**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**(MarkOne)**

 

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

 

**For the Fiscalyear ended: May 31, 2005**

 

**or**

 

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

 

**For the transition period from                                   to                                   **

 

**Commission File Number:  0-23996**

 

**SCHMITT INDUSTRIES, INC.**

(Exact name of registrant as specified in its charter)

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

 

**2765 N.W. Nicolai Street**

**Portland, Oregon 97210**

(Address of principal executive offices) (ZipCode)

 

**(503) 227-7908**

(Registrant’s telephone number, including areacode)

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

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

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**Common Stock - no par value**

(Title of each class)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yesý     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 Form 10-Kor any amendment to this Form 10-K. ý

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).                                                                                                                                               Yeso                  No. ý

 

As of July 29, 2005, the aggregate market valueof the registrant’s Common Stock held by nonaffiliates of the registrant was $22,173,431basedon the closing sales price of the registrant’s Common Stock on the Nasdaq SmallCapMarket.  On that date, there were 2,578,306 sharesof Common Stock outstanding.

 

Documents Incorporated by Reference

 

Portions of the registrant’sdefinitive Proxy Statement for its 2004 Annual Meeting of Shareholders areincorporated by reference into Part III hereof.

 

 

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**PART I**

 

**Item1.  Business**

 

***Introduction***

 

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 Companydesigns, manufactures and markets precision laser measurement systems (theMeasurement Segment). The Company also sells and markets its products in Europethrough its wholly owned subsidiary, Schmitt Europe Ltd. (“SEL”), located inthe United Kingdom. Effective May 30, 2005 the Company has liquidated anddissolved the German Subsidiary, Schmitt Europa, GmbH. The Company’s executiveoffices are located at 2765 N.W. Nicolai Street, Portland, Oregon97210, and its telephone number is (503) 227-7908.

 

***Balancer Segment***

 

The Company’s principalproduct is the Schmitt Dynamic Balance System (the “SBS System”), consisting ofa computer control unit, sensor, spindle-mounting adapter, and balance head.  It is designed as an inexpensive highlyaccurate permanent installation on grinding machines. The Company acquired itsoriginal balancing equipment technology pursuant to a series of agreements from1987 through 1991, substantially enhancing and advancing the patentedtechnology since that time.  Sinceinception the targeted customer base has been operators of grinding machines.

 

The SBS System is fullyautomated, eliminating the need to pre-balance such devices as grindingwheels.  This reduces machine setup timeand ensures a smoother and more efficient operation.  Operating on a principle of mass compensationfor wheel imbalance, the balance head contains two movable eccentric weights,each driven by electric motors through a precision gear train.  These weights are repositioned to offset anyimbalance in a grinding wheel or other application.  Imbalance or vibration is picked up by thesensor that feeds a signal to a controller that filters the signal byrevolutions per minute.  The controllerthen drives the balance head weights in a direction that reduces the amplitudeof the vibration signal. The balance cycle is complete when the weights arepositioned to achieve the lowest vibration level.

 

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

 

Benefits to the systemuser include improved quality of finished parts, ease of product adaptation,minimal downtime, complete and ready installation, elimination of staticbalancing, longer life of the grinding wheel, diamond dressings and spindlebearings, the ability to balance within 0.02 microns and its adaptability toall types of machines.

 

Precision grinding isnecessary in all 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 anestablished worldwide presence in all industrialized countries and is expandingas a method of material removal and processing. Therefore, the Company believes there may be an increase in marketgrowth and the need for automatic balancing. Within the industry there arethree major market segments:

 

***Machine Tool Builders -***These companies designand manufacture a variety of cylindrical, surface and specialty applicationgrinding machines.  SBS Systems aredistributed to a variety of world markets through OEM (original equipmentmanufacturer) accounts, where a special pricing (20% discount) is offered tothe machine builder incorporating the SBS System into its machine.

 

Examplesof some well-known worldwide machine tool builders who have offered and/orinstalled the SBS System include ANCA (Australia), Capco Machinery (U.S.), Ecotech/SMTW(China/U.S.), Erwin Junker (US), Gleason Works (U.S.), Landis Grinding (U.S.), Kellenberger(US), Koyo Machinery (US, Japan), Micron Machinery Limited (Japan/U.S.), NormacIncorporated (U.S.), NTC Toyama America (U.S./Japan), Okomoto (Japan), OkumaMachine (Japan), Shigiya Machine

 

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(Japan),Sumitomo Heavy Industry (Japan), Toyoda Machine (Japan), USACH Technologies,Tschudin (US) and Weldon Machine Tool (U.S.). The Company currently sells its products directly to most of the majormachine builders in the U.S, Western Europe and Asia.

 

***Machine Tool Rebuilders –*** These customers, foundin all industrial nations, develop their business by offering to completelyupdate and refurbish older grinding machines. These rebuilders typically tearthe old machine apart and install new components, such as the SBS System.  The Company currently sells its productsdirectly to major machine rebuilders in the U.S. and Western Europe.

 

***Grinding Machine Users -*** These end users becomeaware of the SBS System through trade shows, trade magazine advertising,distributors, field representatives, 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, EmersonPower Transmission, Ford Motor Company, General Electric Corp., General Motors,Getrag Automotive, Ingersoll Rand, Komatsu, Lawrence Berkeley, Sumitomo HeavyIndustries, NSK Bearing, NTN Bearing, Oakridge National Lab, Purdue University,SKF Bearing Industries, Texas Instruments, The Timken Company, TRW AutomotiveComponents and Universal Bearing.

 

In Fiscal 2005, 2004 and2003, net sales of the Company’s balancing products totaled $7,369,487, $5,924,854and $5,481,010 respectively.  Net salesof balancing products accounted for 70%, 75% and 74% of the Company’s totalsales in Fiscal 2005, 2004 and 2003, respectively.  See Note 11 to Consolidated FinancialStatements.

 

***Competition*:**

 

Management believes theSBS System is one of few fully automatic balancing systems marketed in theworld.  Most competitive products requirespecial setup and training or calibration to the specific machine. The Companybelieves the SBS System is currently the only balancing product that fits allmachines with wheel sizes from 6 to 48 inches in diameter and a spindlerpm of 500 through 12,500.

 

Competitive products comefrom European companies located in Switzerland, Germany, Spain and Italy.  These competitors produce electromechanical andwater balancers similar to the SBS Systems. The Company considers these companies, with their established Europeanbase, to be the major competitors.  Thesebalancers have electronic deficiencies, rendering them less effective insolving essential balancing requirements. They cannot achieve the consistent low balance levels at 500 rpm (lowspeed) or at 7,500 rpm (high speed) as the SBS system can.  In addition, these balancers have inferiorbrush and cable 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 anolder European design still on the market that can be supplied by Schmitt whenspecifically supplied by users.  Theyrequire expensive plumbing and water chambers to be machined into the wheel hubwhile the SBS System does not.  They arecurrently priced about 1.25 times the level of the SBS System.  To install these systems, the grindingmachines must be disassembled and parts remachined or replaced within thespindle assembly.  This can take twodays, far longer than required to install the SBS system.  The water system is “tuned” or “calibrated”to the machine by a factory service technician while the SBS system can beinstalled by the operator.  Water systemswork at mid- and high-speeds but cannot balance in low rpm environments whileSBS products work in both environments. Water systems require periodic monitoring while the SBS systems requirelittle or no operator monitoring.

 

The SBS System list priceis generally $7,995 worldwide.  Competitors’electromechanical systems are priced at $8,000 to $10,000 worldwide while waterbalancers are priced at $9,000 to $11,000 worldwide.  Management believes customers perceive thevalue of an automatic balancer to be approximately $8,000, a sales price thathas been constant for several years.  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 manufacturesand markets a line of laser-based, precision measurement systems and operates aprecision laser light scatter measurement laboratory.  Light scatter technology involves usinglasers, optics and

 

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detectors to throw a beamof light 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 both industrialand military markets.   The Company hasused patents, patent applications, trademarks and other proprietary technologyto focus marketing efforts on industrial markets including electronics,computer disk and silicon wafer manufacturers.

 

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

 

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

 

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

 

Computer hard disksrequire exact manufacturing control and a narrow tolerance band for acceptableroughness, with surface roughness outside that narrow band resulting in areduction in data density or storage capacity. The Company’s technology simultaneously measures disk surface roughnessin two directions, radially, when the read/write head is moving to another disksector, and circumferentially, when the read/write head is processing informationon the disk.  The two separate roughnesslevels are required for proper head operation. The precise measurement methods provided by the Company’s products arenot possible through any other cost effective measurement means. The followingtwo products meet the challenges of disk drive manufacturers and help preventsuch problems from occurring:

 

•                  TheTMS-2000-RC (Texture Measurement System) product is the world’s fastest andmost accurate non-contact texture measurement system.  The product (used on aluminum substrates) iscurrently used worldwide by most major disk drive manufacturers, providingfast, accurate and repeatable microroughness measurements while quadruplingproduction throughput when compared to other testing devices.  Surface roughness can be measured to levelsbelow 0.5 Angstroms (the point of a needle is one million Angstroms indiameter).

