 and the second expires in Fiscal 2007. Equipment recorded under the capital lease was $48,477, with relatedaccumulated depreciation of $37,704 at May 31, 2006.

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As of May 31,2006, future capital lease and purchase contract payments are:

| Years ending May 31, | ** ** |
|-------------------------------------|------------|
| 2007                                |       | $ | 15,204 |   |
| 2008                                |       | $ | 6,408 |   |
| 2009                                |       | $ | — |   |

 

# **NOTE 9**

# **COMMITMENTS AND CONTINGENCIES**

In a transactionrelated to the acquisition of Schmitt Measurement Systems, Inc., formerly TMATechnologies, Inc. (TMA), the Company established a royalty pool and vested ineach shareholder and debt holder of the acquired company an interest in theroyalty pool equal to the amount invested or loaned including interest payablethrough March 1995.  The royalty pool isfunded at 5% of net sales (defined as gross sales less returns, allowances andsales commissions) of the Company’s surface measurement products and futurederivative products developed by Schmitt Industries, Inc., which utilize thesetechnologies.  As part of the royaltypool agreement, each former shareholder and debt holder released TMA from anyclaims with regard to the acquisition except their rights to futureroyalties.  Royalty expense applicable tothe years ended May 31, 2006, 2005 and 2004 amounted to $87,567, $79,268 and$41,430, respectively.

The Company hasentered into various non-cancelable leases for facilities used to supportoperations in the United Kingdom.  Rentexpense for the years ended May 31, 2006, 2005 and 2004 amounted to $39,960,$41,806 and $67,133, respectively.

Lease commitmentsunder these leases for each of the years ending May 31 are as follows:

| Years ending May 31, | ** ** |
|-------------------------------------|------------|
| 2007                                |       | $ | 63,026 |   |
| 2008                                |       | $ | 63,026 |   |
| 2009                                |       | $ | 8,550 |   |
| Thereafter                          |       | $ | 521 |   |

 

# **NOTE 10**

# **SEGMENTS OF BUSINESS**

The Companyoperates principally in two segments of business: the design and assembly ofdynamic balancing systems and components (Balancer) for the machine toolindustry, and the design and assembly of laser measurement systems(Measurement).  The Company also operatesin two principal geographic markets, United States and Europe.

## **SegmentInformation**

| ** **                     | ** ** | **Years ended May 31,** | ** ** |
|--------------------------------|------------|----------------------------------------|------------|
| ** **                     | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **Balancer**                           | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| Gross sales                    |       | $                                      | 8,429,409  |   | $ | 3,765,191 |   | $ | 8,276,258 |   | $ | 3,188,941 |   | $ | 6,644,781 |   | $ | 2,017,494 |   |
| Intercompany  sales            |       | (610,740                               | )          | (80,500 | ) | (845,971 | ) | (27,999 | ) | (719,927 | ) | (17,582 | ) |
| Net sales                      |       | $                                      | 7,818,669  |   | $ | 3,684,691 |   | $ | 7,430,287 |   | $ | 3,160,942 |   | $ | 5,924,854 |   | $ | 1,999,912 |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss)  from operations |       | $                                      | 674,446    |   | $ | 1,059,150 |   | $ | 274,710 |   | $ | 941,750 |   | $ | 2,674 |   | $ | 434,592 |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Intercompany  rent             |       | $                                      | (30,000    | ) | $ | 30,000 |   | $ | (30,000 | ) | $ | 30,000 |   | $ | (30,000 | ) | $ | 30,000 |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  expense          |       | $                                      | 139,905    |   | $ | 36,097 |   | $ | 137,184 |   | $ | 43,146 |   | $ | 111,282 |   | $ | 35,764 |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Amortization  expense          |       | $                                      | —     |   | $ | 34,604 |   | $ | — |   | $ | 34,603 |   | $ | 6,665 |   | $ | 34,603 |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures           |       | $                                      | 54,903     |   | $ | 61,965 |   | $ | 103,658 |   | $ | 17,263 |   | $ | 169,295 |   | $ | 17,948 |   |

 