 

•                  TheTMS-2000-DUV-RC product measures the surface microroughness of ceramic ratherthan aluminum substrates.  Manufacturersrequire the technology and products to measure surface roughness of thesesubstrates to the same exact levels as those that measure aluminum. The DeepUltra-violet light (DUV) technology and product uses the patented light scattertechnology to measure the surface roughness of glass substrates to levels lessthan 0.5 Angstrom.

 

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

 

There are two productsdevoted to the silicon wafer industry, the TMS-2000W-RC and TMS-3000W-RC.  Both products provide fast, accurate,repeatable measurements for manufacturers of silicon wafers, computer chips andmemory devices. This industry demands manufacturing precision to increaseperformance and capacity and these products help achieve those goals. Siliconwafers are carefully cut and polished to provide the base upon which a computeror memory chip is produced.  Therefore,chip manufacturing is extremely dependent on the beginning surface roughness ofthe wafer.  Since all silicon wafersexhibit a microscopic level of surface roughness, stemming from chemicaldeposition, grinding, polishing, etching, or any number of other productiontechniques, some method of measuring these surface characteristics isrequired.  The wafer measurement productsprovide a way for customers in this industry to quantify and control theirmanufacturing process. The system provides measurements to a few hundredths ofan Angstrom, a level unachievable by other testing devices.

 

**Dimensional Sizing Products:**

 

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

 

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The AccuRange 4000 is anoptical distance measurement sensor for most diffuse reflective surfaces, butis ideally suited to level and position measurement, machine vision, autonomousvehicle navigation and 3D imaging applications. It operates by emitting a collimated laser beam that is reflected fromthe target surface and collected by a sensor. The sensor is suitable for a wide variety of distance measurementapplications that demand high accuracy and fast response times.  Notable features include the operating rangefor most surfaces (zero to fifty feet), fast response time (50 kHz maximumsample rate), compact and lightweight power design and has a tightly collimatedoutput beam for small spot size.  Thereare three output beam configurations available: visible infrared, eye safeinfrared and reflective tape targets.

 

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

 

The AR600 series is afamily of triangulating laser displacement sensors with excellent accuracy andsensitivity.  The sensor projects a beamof visible laser light that creates a spot on the target surface. Reflectedlight from the surface is viewed from an angle by a line scan camera and thetarget’s distance is computed from the image pixel data. The line includes 11models measuring displacements from 1/8” to 50” and accuracy’s down to .00015”(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 themost compact series of triangulating laser displacement sensors. Four modelscover metric measurement ranges from six to fifty millimeters.   All models boast a 1/500 accuracy rating formeasurements within twelve microns.   TheAR200 sensor is the only sensor of its kind to feature pushbutton selection ofoutput signals.  All models are standardwith Analog, Limit Switch and Serial outputs. The AR200 sensors, much like the longer-range AR600 sensors, project abeam of visible laser light that creates a spot on the target surface.Reflected light from the surface is viewed from an angle by a line scan cameraand the target’s distance is computed from the image pixel data.  The AR200-6M, -12M, -25M and -50M have rangesin millimeters that match their model number. The AR200 displacement sensor can not be overloaded and measuresaccurately even when a mirror reflects the entire light beam back to thedetector.

 

**Researchand Other Measurement Products:**

 

**CASIScatterometers are sold to companies and institutions involved in researchefforts. A Scatterometer uses ultraviolet or infrared laser light as anondestructive probe to measure surface quality, optical performance,smoothness, appearance, defects and contamination on a wide variety ofmaterials. These products are measurement instruments providing customers withprecise roughness measurements of optical surfaces, diffuse materials,semiconductor wafers, magnetic storage media and precision-machined surfaces,as well as surfaces affecting the cosmetic appearance of consumer products.Customers include Pratt & Whitney, Boeing, The U.S. Navy and RockwellCollins North America.**

 

The mScanSystem is a portable device consisting of a hand-held control unit, aninterchangeable measurement head and a separate charging unit.  To perform a measurement, the operator placesthe measurement head on the objective area and presses a button.  Each measurement takes less than five secondswith results displayed and stored in system memory.  The mScan can store 700measurements in 255 files and provides the capability to program pass/failcriteria.  Software is available forcontrol, analysis and file conversion. From a single measurement, a user candetermine RMS surface roughness, reflectance and scatter light levels (BRDF) onflat or curved surfaces under any lighting conditions.

 

**Testing Laboratory:**

** **

The Company provides ahighly advanced measurement services laboratory, using CASI Scatterometers, toa wide variety of industrial and commercial businesses that require precisemeasurements only advanced laser light scatter technology can provide.  The true value of the laboratory is not onlyits extremely precise measurement capability but also the test item is notaltered, touched or destroyed.  Thus, thelaboratory is widely used by manufacturers of critical optical components inaerospace and defense systems, including such companies as Aerojet, AT&TBell Labs, Eastman Kodak, General Electric, IBM, NASA and dozens of otherindustrial companies, universities and government agencies.

 

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In Fiscal 2005, 2004 and2003, net sales of Measurement products totaled $3,160,942, $1,999,912 and $1,938,511respectively and accounted for 30%, 25% and 26% of the Company’s total sales inFiscal 2005, 2004 and 2003 respectively.  See Note 11 to Consolidated Financial Statements.

 

**Business and Marketing Strategy**

 

The Company designs,assembles and markets all of its products with operations divided into a numberof different areas.

 

**BalancerSegment products:**

 

The Vice President ofOperations directs production of Balancer segment products includingproduction, assembly, and purchasing, engineering and technical services.  Product marketing for all Balancer segmentproducts is managed by the President/CEO. Two Marketing Managers are responsible for domestic sales while a thirdis responsible for sales in Mainland China, Taiwan and Korea.  The Company also has one person who performsfield service/sales.  The President/CEOis responsible for European sales and oversees the efforts of the European MarketingManager who is headquartered in the United Kingdom.  Finally, research and development efforts aresupervised directly by the President/CEO and the Vice President of Operations.

 

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

 

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

 

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

 

**In NorthAmerica and 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.**

 

**MeasurementSegment Products:**

 

The Vice President ofOperations directs production of all Measurement segment products includingproduction, assembly, and purchasing, engineering and technical services.

 

Similar to the Balancersegment, the Measurement segment uses a variety of methods to market and sellits products.  First, a MarketingManager, under the direction of the President/CEO, directs the overallworldwide marketing efforts for surface measurement products.  Second, both a marketing and a sales manager,again under the direction of the President/CEO, direct the overall worldwidemarketing and sales efforts for dimensional sizing products.  Third, the Company has an exclusivedistribution agreement with a company in Asia for the promotion and sale of surfacemeasurement products in China, Taiwan, Malaysia, Singapore, Thailand and the Philippines.  In addition, there are nonexclusivedistribution agreements with two companies in Japan and one in Korea. Fourth,trade shows represent a significant amount of marketing/sales effort.  The President/CEO attends these events alongwith various Company representatives. These individuals operate a display booth featuring demonstrations ofMeasurement segment products along with product and technical

 

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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 Measurementsegment products are assembled in the Portland, Oregon facility and shippedworldwide directly to customers.**

 

**The Balancerand Measurement segment customer bases each consist of over 250 companies.**

 

# **Manufacturing**

 

There are no uniquesources of supply or raw materials in any product lines.  Essential electronic components, available inlarge quantities from various suppliers, are assembled into the Balancing andMeasurement electronic control units under the Company’s quality and assemblystandards.  Company-owned software andfirmware are coupled with the electronic components to provide the basis of theCompany’s various electronic control units. Management believes several supply sources exist for all electroniccomponents and assembly work incorporated into its electronic controlsystems.  The primary outside supplier ofelectronic assemblies is Silicon Forest Electronics of Vancouver, Washington, acustom supplier of assembled electronic products for several Pacific Northwestcompanies.  In the event of supplyproblems, the Company believes that two or three alternatives could bedeveloped within thirty days to supplement or replace Silicon ForestElectronics.

 

Mechanical parts for theCompany’s products are produced by high quality CNC machine shops.  The Company is not dependent on any onesupplier of mechanical components.  Principalsuppliers of components for the Company’s products include MacKay Manufacturingof Spokane, Washington; OEM Manufacturing of Corvallis, Oregon; Davis Tool ofPortland, Oregon; and Forest City Gear of Roscoe, Illinois.

 

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

 

In-house personnelassemble various products and test all finished components before placing themin the finished goods inventory. Finished goods inventory is maintained via computer to assure timelyshipment and service to customers.  Allcustomer shipments are from the finished goods inventory.

 

In November 1996,the Company’s Quality Control Program received full ISO-9001certification.  The Company is presentlytransitioning its certification to the new ISO-2000 requirements.

 

**Proprietary Technology**

 

The Company’s successdepends in part on its proprietary technology, which the Company attempts toprotect through patents, copyrights, trademarks, trade secrets and othermeasures.

 

The Company has U.S.patents covering both Balancer and Measurement products, processes and methodswhich the Company believes provide it with a competitive advantage.  The Company has a policy of seeking patentswhere appropriate on inventions concerning new products and improvementsdeveloped as part of its ongoing research, development and manufacturingactivities.  While patents providecertain legal rights of enforceability, there can be no assurance the historiclegal standards surrounding questions of validity and enforceability willcontinue to be applied or that current defenses as to issued patents will, 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” areregistered trademarks and are affixed to all products and literature created inthe Company’s balancer and measurement product lines, respectively.

 

The Company manufacturesits Balancer segment products under copyright protection in the U.S. forelectronic board designs.  Encapsulationof the finished product further protects the Company’s technologies includingsoftware.

 

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The Company also reliesupon 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 pursuespatent, trademark, trade secret and copyright protection for products andvarious marks, it also relies on know-how and continuing technologyadvancement, manufacturing capabilities, affordable high-quality products, newproduct introduction and direct marketing efforts to develop and maintain itscompetitive position.

 

**Product Development**

 

The Company maintains anongoing research and development program to expand the product lines andcapabilities of both product segments. The goal of this program is to expand the product base in historicmarkets and to enter new market areas so as to reduce reliance on historicmarket segments.  In the past few Fiscalyears, the Company has developed the following new balancing and lasermeasurement products:

 

**The SB-4500controller is a multi-function unit providing the versatility to controlseveral activities including all balancer products.  It controls balancing in applications withspeeds ranging from 300 to 30,000 rpm compared to a range of 500 to 12,500 rpmwith the prior Schmitt product. Vibrations are measured to 0.02 microns or 0.75 millionths of aninch.  It also allows customers tobalance their grinding machines faster, reducing costly down time andincreasing factory throughput. This computer controller allows the futureaddition of new products.**

** **

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

 

The disk drive industrypresented the Company with the challenge of developing the technology andproducts to measure the surface roughness of glass substrates. 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 levelsrequired by the industry. This technology compliments existing products andprovides the Company the ability to supply solutions for all media used by thedisk drive industry.

 

DuringFiscal 2005, 2004 and 2003, the Company’s research and development expensetotaled $42,395, $30,370 and $192,686 respectively.  The Fiscal 2005 and 2004 levels were lowerthan in prior years as the Company devoted much of its internal labor efforts(most R&D costs are internal labor costs) to expanding production levelsand the transition of engineering and production of dimensional sizing productsfrom Menlo Park, CA to Portland, OR. Management expects amounts expended for R&D in Fiscal 2006 to returnto levels approximating those experienced in Fiscal 2003.

 

**Business Risks**

 

Thisreport includes “forward-looking statements” as that term is defined in Section 21Eof 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 containsnumerous forward-looking statements. All forward-looking statements in thisreport are made based on management’s current expectations and estimates, whichinvolve risks and uncertainties, including those described in the followingparagraphs. Among these factors are the following:

 

•                  *Demand for Company products may change.*

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

 

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

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

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

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

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

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

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

 

Suchrisks and uncertainties could cause actual results to be materially differentfrom those in the forward-looking statements. Readers are cautioned not toplace undue reliance on the forward-looking statements in this report. Weassume no obligation to update such information.

 

*Demand for Company products may change:*

 

Overthe past five fiscal quarters, the Company has experienced increasing demandfor its Balancer products in North America and Europe.  These increases are attributed to animproving economy in North America and more focused and aggressive sales andmarketing techniques in Europe.  Theconditions and circumstances could change in future periods and as a resultdemand 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 current customer base.  Second, there are uses for the Company’sBalancer products in industries other than those in the Company’s historiccustomer base.  Management is devoting asignificant portion of its time to identify these markets and educate thosemarkets on the value of those products within their operations.

 

Thelaser light-scatter products of the Measurement segment have relied heavilyupon sales to disk drive and silicon wafer manufacturers.  Conditions in those markets adverselyaffected sales beginning in Fiscal 1999 and those poor conditions continuedinto Fiscal 2004 and consequently, demand for drives fell over these periods.As the operations of those companies suffered, they in turn reduced capitalspending resulting in minimal demand for and sporadic sales of the Company’slaser light-scatter products.  Industryforecasts are for improving conditions and the Company has experiencedincreasing sales in Fiscal 2005 to those industries.  However, the long-term impact on demand forthe Company’s surface Measurement products cannot be predicted with anycertainty.

 

Thesemiconductor industry has also faced a down cycle over the past few fiscalyears. Beginning in Fiscal 2002 the semiconductor industry experienced backlogcancellations, resulting in slower revenue growth and these conditionscontinued into Fiscal 2004.  The resultis similar to disk drive manufacturers in that capital spending has declinedsignificantly and consequently so has demand for and sales of the Company’swafer products.  Some improvement inmarket conditions is forecasted to occur sometime in the next several months,although there is no certainty if and when those improvements will occur.

 

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

 

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

 

Thefailure to develop new technologies, or react to changes in existingtechnologies, could materially delay development of new products, which couldresult in decreased revenues and a loss of market share to competitors.Financial performance depends on the ability to design, develop, manufacture,assemble, test, market and support new products and enhancements on a timelyand cost-effective basis.  New productopportunities may not be identified and developed and brought to market in a timelyand cost-effective manner.  Products ortechnologies developed by other companies may render products or technologies

 

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obsoleteor noncompetitive or a fundamental shift in technologies in the product marketscould have a material adverse effect on the Company’s competitive positionwithin historic industries.

 

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

 

Failureto protect existing intellectual property rights may result in the loss ofvaluable technologies or paying other companies for infringing on theirintellectual property rights.  TheCompany relies on patent, trade secret, trademark and copyright law to protectsuch technologies.  There is no assuranceany of the Company’s U.S. patents will not be invalidated, circumvented,challenged or licensed to other companies.

 

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

 

Manufacturingoperations depend upon obtaining adequate supplies of raw materials on a timelybasis.  The results of operations couldbe adversely affected if adequate supplies of raw materials cannot be obtainedin a timely manner or if the costs of raw materials increased significantly.

 

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

 

Quarterlyand annual operating results are likely to fluctuate in the future due to avariety of factors, some of which are beyond management’s control. As a resultof quarterly operating fluctuations, it is important to realizequarter-to-quarter comparisons of operating results are not necessarilymeaningful and should not be relied upon as indicators of future performance

 

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

 

Operatingexpenses are generally fixed in nature and largely based on anticipatedsales.  However, should future salesdecline significantly and rapidly, there is no guarantee management could takeactions that would further reduce operating expenses in either a timely manneror without seriously impacting the operations of the Company.

 

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

 

TheCompany believes it maintains a competitive advantage by shipping product toits customers more rapidly than its competitors.  As a result, the Company has a significantinvestment in inventories.  Theseinventories are recorded using the lower-of-cost or market method, whichrequires Management 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:*

 

Futuresuccess depends on the efforts and continued services of key management,technical and sales personnel. Significant competition exists for such personnel and there is noassurance key technical and sales personnel can be retained nor assurancesthere will be the ability to attract, assimilate and retain other highlyqualified technical and sales personnel as required.  There is also no guarantee key employees willnot leave and subsequently compete against the Company. The inability to retainkey personnel could adversely impact the business, financial condition andresults of operations.

 

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

 

TheCompany markets and sells its products worldwide and international sales haveaccounted for and are expected to continue to account for a significant portionof future revenue.  International salesare subject to a number of risks, including: the imposition of governmentalcontrols; trade restrictions; difficulty in collecting receivables; changes intariffs and taxes; difficulties in staffing and managing internationaloperations; political and economic instability; general economic conditions;and fluctuations in foreign currencies. No assurances can be given these factors will not have a materialadverse effect on future

 

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internationalsales and operations and, consequently, on business, financial condition andresults of operations.

 

**International Sales**

 

The Company’s sales inthe last three Fiscal years by geographic areas are:

 
| ** **  | ** ** | **North America** | ** ** | **Europe** | ** ** | **Asia**  | ** ** | **Others** | ** ** |
|-------------|------------|-------------------|------------|------------|------------|-----------|------------|------------|------------|
| Fiscal 2005 |       | $                 | 5,811,940  |       | $          | 2,076,089 |       | $          | 2,122,384  |   | $ | 520,016 |   |
| Fiscal 2004 |       | $                 | 4,520,940  |       | $          | 1,777,250 |       | $          | 1,365,840  |   | $ | 260,736 |   |
| Fiscal 2003 |       | $                 | 4,150,797  |       | $          | 2,348,102 |       | $          | 849,940    |   | $ | 70,682 |   |

 

**Backlog**

 

The Company does notgenerally track backlog.  Normally,orders are shipped within a few days after receipt unless the customer requestsotherwise.

 

**Employees**

 

**As of July 9,2005, the Company employed 37 individuals worldwide on a full-timebasis.  There were no regular part-timeemployees.  None of the Company’semployees is covered by a collective bargaining agreement.**

 

**Item 2.****      ****Properties**

 

The Company’s design andassembly facilities and executive offices are located in Portland, Oregon inthree company-owned buildings with total approximate square footage of 40,500square feet.  SEL occupies a 1,893-squarefoot facility in Coventry, England pursuant to a three-year lease beginning June 1,2005 with a basic monthly rent of £1,875 (approximately $3,400 as of July 12,2005).

 

**Item 3.****      ****Legal Proceedings**

 

There are no materiallegal proceedings currently pending against the Company.

 

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

 

No matters were submittedto a vote of the security holders of the Company during the fourth quarterended May 31, 2005.