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***GeographicInformation***

| Geographic Sales | ** ** | **Years ended May 31,** | ** ** |
|-----------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| North American Sales  |       |                                   |       |   |   |   |   |
| United States         |       | $                                      | 5,709,044  |   | $ | 5,610,274 |   | $ | 4,320,421 |   |
| Intercompany          |       | —                                 |       | — |   | — |   |
|                  |       | 5,709,044                              |       | 5,610,274 |   | 4,320,421 |   |
| Canada and  Mexico    |       | 169,494                                |       | 262,466 |   | 200,519 |   |
|                  |       |                                   |       |   |   |   |   |
| North America  total  |       | 5,878,538                              |       | 5,872,740 |   | 4,520,940 |   |
|                  |       |                                   |       |   |   |   |   |
| European Sales        |       |                                   |       |   |   |   |   |
| Germany               |       | 313,655                                |       | 552,438 |   | 469,342 |   |
| Intercompany          |       | (10,293                                | )          | — |   | — |   |
| Germany total         |       | 303,362                                |       | 552,438 |   | 469,342 |   |
|                  |       |                                   |       |   |   |   |   |
| United Kingdom        |       | 1,081,981                              |       | 1,276,968 |   | 1,136,035 |   |
| Intercompany          |       | (677,415                               | )          | (873,970 | ) | (737,509 | ) |
| United Kingdom  total |       | 404,566                                |       | 402,998 |   | 398,526 |   |
| Other European  Sales |       | 1,056,419                              |       | 1,120,653 |   | 909,382 |   |
|                  |       |                                   |       |   |   |   |   |
| Total Europe          |       | 1,764,347                              |       | 2,076,089 |   | 1,777,250 |   |
|                  |       |                                   |       |   |   |   |   |
| Asia                  |       | 2,919,556                              |       | 2,122,384 |   | 1,365,840 |   |
| Others                |       | 940,919                                |       | 520,016 |   | 260,736 |   |
|                  |       | $                                      | 11,503,360 |   | $ | 10,591,229 |   | $ | 7,924,766 |   |

 

 
| ** **                     | ** ** | **Years ended May 31,** | ** ** |
|--------------------------------|------------|----------------------------------------|------------|
| ** **                     | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **United States**                 | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** |
| Income (loss)  from operations |       | $                                      | 1,730,712  |   | $ | 2,884 |   | $ | 1,547,349 |   | $ | (330,889 | ) | $ | 623,887 |   | $ | (186,621 | ) |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  expense          |       | $                                      | 164,394    |   | $ | 11,608 |   | $ | 172,903 |   | $ | 7,427 |   | $ | 137,606 |   | $ | 9,440 |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Amortization  expense          |       | $                                      | 34,604     |   | $ | — |   | $ | 34,603 |   | $ | — |   | $ | 41,268 |   | $ | — |   |
|                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures           |       | $                                      | 112,101    |   | $ | 4,767 |   | $ | 120,921 |   | $ | — |   | $ | 182,094 |   | $ | 5,149 |   |

##  

## **Long-termAssets**

|               | ** ** | **May 31, 2006** | ** ** | **May 31, 2005** | ** ** |
|---------------|------------|----------------------------|------------|----------------------------|------------|
| Segment:      |       |                       |       |                       |       |
| Balancer      |       | $                          | 1,483,166  |                       | $          | 1,563,468 |   |
| Measurement   |       | $                          | 486,991    |                       | $          | 495,728 |   |
|          |       |                       |       |                       |       |
| Geographic:   |       |                       |       |                       |       |
| United States |       | $                          | 1,949,390  |                       | $          | 2,031,587 |   |
| Europe        |       | $                          | 20,767     |                       | $          | 27,609 |   |

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

**NOTE 11**

# **STOCK OPTIONS**

The Board ofDirectors adopted a Stock Option Plan in December 1995, which plan was amendedin August 1996 and October 2004 and restated in August 1998.  An option granted under the Amended andRestated Stock Option Plan (the Plan) might be either an incentive stock option(ISO), or a nonstatutory stock option (NSO). ISOs may be granted only to employees and members of the Board of Directorsof the Company and are subject to certain limitations, in addition torestrictions applicable to all stock options under the Plan.  Options not meeting these limitations will betreated as NSOs.  The purchase price ofISOs is fair market value on the date of grant; the purchase price of NSOs mayvary from fair market value.  Vesting isat the discretion of the compensation committee of the Board of Directors, butis either 50% at grant date and 16.7% on each anniversary thereafter or 50% atgrant date and 25% on each anniversary thereafter.  The Company initially reserved 400,000 sharesfor issuance under the Plan and in October 2004 the shareholders approvedanother 400,000 shares for issuance under the Plan.  All outstanding options will expire no laterthan 2015.