 

**PART II**

 

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

 

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

 

**Thefollowing tables set forth the high and low sales prices of the Company’sCommon Stock as reported on the the Nasdaq Smallcap Market for the periodsindicated.**

** **
| **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 |   |

 
| **Year Ended May 31, 2004** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------|------------|----------|------------|---------|------------|
| First Quarter                    |       | $        | 1.82       |    | $          | 1.24 |   |
| Second Quarter                   |       | $        | 2.53       |    | $          | 1.48 |   |
| Third Quarter                    |       | $        | 2.69       |    | $          | 1.86 |   |
| Fourth Quarter                   |       | $        | 2.75       |    | $          | 1.75 |   |

 

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As of July 29, 2005,there were 2,578,306 shares of Common Stock outstanding held by approximately130 holders of record.  The numberof holders does not include individual participants in security positionlistings; the Company believes that there are more than 2,500 individualholders of shares of Common Stock.

 

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

 

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**Item 6.****       SelectedFinancial Data**

 

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

 
| **Year Ended**                              | ** ** | **5/31/05** | ** ** | **5/31/04** | ** ** | **5/31/03** | ** ** | **5/31/02** | ** ** | **5/31/01** | ** ** |
|---------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Sales                                       |       | $           | 10,530     |        | $          | 7,925       |       | $           | 7,420      |        | $          | 6,875 |   | $ | 7,580 |   |
| Net Income  (Loss)                          |       | $           | 1,608      |        | $          | 517         |       | $           | (1,487     | )           | $          | (1,599 | ) | $ | (2,367 | ) |
| Net Income  (Loss) Per Share, Basic         |       | $           | .64        |        | $          | .21         |       | $           | (.60       | )           | $          | (.64 | ) | $ | (.90 | ) |
| Weighted Average  No. Shares, Basic    |       | 2,528       |       | 2,439       |       | 2,468       |       | 2,488       |       | 2,635       |       |
| Net Income  (Loss) Per Share, Diluted       |       | $           | .59        |        | $          | .20         |       | $           | (.60       | )           | $          | (.64 | ) | $ | (.90 | ) |
| Weighted Average  No. Shares, Diluted  |       | 2,709       |       | 2,524       |       | 2,468       |       | 2,488       |       | 2,635       |       |
| Stockholders’  Equity                  |       | $           | 7,979      |        | $          | 6,114       |       | $           | 5,665      |        | $          | 7,251 |   | $ | 8,930 |   |
| Total Assets                                |       | $           | 9,075      |        | $          | 7,100       |       | $           | 6,272      |        | $          | 8,161 |   | $ | 10,291 |   |
| Long-term Debt  (including current portion) |       | $           | 53         |        | $          | 67          |       | $           | 24         |        | $          | 280 |   | $ | 353 |   |

 

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

 

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

 

# **RESULTSOF 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. Beginning in March 2004, improving economic conditions in NorthAmerica resulted in increased sales in that geographic market.  Sales people, representatives anddistributors throughout these geographic areas spend a large amount of timewith targeted customers.  They arefinding many of the customers in the automotive, bearing and aircraftindustries refer to improved economic conditions and its impact on the machinetool industry in North America as the reason for their increased orders.  While those customers are optimisticregarding short term demand for Balancer products, they remain uncertain as tothe strength and duration of current business conditions in North America fortheir products which incorporate the Balancer segment product line.  Market demand in Asia for the Balancersegment products remains strong, although with increasing competition there wasa small decline in sales volumes in Fiscal 2005 when compared to Fiscal 2004.   As with the North American market, theduration of the strong demand in Asia cannot be forecasted with anycertainty.  Despite a soft Europeanmarket, there have been some increases in the number of units sold into thatgeographic market.  This is attributed tomore focused and aggressive sales and marketing techniques by the Europeanbased sales and marketing staff. However, until the markets for the products of the Company improve inEurope, there is no guarantee these more aggressive efforts will continue togenerate increasing unit sales.

 

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

 

Laserlight-scatter products for disk drive and silicon wafer manufacturers – Theprimary target markets for Measurement products have been disk drive andsilicon wafer manufacturers and companies and organizations involved inresearch efforts.  Management and thesales staff monitor industry publications and public financial information inorder to judge the potential demand for products by the targetedindustries.  Over the past severalmonths, this information has indicated improving demand for and sales of theproducts of those industries.  Also,frequent discussions with customers have confirmed the information

 

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presentedin the public information.  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, although sales personnel have seen increasing interest andinquiries regarding the Company’s products.

 

Laserlight-scatter products for research organizations – The Company continues toreceive inquiries for these products and provide quotes to interestedparties.  However, in the current Fiscalyear, no sales of these products have been realized.

 

Dimensionalsizing products – These products are marketed and sold into a wide array ofindustries.  In Fiscal 2004 Managementbuilt a sales distribution network covering all fifty states.  As a result of this action, the Companyexperienced increasing interest and sales in these products in the most recentfiscal period when compared to the same period in the prior fiscal year.  During the quarter ended August 31,2003, Management consolidated the operations related to these products (whichhad been located in Menlo Park, California) into the Measurement segmentoperations in Portland, Oregon.  Thisaction reduced the engineering and administrative staff by four people and,beginning in November 2003, reduced monthly rental costs by $7,500.   As a result of the physical relocation ofthe business in the fiscal quarter ended August 31, 2003, operations weresuspended for a period of time and served to dampen the sales volume ofdimensional sizing products in that period. The relocation was completed as of August 31, 2003.   Since relocation to Portland, sales of theseproducts were $1,763,307 and $1,023,278 in Fiscal 2005 and 2004 respectively.

 

**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 other significantobligations remain after products are delivered, revenue is recognized onlyafter such obligations are fulfilled.

 

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

 

Inventories– These assets are stated at the lower of cost or market on an average costbasis. Each fiscal quarter, Management utilizes various analyses based on salesforecasts, historical sales and inventory levels to ensure the current carryingvalue of inventory accurately reflects current and expected requirements withina reasonable timeframe.

 

Long-termDeferred Tax Asset– The Company applies the asset and liability method inrecording income taxes, under which deferred income tax assets and liabilitiesare determined, based on the differences between the financial reporting andtax bases of assets and liabilities and are measured using currently enactedtax rates and laws. Additionally, deferred tax assets are evaluated and avaluation allowance is established if it is more likely than not that all or aportion of the deferred tax asset will not be realized. In Fiscal 2005 Managementconcluded future operations would produce sufficient earnings so that a portionof this asset could be used in future periods to reduce Federal and State taxliabilities.  As a result, the valuationreserve for this asset was reduced as of May 31, 2005 to reflect theamount of the asset management expects to utilize in future fiscalperiods.  Management continues to reviewthe level of the valuation allowance on a quarterly basis.

 

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

 

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fairvalue of the assets.   As of May 31,2005, Management does not believe impairment, as defined above, exists.

 

**Recently issued accounting pronouncements:**

 

TheFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 151, “Inventory Costs an Amendment to ARB No. 43,Chapter 4” in November 2004.  ThisStatement requires that abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage) costs be recognized ascurrent-period charges.  In addition,this Statement requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities.  The Company does not expectthis pronouncement to have a material impact on the financial statements.

 

TheFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 153, “Exchanges of Nonmonetary Assets—an amendment of APBOpinion No. 29” in December 2004.  The guidance in APB Opinion No. 29, “Accounting for NonmonetaryTransactions”, is based on the principle that exchanges of nonmonetary assetsshould be measured based on the fair value of the assets exchanged. Theguidance in that Opinion, however, included certain exceptions to thatprinciple. This Statement amends Opinion 29 to eliminate the exception fornonmonetary exchanges of similar productive assets and replaces it with ageneral exception for exchanges of nonmonetary assets that do not havecommercial substance. A nonmonetary exchange has commercial substance if thefuture cash flows of the entity are expected to change significantly as aresult of the exchange.  The Company doesnot expect this pronouncement to have a material impact on the financialstatements.

 

TheFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 154, “Accounting Changes and Error Corrections—a replacementof APB Opinion No. 20 and FASB Statement No. 3”.  This Statement replaces APB Opinion No. 20,“Accounting Changes”, and FASB Statement No. 3, “Reporting AccountingChanges in Interim Financial Statements”, and changes the requirements for theaccounting for and reporting of a change in accounting principle. ThisStatement applies to all voluntary changes in accounting principle. It alsoapplies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. When a pronouncement includes specific transition provisions, thoseprovisions should be followed.  TheCompany does not expect this pronouncement to have a material impact on thefinancial statements.

 

TheFinancial Accounting Standards Board revised Statement of Financial AccountingStandards No. 123, “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 expects the effect of thispronouncement to approximate the proforma amounts disclosed in Note 2.

 

**Discussion ofoperating results:**

 
| ** **          | ** ** | **Year ended May 31, 2005** | ** ** |
|---------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **Consolidated**                 | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| ** **          | ** ** | **Dollars**                      | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Sales               |       | $                                | 10,530,429 |   | 100.0 | % | $ | 7,369,487 |   | 100.0 | % | $ | 3,160,942 |   | 100.0 | % |
| Cost of sales       |       | 4,460,769                        |       | 42.4 | % | 3,491,858 |   | 47.4 | % | 968,911 |   | 30.7 | % |
| Gross profit        |       | 6,069,660                        |       | 57.6 | % | $ | 3,877,629 |   | 52.6 | % | $ | 2,192,031 |   | 69.3 | % |
| Operating  expenses |       | 4,856,200                        |       | 46.1 | % |   |   |   |   |   |   |   |   |
| Operating income    |       | $                                | 1,213,460  |   | 11.5 | % |   |   |   |   |   |   |   |   |

 

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| ** **          | ** ** | **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 | % |   |   |   |   |   |   |   |   |

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

 

Worldwide sales of Balancer products in Fiscal 2005 increased fromFiscal 2004 as sales to the North American and European markets increased by 32%and 18%, respectively, while they decreased in the Asian markets by 9%.  The increase in North America is attributedto stronger economic conditions in Fiscal 2005 compared to Fiscal 2004 andtherefore increased customer demand, resulting in higher unit sales.  The increase in Europe is attributed to improvingeconomic conditions and more aggressive sales efforts by the European basedsales staff, again resulting in higher unit sales.  The decrease in Asia is attributed to increasedcompetition in a growing geographic market. Worldwide sales of Balancer products in Fiscal 2004 increased fromFiscal 2003 as sales to the North American and Asian markets increased by 5% and69% respectively, while they decreased in the European market by 15%.  The increase in North America was attributedto improving economic conditions and therefore increased customer demand whilethe increase in Asia was attributed to continued strong economicconditions.  The decrease in Europe wasattributed to ongoing economic weakness in the targeted customer markets.

 

Worldwide sales of Measurement products in Fiscal 2005 increased fromFiscal 2004 as sales of the Company’s surface measurement products increased by43% and dimensional sizing products increased by 72%.  The sales of surface measurement productsincreased as they included more unit sales of large value laser light-scatterproducts than in the same fiscal period in the prior year.  The increase in the dimensional sizingproducts was due to increasing unit sales which were directly attributed to theexpanding sales and marketing efforts by the Company’s sales staff that isdevoted exclusively to the sale of these products.  Total sales of Measurement products in Fiscal2004 were comparable to those experienced in Fiscal 2003, although sales levelsof the Company’s surface measurement products increased by 32% while sales ofthe Company’s dimensional sizing products decreased by 15%.  Sales of surface measurement products increasedas there were larger sales of large value laser light-scatter products inFiscal 2004 compared to Fiscal 2003.  Thedecrease in the dimensional sizing products were due to lower unit sales whichare directly attributed to the closure in operations during the relocation ofthe production operations for those products into the Portland, Oregon facilityin the first two fiscal quarters of Fiscal 2004.

 

Cost of sales, as a percentage of sales, for the Balancer segment inFiscal 2005 increased slightly from those in Fiscal 2004.  This occurred as some vendors increased theunit costs of the various raw materials the Company purchases and thoseincreases were not passed along to the customers of the Company.  Cost of sales, as a percentage of sales, forthe Balancer segment decreased in Fiscal 2004 when compared to Fiscal 2003.  The decline can be largely attributed to the geographicsales mix.  Sales to the North Americanmarkets were a higher percentage of total Balancer segment sales in Fiscal 2004than they were in Fiscal 2003.  Unitsales prices in North America are higher than they are in other geographicmarkets and therefore the costs on those sales are lower as a percentage ofsales than in other geographic markets. When sales to the North American market are a higher proportion of totalsales, as they were in Fiscal 2004

 

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compared to Fiscal 2003, the effect is to lower cost of sales as apercentage of sales.  Also, the materialscosts were in higher in Fiscal 2003 than in Fiscal 2004 as the earlier fiscalyear included a write-off of $18,561 in excess inventory quantities while inFiscal 2004 no excess inventory quantities were written off.

 

Cost of sales in theMeasurement segment were lower in Fiscal 2005 compared to Fiscal 2004 due tolower material and direct labor costs as a percentage of sales.  Materials costs as a percentage of sales inthe current fiscal year were 12% compared to 17% in the same period in theprior fiscal year.  In the prior year theCompany had higher materials costs than normal on a large product order.  These higher materials costs occurred becausethe customer cancelled the order but the materials purchased for the productwere expensed as they had been ordered specifically for that project.  If the impact of the higher than normalmaterials costs resulting from that order is excluded from the prior yearresults, the materials costs as a percentage of sales would have been more inline with the current fiscal period results. Direct labor costs (as a percentage of sales) for the fiscal periodended May 31, 2005 was 18% compared to 17% for the fiscal period ended May 31,2004.  The increase in direct labor costsas a percentage of sales occurred due to the types of products produced.  Cost-of-sales in the Measurement segment increasedin Fiscal 2004 when compared to Fiscal 2003. The primary reason for the decrease was that Fiscal 2003 included awrite-off of excess inventory quantities of $383,112 while there were no suchwrite-offs in Fiscal 2004.  This decreasewas offset by overall lower costs of sales as a percentage of sales in Fiscal2003 compared to Fiscal 2004 due to the mix of products sold.

 

The increase in operating expensesbetween Fiscal 2005 and 2004 occurred primarily due to the higher levels ofsales.  The decrease in operatingexpenses between Fiscal 2004 and 2003 occurred primarily due to a decrease inpayroll costs at the Acuity Research subsidiary.  The costs at Acuity decreased due to thereduction in engineering and administration staff that occurred due to theconsolidation of Acuity operations in Portland during the quarter ended August 31,2003.

 

Netsales outside North America accounted for approximately 45% of the Company’srevenues in Fiscal 2005, 43% in Fiscal 2004 and 44% in Fiscal 2003.  Some foreign customers purchase in their owncountry’s currencies, thereby imposing on the Company a currency risk.  Of total sales in Fiscal 2005, 2004 and 2003,approximately 20%, 23% and 27% were denominated in currencies other than U.S.dollars.  To date, currency fluctuationshave had minimal impact on sales. However, significant variations in the value of the U.S. dollar,relative to currencies of countries in which the Company has significantcompetitors, can impact future sales. The Company does not engage in currency hedging.  In addition, the longer payment cycles ofinternational sales can have a negative impact on liquidity.  The Company believes international sales willcontinue to grow in future periods.

 

The net income for Fiscal 2005of $1,608,140 ($0.59 per fully diluted share) compared to net income of $516,585($0.20 per fully diluted share) and net losses of $1,487,131 ($0.60 per share) inFiscal 2004 and 2003 respectively.  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 in thedeferred tax asset valuation allowance. The net loss in Fiscal 2003 included threesignificant items: a $612,200 non-operating charge for a write-down of theCompany’s long-term investment in Air Packaging Technologies, Inc, $401,673 inwrite-downs of excess inventory quantities and an increase in the deferred taxasset valuation allowance of $636,006.

 

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

 

For Fiscal years 2005,2004 or 2003, sales to a single customer did not exceed 10% of total revenues.

 

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

 

17

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# **LIQUIDITYAND CAPITAL RESOURCES**

 

The Company’s ratio ofcurrent assets to current liabilities increased to 6.5 to 1 at May 31, 2005compared to 5.7 to 1 at May 31, 2004. As of May 31, 2005 the Company had $1,176,959 in cash compared to $604,194at May 31, 2004.

 

During the year ended May 31, 2005, cash provided from operatingactivities amounted to $451,015 with the changes described as follows:

 

•                  Thenet income for the year ended May 31, 2005 of $1,608,140 and threenon-cash items: depreciation and amortization of $214,933, an increase in thedeferred tax asset of $640,000 and the increase in the provision for doubtfulaccounts of $8,816.

 

•                  Accountsreceivable used cash as the balance increased by $302,542 (exclusive of the changein the allowance for doubtful accounts) to a May 31, 2005 balance of $2,109,143compared to $1,815,417 at May 31, 2004. At May 31, 2005, $41,366 inaccounts receivable were considered as doubtful of collection and therefore areserve in that amount has been provided for. 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.

 

•                  Inventoriesincreased $618,220 to a May 31, 2005 balance of $3,533,313 compared to $2,915,093at May 31, 2004.  The Companymaintains levels of inventory sufficient to satisfy normal customer demandsplus an increasing short-term delivery requirement for a majority of itsBalancer products.  Management believesits ability to provide prompt delivery gives it a competitive advantage forcertain sales.

 

•                  Prepaidexpenses decreased by $20,056 to a May 31, 2005 balance of $104,292compared to $124,348 at May 31, 2004 due to the amortization of severalitems including prepaid trade show costs, professional fees and variousbusiness and life insurance costs.

 

•                  Tradeaccounts payable decreased by $68,340 to a May 31, 2005 balance of $497,206compared to $565,546 at May 31, 2004 with the increase due to increasedpurchasing activities in both the Balancer and Measurement segments.

 

•                  Otheraccrued liabilities (including commission, payroll items and other accruedexpenses) increased by $166,131 to a May 31, 2005 balance of $520,178compared to $354,047 at May 31, 2004.

 

During the year ended May 31,2005, net cash used in investing activities was $93,060 consisting of net additionsto property and equipment.  Net cash providedby financing activities amounted to $93,215, which consists of repayments on capitalizedobligations of $42,064 and common stock issued to employees and directorsexercising stock options for $135,279.