31

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The followingsummarizes the options outstanding as of May 31, 2006:

|                                    | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------|------------|
| 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       |   |
| Options granted                    |       | 165,500    |       | 2.30                                   |       |
| Options  exercised                 |       | (85,226    | )          | 1.59                                   |       |
| Options  forfeited/cancelled       |       | —     |       | —                                 |       |
|                               |       |       |       |                                   |       |
| Options  outstanding May 31, 2005  |       | 250,790    |       | $                                      | 1.79       |   |
| Options granted                    |       | 34,000     |       | 6.47                                   |       |
| Options  exercised                 |       | (63,294    | )          | 1.83                                   |       |
| Options  forfeited/cancelled       |       | (5,000     | )          | 2.30                                   |       |
|                               |       |       |       |                                   |       |
| Options outstanding May  31, 2006  |       | 216,496    |       | $                                      | 2.52       |   |

 

The Company continues to measure compensation cost for thePlan using the method of accounting prescribed by APB 25.  In electing to continue to follow APB 25 forexpense recognition purposes, the Company is required to provide the expandeddisclosures required under SFAS No. 148 for stock-based compensation granted,including disclosure of pro forma net income and earnings per share, as if thefair value based method of accounting defined in the SFAS No. 123, had beenadopted.

The Company has computed, for pro forma disclosure purposes,the value of all stock options granted during Fiscal 2006 and 2005 using theBlack-Scholes option pricing model as prescribed by SFAS No. 123 using thefollowing assumptions:

|                          | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|--------------------------|------------|-----------|------------|-----------|------------|
| Risk-free  interest rate |       | 4.25-4.45 | %          | 3.8-4.0   | %          |
| Expected  dividend yield |       | 0         | %          | 0         | %          |
| Expected life            |       | 4.7 years |       | 4.0 years |       |
| Expected volatility      |       | 98        | %          | 95-102    | %          |

 

Using the Black-Scholesmethodology, the total value of stock options granted during Fiscal 2006 and2005 was $143,432 and $270,684 respectively, which would be amortized on a proforma basis over the vesting period of the options.  The average fair value of the options grantedin Fiscal 2006 and 2005 was $4.84 and $1.64, respectively.  No stock options were granted during Fiscal2004.

The following table summarizedinformation about stock options outstanding at May 31, 2006:
| **Outstanding Options** | ** ** | **Exercisable Options** | ** ** |
|------------------------------|------------|------------------------------|------------|
| **Exercise  Price**          | ** ** | **Number  of  Shares**       | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual Life  (yrs)** | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $1.20                        |       | 86,414                       |       | $ | 1.20 |   | 5.8 |   | 86,414 |   | $ | 1.20 |   |
|  2.30                   |       | 96,082                       |       | 2.30 |   | 8.0 |   | 59,666 |   | 2.30 |   |
|  5.80                   |       | 5,000                        |       | 5.80 |   | 9.4 |   | 1,667 |   | 5.80 |   |
|  6.58                   |       | 29,000                       |       | 6.58 |   | 9.3 |   | 8,250 |   | 6.58 |   |
|                         |       | 216,496                      |       | $ | 2.52 |   | 7.3 |   | 155,997 |   | $ | 1.95 |   |

 

32

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# **NOTE 12**

# **EARNINGS PER SHARE**

Basic earnings per share is computed using the weightedaverage number of shares outstanding. Diluted earnings per share is computed using the weighted average numberof shares outstanding, adjusted for dilutive incremental shares attributed tooutstanding options to purchase common stock. The following table is a reconciliation of the numerators anddenominators of the basic and diluted per share computations for each of thethree years in the period ended May 31, 2006:
| ** **                                  | ** ** | **Income  (Numerator)** | ** ** | **Weighted  Average Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|--------------------------------------------------|------------|------------------------|------------|
| **Year ended May 31, 2006**                 | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **             | ** ** |
| Basic earnings  per share                   |       |                    |       |                                             |       |                   |       |
| Income available to common stockholders     |       | $                       | 1,350,129  |                                             | 2,606,039  |                   | $          | 0.52 |   |
| Effect of dilutive securities stock options |       | —                  |       | 140,363                                          |       |                   |       |
| Diluted earnings  per share                 |       |                    |       |                                             |       |                   |       |
| Income available to common stockholders     |       | $                       | 1,350,129  |                                             | 2,746,402  |                   | $          | 0.49 |   |
| ** **                                  | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **             | ** ** |
| **Year ended May 31, 2005**                 | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **             | ** ** |
| Basic earnings  per share                   |       |                    |       |                                             |       |                   |       |
| Income available to common stockholders     |       | $                       | 1,608,140  |                                             | 2,527,665  |                   | $          | 0.64 |   |
| Effect of dilutive securities stock options |       | —                  |       | 181,132                                          |       |                   |       |
| Diluted earnings  per share                 |       |                    |       |                                             |       |                   |       |
| Income available to common stockholders     |       | $                       | 1,608,140  |                                             | 2,708,797  |                   | $          | 0.59 |   |
| ** **                                  | ** ** | ** **              | ** ** | ** **                                       | ** ** | ** **             | ** ** |
| **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 |   |