 

The following summarizescontractual obligations at May 31, 2005 and the effect on future liquidityand cash flows:

 
| **Years Ending  May 31,** | ** ** | **Capital Lease  and Purchase  Contract** | ** ** | **Operating Leases** | ** ** | **Total  Contractual  Obligations** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|----------------------|------------|-------------------------------------|------------|
| 2006                           |       | $                                         | 32,114     |                 | $          | 41,021                              |       | $ | 73,135 |   |
| 2007                           |       | 14,382                                    |       | 41,021               |       | 55,403                              |       |
| 2008                           |       | 6,374                                     |       | 41,021               |       | 47,395                              |       |
| 2009                           |       | —                                    |       | —               |       | —                              |       |
| 2010                           |       | —                                    |       | —               |       | —                              |       |
| Thereafter                     |       | —                                    |       | —               |       | —                              |       |
| Total                          |       | $                                         | 52,870     |                 | $          | 123,063                             |       | $ | 175,933 |   |

 

18

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Part of the acquisitionof SMS in Fiscal 1995 resulted in the acquisition of a tax net operating lossof approximately $5.5 million, which is available to offset domestic earningsthrough the year 2009.  As of May 31,2005, approximately $550,000 of the losses from SMS remain.

 

Management has respondedto business challenges over the past few years by reducing operating expenses,developing new products and attempting to penetrate new markets for the Company’sproducts.  As a result of these efforts,Management believes its cash flows from operations, cash position and operatingline of credit will provide adequate funds on both a short-term and long-termbasis to cover currently foreseeable debt payments, lease commitments andpayments under existing and anticipated supplier agreements.  Management believes that such cash flow(without the raising of external funds) is sufficient to finance currentoperations, projected capital expenditures, anticipated long-term salesagreements and other expansion-related contingencies during Fiscal 2006.  However, in the event the Company fails toachieve its operating and financial goals for Fiscal 2006, 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, borrowings fromcredit facilities or entering into additional borrowing arrangementscollateralized by fixed assets.

 

**Item 7A.****    Qualitativeand Quantitative Disclosures about Market Risk**

 

**Interest Rate Risk**

 

The Company did not haveany derivative financial instruments as of May 31, 2005.  However, the Company is exposed to interestrate risk.  The Company employsestablished policies and procedures to manage its exposure to changes in themarket risk of its marketable securities.

 

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

 

The Company does have a lineof credit but does not have an outstanding balance as of May 31,2005.  Also there is no other debt whoseinterest rates are based on variable rates that may fluctuate over time basedon economic changes in the environment. Therefore, at this time, the Company is not subject to interest raterisk if market interest rates fluctuate and does not expect any change in theinterest rates to have a material effect on the Company’s results fromoperations.

 

**Foreign Currency Risk**

 

The Company operates a subsidiaryin the United Kingdom.  Therefore, theCompany’s business and financial condition is sensitive to currency exchangerates or any other restrictions imposed on their currencies.  For the years ended May 31, 2005, 2004and 2003, results of operations included gains (losses) on foreign currencytranslation of $(184,106), $40,608 and $192,010, 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 2005Management 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 and it will be dissolved early in Fiscal 2006, the accumulatedforeign exchange loss, included in other comprehensive income on the balancesheet in prior periods, was recognized in the fourth quarter of Fiscal2005.  The foreign exchange gains inFiscal 2004 and 2003 are primarily attributable to Company’s United Kingdomsubsidiary, Schmitt Europe, Ltd. (SEL) and the majority of those gains occurfrom payments to the parent company for product purchased.  SEL purchases the majority of its productsfrom the parent company with the billings denominated in US dollars.  The asset and liability at SEL are convertedto UK currency using the foreign exchange rates at the time of thetransaction.  When those amounts arerepaid to the parent company, payment is in US currency and therefore gains orlosses are recognized at the time the liability is converted to US dollars.  In the case of Fiscal 2004 and 2003, theweakening US dollar compared to British Pounds Sterling produced the foreignexchange gains at SEL.

 

19

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

 

**SCHMITT INDUSTRIES, INC.**

##### **CONSOLIDATEDBALANCE SHEETS**

**MAY 31,2005 AND 2004**

 
| ** **                                                                                                                                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                    |       |       |       |       |       |
| ** **                                                                                                                                                    |       |       |       |       |       |
| ***Current  Assets***                                                                                                                                         |       |       |       |       |       |
| Cash                                                                                                                                                          |       | $          | 1,176,959  |       | $          | 604,194 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $41,366 and $32,550 in  2005 and 2004 respectively                                            |       | 2,109,143  |       | 1,815,417  |       |
| Inventories                                                                                                                                                   |       | 3,533,313  |       | 2,915,093  |       |
| Prepaid expenses                                                                                                                                              |       | 104,292    |       | 124,348    |       |
| Deferred tax  asset                                                                                                                                           |       | 92,319     |       | —     |       |
| Income taxes  receivable                                                                                                                                      |       | —     |       | 35,894     |       |
|                                                                                                                                                          |       | 7,016,026  |       | 5,494,946  |       |
|                                                                                                                                                          |       |       |       |       |       |
| ***Property  and Equipment***                                                                                                                                 |       |       |       |       |       |
| Land                                                                                                                                                          |       | 299,000    |       | 299,000    |       |
| Buildings and  improvements                                                                                                                                   |       | 1,214,348  |       | 1,214,500  |       |
| Furniture,  fixtures and equipment                                                                                                                            |       | 1,120,946  |       | 1,115,788  |       |
| Vehicles                                                                                                                                                      |       | 96,849     |       | 94,261     |       |
|                                                                                                                                                          |       | 2,731,143  |       | 2,723,549  |       |
| Less accumulated  depreciation and amortization                                                                                                               |       | (1,462,637 | )          | (1,395,634 | )          |
|                                                                                                                                                          |       | 1,268,506  |       | 1,327,915  |       |
| ***Other  Assets***                                                                                                                                           |       |       |       |       |       |
| Long-term  deferred tax asset                                                                                                                                 |       | 547,681    |       | —     |       |
| Other assets                                                                                                                                                  |       | 243,009    |       | 277,612    |       |
|                                                                                                                                                          |       | 790,690    |       | 277,612    |       |
| **TOTAL  ASSETS**                                                                                                                                             |       | $          | 9,075,222  |       | $          | 7,100,473 |   |
|                                                                                                                                                          |       |       |       |       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                 |       |       |       |       |       |
| ** **                                                                                                                                                    |       |       |       |       |       |
| ***Current  Liabilities***                                                                                                                                    |       |       |       |       |       |
| Accounts payable                                                                                                                                              |       | $          | 497,206    |       | $          | 565,546 |   |
| Accrued  commissions                                                                                                                                          |       | 275,745    |       | 189,679    |       |
| Accrued payroll  liabilities                                                                                                                                  |       | 102,883    |       | 37,523     |       |
| Other accrued liabilities                                                                                                                                     |       | 141,550    |       | 126,845    |       |
| Income taxes  payable                                                                                                                                         |       | 26,147     |       | —     |       |
| Current portion  of long-term obligations                                                                                                                     |       | 32,114     |       | 39,831     |       |
|                                                                                                                                                          |       | 1,075,645  |       | 959,424    |       |
|                                                                                                                                                          |       |       |       |       |       |
| **Long-term  Obligations**                                                                                                                                    |       | 20,756     |       | 27,242     |       |
|                                                                                                                                                          |       |       |       |       |       |
| **Commitments  and Contingencies**                                                                                                                            |       | —     |       | —     |       |
|                                                                                                                                                          |       |       |       |       |       |
| ***Stockholders’  Equity***                                                                                                                              |       |       |       |       |       |
| Common stock, no  par value, 20,000,000 shares authorized, 2,559,687 and 2,474,461 shares  issued and outstanding at May 31, 2005 and 2004, respectively |       | 7,496,098  |       | 7,360,819  |       |
| Accumulated  other comprehensive loss                                                                                                                         |       | (254,654   | )          | (376,249   | )          |
| Retained  earnings (accumulated deficit)                                                                                                                      |       | 737,377    |       | (870,763   | )          |
|                                                                                                                                                          |       | 7,978,821  |       | 6,113,807  |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                          |       | $          | 9,075,222  |       | $          | 7,100,473 |   |

 