 

**NOTE 14**

# **RELATED PARTY TRANSACTIONS**

Effective June 1, 2004, the Company entered into a contractto provide consulting services to PulverDryer USA, Inc., (“PulverDryer”)pursuant to which PulverDryer paid the Company $8,000 a month from June 2004through October 2004.  PulverDryer alsobuys certain products from the Company at normal prevailing rates.  The Company and PulverDryer extended thecontract from November 1, 2004 forward at that same monthly fee of $8,000.  Product sales to PulverDryer during thefiscal years ended May 31, 2006 and 2005 totaled $152,305 and $88,873,respectively.

In connection with the contract, the Board authorized WayneCase, the Company’s Chief Executive Officer, to provide advisory services toPulverDryer, and permitted Mr. Case to receive as compensation the totalconsulting fees paid by PulverDryer from June 2004 through October 2004.  Effective November 1, 2004, Mr. Case receives40% of the ongoing consulting fee from PulverDryer, which percentage was determinedby the Compensation Committee.  Mr. Casealso serves on the board of directors of PulverDryer.

33

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#### **SUMMARIZEDQUARTERLY FINANCIAL DATA**

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

 
| **2005 Quarter Ended** | ** ** | **August 31** | ** ** | **November 30** | ** ** | **February 28** | ** ** | **May 31** | ** ** |
|----------------------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|-----------------|------------|
| Sales                            |       | $                  | 2,432      |                 | $          | 2,481                |       | $               | 2,563      |   | $ | 3,115 |   |
| Gross profit                     |       | $                  | 1,358      |                 | $          | 1,481                |       | $               | 1,466      |   | $ | 1,825 |   |
| Net income                       |       | $                  | 280        |                 | $          | 289                  |       | $               | 253        |   | $ | 786 | (1) |
| Net income per  share, basic     |       | $                  | .11        |                 | $          | .11                  |       | $               | .10        |   | $ | .32 |   |
| Net income per  share, diluted   |       | $                  | .10        |                 | $          | .11                  |       | $               | .09        |   | $ | .29 |   |
| Market Price of Common  Stock    |       |               |       |                 |       |                 |       |            |       |
| High                             |       | $                  | 8.16       |                 | $          | 9.54                 |       | $               | 9.71       |   | $ | 9.70 |   |
| Low                              |       | $                  | 2.20       |                 | $          | 5.65                 |       | $               | 5.82       |   | $ | 6.23 |   |

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(1)—Includes $606,000income tax benefit.

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

Board of Directors andShareholders

Schmitt Industries, Inc.

We have audited theaccompanying consolidated balance sheets of Schmitt Industries, Inc. and itssubsidiaries as of May 31, 2006 and 2005, and the related consolidatedstatements of operations, changes in stockholders’ equity and cash flows foreach of the three years in the period ended May 31, 2006.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform an audit of its internal control over financialreporting.  Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Schmitt Industries, Inc. andits subsidiaries as of May 31, 2006 and 2005, and the consolidated results oftheir operations and their consolidated cash flows for each of the three yearsin the period ended May 31, 2006, in conformity with accounting principlesgenerally accepted in the United States of America.
|  | /s/ GRANT  THORNTON LLP |
|--|-------------------------|

 

Portland, OregonAugust 15, 2006

34

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**ITEM 9.    Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure**

None.

**Item 9A. Controls and Procedures**

(a)                                  Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rules 13a-15(e) and 15d — 15(e) promulgated under the Securities ExchangeAct of 1934, as amended, as of the end of the period covered by thisreport.  Based on their evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures are effective as of the end of the periodcovered by this report.

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

**Item 9B. Other Information**

None.

**PART III**

Certaininformation required by Part III is included in the Company’s definitive ProxyStatement for its 2006 Annual Meeting of Shareholders (“Proxy Statement”) andis incorporated herein by reference.  TheProxy Statement will be filed pursuant to Regulation 14A of the SecuritiesExchange Act of 1934 not later than 120 days after the end of the Fiscal yearcovered by this Report.

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

The information required by these items is included in the ProxyStatement under the headings “Management,” “Executive Compensation,” “SummaryCompensation Table,” “Options Grants in Fiscal 2006,” “Aggregated OptionExpenses in Fiscal 2006 and Fiscal Year-End Option Values,” “Section 16(a)Beneficial Ownership Reporting Compliance” and “Code of Ethics” and isincorporated herein by reference.