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

** **

**20**

----

** **

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

##### **CONSOLIDATEDSTATEMENTS OF OPERATIONS**

##### **FOR THE YEARSENDED MAY 31, 2005, 2004 AND 2003**

 
| ** **                                           | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| **Net  Sales**                                       |       | $         | 10,530,429 |      | $          | 7,924,766 |       | $ | 7,419,521 |   |
|                                                 |       |      |       |      |       |      |       |
| **Cost of  Sales**                                   |       |      |       |      |       |      |       |
| Operations,  exclusive of inventory write-downs      |       | 4,460,769 |       | 3,405,761 |       | 3,188,566 |       |
| Inventory  write-downs                               |       | —    |       | —    |       | 401,673   |       |
| Total cost of  sales                                 |       | 4,460,769 |       | 3,405,761 |       | 3,590,239 |       |
|                                                 |       |      |       |      |       |      |       |
| Gross profit                                         |       | 6,069,660 |       | 4,519,005 |       | 3,829,282 |       |
|                                                 |       |      |       |      |       |      |       |
| **Operating  expenses:**                             |       |      |       |      |       |      |       |
| General,  administrative and selling                 |       | 4,813,805 |       | 4,051,369 |       | 4,039,013 |       |
| Research and  development                            |       | 42,395    |       | 30,370    |       | 192,686   |       |
| Total operating  expenses                            |       | 4,856,200 |       | 4,081,739 |       | 4,231,699 |       |
|                                                 |       |      |       |      |       |      |       |
| **Operating  income (loss)**                         |       | 1,213,460 |       | 437,266   |       | (402,417  | )          |
|                                                 |       |      |       |      |       |      |       |
| **Other  income and (expense):**                     |       |      |       |      |       |      |       |
| Gain (loss) on  foreign currency exchange            |       | (184,106  | )          | 40,608    |       | 192,010   |       |
| Miscellaneous  (expense) income                      |       | (27,214   | )          | 45,511    |       | (28,518   | )          |
| Loss on  write-down of long-term investment          |       | —    |       | (6,800    | )          | (612,200  | )          |
| Other income and  (expense)                          |       | (211,320  | )          | 79,319    |       | (448,708  | )          |
|                                                 |       |      |       |      |       |      |       |
| **Income  (loss) before provision for income taxes** |       | 1,002,140 |       | 516,585   |       | (851,125  | )          |
|                                                 |       |      |       |      |       |      |       |
| **(Benefit  from) provision for income taxes**       |       | (606,000  | )          | —    |       | 636,006   |       |
|                                                 |       |      |       |      |       |      |       |
| **Net  income (loss)**                               |       | $         | 1,608,140  |      | $          | 516,585   |       | $ | (1,487,131 | ) |
|                                                 |       |      |       |      |       |      |       |
| Net income  (loss) per common share, basic           |       | $         | 0.64       |      | $          | 0.21      |       | $ | (0.60 | ) |
|                                                 |       |      |       |      |       |      |       |
| Weighted average  number of common shares, basic     |       | 2,527,665 |       | 2,438,895 |       | 2,467,651 |       |
|                                                 |       |      |       |      |       |      |       |
| Net income  (loss) per common share, diluted         |       | $         | 0.59       |      | $          | 0.20      |       | $ | (0.60 | ) |
|                                                 |       |      |       |      |       |      |       |
| Weighted average  number of common shares, diluted   |       | 2,708,797 |       | 2,524,050 |       | 2,467,651 |       |

 

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

 

21

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

##### **CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**FOR THEYEARS ENDED MAY 31, 2005, 2004 AND 2003**

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

 

##### ***The accompanying notes are an integral part of these consolidatedfinancial statements***

 

22

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

##### **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

## ***FOR THE YEARS ENDED MAY 31, 2005, 2004 AND 2003***

 
| ** **                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Cash  Flows Relating to Operating Activities**                                         |       |     |       |     |       |     |       |
| Net income  (loss)                                                                       |       | $        | 1,608,140  |     | $          | 516,585  |       | $ | (1,487,131 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities |       |     |       |     |       |     |       |
| Write-down of  long-term investment                                                      |       | —   |       | 6,800    |       | 612,200  |       |
| Write-down of  excess inventory quantities                                               |       | —   |       | —   |       | 401,673  |       |
| Depreciation and  amortization                                                           |       | 214,933  |       | 188,314  |       | 240,265  |       |
| Deferred taxes                                                                           |       | (640,000 | )          | —   |       | 636,006  |       |
| Provision for  bad debts                                                                 |       | 8,816    |       | 8,490    |       | 24,060   |       |
| (Increase)  decrease in:                                                                 |       |     |       |     |       |     |       |
| Accounts  receivable                                                                     |       | (302,542 | )          | (499,707 | )          | (213,224 | )          |
| Inventories                                                                              |       | (618,220 | )          | (189,162 | )          | 80,518   |       |
| Prepaid expenses                                                                         |       | 20,056   |       | 42,844   |       | (5,312   | )          |
| Income taxes  receivable                                                                 |       | 35,894   |       | (3,235   | )          | 123,977  |       |
| Increase  (decrease) in:                                                                 |       |     |       |     |       |     |       |
| Accounts payable                                                                         |       | (68,340  | )          | 210,217  |       | 116,321  |       |
| Accrued  commissions and other accrued liabilities                                       |       | 166,131  |       | 127,014  |       | 35,730   |       |
| Income taxes  payable                                                                    |       | 26,147   |       | —   |       | —   |       |
| Net cash  provided by operating activities                                               |       | 451,015  |       | 408,160  |       | 565,083  |       |
|                                                                                     |       |     |       |     |       |     |       |
| **Cash  Flows Relating to Investing Activities**                                         |       |     |       |     |       |     |       |
| Purchase of property  and equipment                                                      |       | (93,060  | )          | (108,796 | )          | (74,505  | )          |
| Disposal of  property and equipment                                                      |       | —   |       | (1,686   | )          | 26,399   |       |
| Net cash used in  investing activities                                                   |       | (93,060  | )          | (110,482 | )          | (48,106  | )          |
|                                                                                     |       |     |       |     |       |     |       |
| **Cash  Flows Relating to Financing Activities**                                         |       |     |       |     |       |     |       |
| Line of credit  repayments                                                               |       | —   |       | —   |       | (200,000 | )          |
| Proceeds of  long-term borrowings                                                        |       | —   |       | —   |       | 38,250   |       |
| Repayment of  long-term debt                                                             |       | (42,064  | )          | (35,678  | )          | (294,408 | )          |
| Common stock  issued                                                                     |       | 135,279  |       | 67,835   |       | —   |       |
| Common stock  repurchased                                                                |       | —   |       | (40,000  | )          | (10,637  | )          |
| Net cash  provided by (used in) financing activities                                     |       | 93,215   |       | (7,843   | )          | (466,795 | )          |
|                                                                                     |       |     |       |     |       |     |       |
| **Effect  of foreign exchange translation on cash**                                      |       | 121,595  |       | (95,886  | )          | (87,616  | )          |
|                                                                                     |       |     |       |     |       |     |       |
| **Increase  (decrease) in cash**                                                         |       | 572,765  |       | 193,949  |       | (37,434  | )          |
|                                                                                     |       |     |       |     |       |     |       |
| **Cash,**beginning  of year                                                              |       | 604,194  |       | 410,245  |       | 447,679  |       |
|                                                                                     |       |     |       |     |       |     |       |
| **Cash,**end  of year                                                                    |       | $        | 1,176,959  |     | $          | 604,194  |       | $ | 410,245 |   |
|                                                                                     |       |     |       |     |       |     |       |
| **Supplemental  Disclosure of Cash Flow Information**                                    |       |     |       |     |       |     |       |
| Cash paid during  the period for interest                                                |       | $        | 1,083      |     | $          | 4,330    |       | $ | 22,824 |   |
| Cash paid during  the period for income taxes                                            |       | $        | 7,853      |     | $          | 4,035    |       | $ | 26,110 |   |
|                                                                                     |       |     |       |     |       |     |       |
| **Supplemental  Schedule of Noncash Investing and Financing Activities**            |       |     |       |     |       |     |       |
| Fixed assets  financed                                                                   |       | $        | 27,861     |     | $          | 78,447   |       | $ | — |   |

 

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

 

23

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**Schmitt Industries, Inc.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**FOR THE YEARS ENDED MAY 31, 2005,2004 AND 2003**

 

# **NOTE1**

# **ORGANIZATIONAND NATURE OF OPERATIONS**

 

Schmitt Industries, Inc.(the Company) designs, assembles, markets and distributes electronic andmechanical components for machine tool products and laser measurement systemsworldwide.

 

# **NOTE2**

**SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

# **Principlesof Consolidation**

 

# **These consolidated financialstatements include those of the Company and its wholly owned subsidiaries:Schmitt Measurement Systems, Inc. (SMS), Schmitt Europe, Ltd. (SEL) andSchmitt Europa GmbH (SEG).  Effective May 31,2005 SEG has been liquidated.  All significant intercompany accounts andtransactions have been eliminated in the preparation of the consolidatedfinancial 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.

 

# **Cashand Cash Equivalents**

 

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

 

**Accounts Receivable**

 

The Company maintainscredit limits for all customers based upon several factors, included 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 each of the Company’s domestic andinternational customers. If these analyses lead Management to the conclusionthat potential significant accounts are uncollectible, a reserve is provided.

 

**Inventory**

 

Inventory is valued atthe lower of cost or market with cost determined on the average costbasis.  As of May 31, 2005 and 2004,inventories consisted of raw materials ($1,830,748 and $1,824,897,respectively), work-in-process ($127,001 and $68,287, respectively), andfinished goods ($1,575,564 and $1,021,909, respectively).

 

# **Propertyand Equipment**

 

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

 

24

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# **ForeignCurrency Translation**

 

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

 

# **Advertising**

 

Advertising costsincluded in general, administrative and selling, are expensed when theadvertising first takes place. Advertising expense was $87,853, $86,648 and$67,530 for the fiscal years ended May 31, 2005, 2004 and 2003,respectively.

 

# **Researchand Development Costs**

 

Research and developmentcosts are charged to expense when incurred.

 

# **Stock-BasedCompensation**

 

TheCompany has elected to follow the accounting provisions of AccountingPrinciples Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issuedto Employees”, for stock-based compensation and to furnish the pro formadisclosures required under SFAS No. 148, “Accounting for Stock-BasedCompensation – Transition and Disclosure.” No stock-based employee compensation cost is reflected in net incomebecause all options granted under those plans had an exercise price equal tothe market value of the underlying common stock on the date of the grant.