**Item 12.                 Security Ownership of Certain Beneficial Owners andManagement**

The information required by this item is included in the Proxy Statementunder the heading “Security Ownership of Certain Beneficial Owners” and isincorporated herein by reference.

**Item 13.                 Certain Relationships and Related Transactions**

The information required by this item is included in the Proxy Statementunder the heading “Certain Relationships and Related Transactions” and isincorporated herein by reference.

**Item 14.                 PrincipalAccounting Fees and Services**

The information required by this item is included in the Proxy Statementunder the heading “Independent Public Accountants” and is incorporated hereinby reference.

35

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**PART IV**

**Item 15.                 Exhibits and Financial Statement Schedules**

*(a)          Financial Statements:*

| (1)    |     | Consolidated Balance  Sheets as of May 31, 2006 and 2005                                                                                                                                                                     |
|--------|----------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |     | Consolidated Statements  of Operations for the years ended May 31, 2006, 2005 and 2004                                                                                                                                       |
|   |     | Consolidated Statements  of Cash Flows for the years ended May 31, 2006, 2005 and 2004                                                                                                                                       |
|   |     | Consolidated Statements  of Changes in Stockholders’ Equity for the years ended May 31, 2006, 2005 and  2004                                                                                                            |
|   |     | Notes to Consolidated Financial  Statements for the years ended May 31, 2006, 2005 and 2004                                                                                                                                  |
|   |     | Report of Independent  Registered Public Accounting Firm                                                                                                                                                                     |
| (2)    | * * | *Financial Statement Schedules:*All  financial statement schedules are omitted either because they are not  applicable, not required, or the required information is included in the  financial statements or notes thereto. |
| (3)    | * * | *Exhibits:*Reference  is made to the list on page 38 of the Exhibits filed with this report.                                                                                                                                 |

 

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

**SCHMITT INDUSTRIES, INC.**

By:       /s/ Wayne A. Case                                                                              WayneA. Case

*            Chairmanof the Board, President            andChief Executive Officer*

Date:  August 21, 2006

36

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Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities indicated on August21, 2006.
| Signature                 | ** ** | ** **                                       | ** ** | **Title** | ** ** | ** ** |
|---------------------------|------------|--------------------------------------------------|------------|-----------|------------|------------|
| /s/ Wayne A.  Case        |       | Chairman of the Board,  President and Chief      |
| Wayne A. Case             |       | Executive Officer (Principal  Executive Officer) |
| /s/ Michael S. McAfee     |       | Chief Financial  Officer/Treasurer               |
| Michael S.  McAfee        |       | (Principal Financial  and Accounting Officer)    |
| /s/ Maynard Brown         |       | Director                                         |
| Maynard Brown             |       |                                             |
| /s/ Timothy D.J. Hennessy |       | Director                                         |
| Timothy D.J.  Hennessy    |       |                                             |
| /s/ David M. Hudson       |       | Director                                         |
| David M. Hudson           |       |                                             |
| /s/ Michael J.  Ellsworth |       | Director                                         |
| Michael J.  Ellsworth     |       |                                             |

 

37

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**INDEX TO EXHIBITS**
| Exhibits | ** ** | **Description**                                                                                                                                                                                                            |
|----------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |       |                                                                                                                                                                                                                       |
| 3.1      |       | 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. |
|     |       |                                                                                                                                                                                                                       |
| 3.2      |       | 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.                                               |
|     |       |                                                                                                                                                                                                                       |
| 4.1      |       | See exhibits 3.1 and 3.2 for provisions of the  Articles of Incorporation and Bylaws defining the rights of security holders.                                                                                              |
|     |       |                                                                                                                                                                                                                       |
| *10.1    |       | Schmitt Industries, Inc. Amended & Restated  Stock Option Plan. 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. Incorporated by  reference to Exhibit 14.1 to the Company’s Annual Report on Form 10-K for the  Fiscal year ended May 31, 2004.                                                  |
|     |       |                                                                                                                                                                                                                       |
| **21.1   |       | Subsidiaries of Schmitt Industries, Inc. as of May  31, 2006.                                                                                                                                                              |
|     |       |                                                                                                                                                                                                                       |
| **23.1   |       | Consent of Independent Registered Public Accounting  Firm.                                                                                                                                                                 |
|     |       |                                                                                                                                                                                                                       |
| **31.1   |       | Certification of Principal Executive Officer  pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                  |
|     |       |                                                                                                                                                                                                                       |
| **31.2   |       | Certification of Principal Financial Officer  pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                  |
|     |       |                                                                                                                                                                                                                       |
| **32.1   |       | Certification of Principal Executive Officer and  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.                                   |

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*Management contract or compensatory plan.

**Filed herewith

 

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