 

Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of SFAS 123 tostock-based compensation:

 
| ** **                                | ** **                                                                                                                    | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------|----------|------------|----------|------------|----------|------------|
| Net income  (loss), as reported           |                                                                                                                          | $        | 1,608,140  |     | $          | 516,585  |       | $ | (1,487,131 | ) |
|                                      | 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 |     | (230,865   | )        | (28,937    | )        | (104,190   | ) |
| Pro forma net  income (loss)              |                                                                                                                          | $        | 1,377,275  |     | $          | 487,648  |       | $ | (1,591,321 | ) |
|                                      |                                                                                                                          |     |       |     |       |     |       |
| Earnings (loss)  per share – basic   |                                                                                                                          |     |       |     |       |     |       |
| As reported                               |                                                                                                                          | $        | 0.64       |     | $          | 0.21     |       | $ | (0.60 | ) |
| Pro forma                                 |                                                                                                                          | $        | 0.54       |     | $          | 0.20     |       | $ | (0.64 | ) |
| Earnings (loss)  per share – diluted |                                                                                                                          |     |       |     |       |     |       |
| As reported                               |                                                                                                                          | $        | 0.59       |     | $          | 0.20     |       | $ | (0.60 | ) |
| Pro forma                                 |                                                                                                                          | $        | 0.51       |     | $          | 0.19     |       | $ | (0.64 | ) |

 

Theeffects of applying SFAS No. 123 in this pro forma disclosure are notnecessarily indicative of future amounts.

 

# **IncomeTaxes**

 

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

 

25

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measured by the enactedtax rates which are expected to be in effect when these differencesreverse.   Income tax expense is the taxpayable for the period and the change during the period in net deferred taxassets and liabilities. Management establishes a valuation allowance againstits net deferred tax assets to reduce the net asset to the amount that, basedupon their evaluation, will more likely than not be realized.

 

# **EarningsPer Share**

 

Basicearnings per share is computed using the weighted average number of sharesoutstanding.  Diluted earnings per shareis computed using the weighted average number of shares outstanding, adjustedfor dilutive incremental shares attributed to outstanding options to purchasecommon stock.

 

**Concentration of Credit Risk**

 

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

 

# **FinancialInstruments**

 

Based on borrowing ratescurrently 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, accountsreceivable and accounts payable) also approximate fair value because of theirshort-term maturities.

 

# **Useof Estimates**

# ** **

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

 

# **NewAccounting Pronouncements**

# ** **

TheFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 151, “Inventory Costs an Amendment to ARB No. 43,Chapter 4” in November 2004.  ThisStatement requires that abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage) costs be recognized ascurrent-period charges.  In addition,this Statement requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities.  The Company does not expectthis pronouncement to have a material impact on the financial statements.

 

TheFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 153, “Exchanges of Nonmonetary Assets—an amendment of APBOpinion No. 29” in December 2004.  The guidance in APB Opinion No. 29, “Accounting for NonmonetaryTransactions”, is based on the principle that exchanges of nonmonetary assetsshould be measured based on the fair value of the assets exchanged. Theguidance in that Opinion, however, included certain exceptions to that principle.This Statement amends Opinion 29 to eliminate the exception for nonmonetaryexchanges of similar productive assets and replaces it with a general exceptionfor exchanges of nonmonetary assets that do not have commercial substance. Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange.  The Company does not expect thispronouncement to have a material impact on the financial statements.

 

TheFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 154, “Accounting Changes and Error Corrections—a replacementof APB Opinion No. 20 and FASB Statement No. 3”.  This Statement replaces APB Opinion No. 20,“Accounting Changes”, and FASB Statement No. 3,

 

26

----

 

“ReportingAccounting Changes in Interim Financial Statements”, and changes therequirements for the accounting for and reporting of a change in accountingprinciple. This Statement applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. When a pronouncement includes specific transitionprovisions, those provisions should be followed.  The Company does not expect thispronouncement to have a material impact on the financial statements.

 

TheFinancial Accounting Standards Board revised Statement of Financial AccountingStandards 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 fromemployees in exchange for awards of share-based compensation generally shall bemeasured based on the grant-date fair value of the equity instrumentsissued.  The Company expects the effectof this pronouncement to approximate the proforma amounts disclosed in Note 2.

 

**Reclassifications**

 

Certainreclassifications have been made to the 2004 and 2003 amounts to conform to2005 presentations.

 

**NOTE 3**

**ACCOUNTS RECEIVABLE**

 

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

 
| ** **            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
| Beginning  balance    |       | $        | 32,550     |     | $          | 24,060 |   |
| Bad debt expense      |       | 40,527   |       | 17,742   |       |
| Accounts written  off |       | (31,711  | )          | (9,252   | )          |
| Ending balance        |       | $        | 41,366     |     | $          | 32,550 |   |

 

**NOTE 4**

**INVENTORIES**

 

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

 
| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Beginning  balance        |       | $        | 172,696    |     | $          | 53,097 |   |
| Items added to  allowance |       | 94,664   |       | 121,968  |       |
| Items used in  production |       | (103,946 | )          | (2,369   | )          |
| Ending balance            |       | $        | 163,414    |     | $          | 172,696 |   |

 

# **NOTE5**

# **LONG-TERMINVESTMENTS**

 

# **The Company owns 1,375,716 sharesor approximately 9% of the outstanding shares of Air Packaging Technologies, Inc.  That company is engaged in the design,manufacture, marketing and sales of “Air Box” patented packaging systems usedin the retail, industrial protective and promotional packaging marketsworldwide.  This investment is classifiedas “Available-for-sale securities” under Statement of Financial AccountingStandards No. 115 (SFAS No. 115). As required under that statement, all unrealized gains and losses arereported in Accumulated Other Comprehensive Loss and included as a separatecomponent in**

 

27

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# **Other Comprehensive Loss inStockholders’ Equity until realized or until unrealized losses are deemed to be“other than temporary”.**

 

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

 

# **NOTE6**

**LINE OF CREDIT**

 

TheCompany has a $1.0 million short-term line of credit agreement with Bank ofAmerica, secured by U.S. accounts receivable, inventories and generalintangibles.  The line is guaranteed bythe Company’s wholly owned subsidiary, Schmitt Measurement Systems, Inc.  Interest is payable at the bank’s prime rateand expires on September 1, 2006.

 

# **NOTE7**

**INCOME TAXES**

 

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

 
| ** **                                       | ** ** | **Years ended May 31,** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current                                          |       | $                            | 34,000     |   | $ | — |   | $ | — |   |
| Deferred                                         |       | 420,167                      |       | 226,827 |   | (363,021 | ) |
| (Decrease)  increase in valuation allowance      |       | (1,060,167                   | )          | (226,827 | ) | 999,027 |   |
| Total (benefit  from) provision for income taxes |       | $                            | (606,000   | ) | $ | — |   | $ | 636,006 |   |

 

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

 
| ** **                                                                          | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Depreciation                                                                        |       | $          | —     |       | $          | — |   |
| Net operating  loss carryforwards                                                   |       | 530,255    |       | 1,244,724  |       |
| Deferred taxes  related to the decline in fair market value of long-term investment |       | 694,696    |       | 819,840    |       |
| Other deferred  items, net                                                          |       | 502,927    |       | 83,481     |       |
| Gross deferred  tax assets                                                          |       | 1,727,878  |       | 2,148,045  |       |
|                                                                                |       |       |       |       |       |
| Deferred tax  asset valuation allowance                                             |       | (1,087,878 | )          | (2,148,045 | )          |
|                                                                                |       |       |       |       |       |
| Net deferred tax  asset                                                             |       | $          | 640,000    |       | $          | — |   |

 

TheCompany has approximately $550,000 of U.S. federal net operating losscarryforwards that were acquired as part of the acquisition of SchmittMeasurement Systems, Inc.  TheseNOLs are subject to limitations that restrict their use and expire in2010.  The Company also has approximately$0.9 million of U.S. Federal and State net operating loss carryforwards, theutilization of which could be limited upon a change in control of the Company,and expire in the year 2024.

 

28

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In2005, Management believed business and economic conditions had improved to thepoint where a portion of the valuation allowance on the deferred tax assetcould be reduced.  Therefore, theallowance was reduced to a level which management believes can be utilized inFiscal 2006 forward.

 

In2003, due to the uncertainty of utilization of certain of the Company’s NOLsand in consideration of other factors, Management had recorded a valuationallowance on the deferred tax asset to reduce the net deferred tax asset to theamount that it has deemed will more likely than not be realized.

 

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

 
| ** **                                  | ** ** | **Years Ended May 31,** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Statutory  federal tax rate                 |       | 34.0                         | %          | 34.0 | % | (34.0 | )% |
| State taxes, net  of federal benefit        |       | 4.4                          |       | — |   | — |   |
| Change in  deferred tax valuation allowance |       | (105.8                       | )          | (43.9 | ) | 117.4 |   |
| Permanent and  other differences            |       | 6.9                          |       | 9.9 |   | (8.7 | ) |
|                                        |       |                         |       |   |   |   |   |
| Effective tax  rate                         |       | (60.5                        | )%         | — | % | 74.7 | % |
|                                        |       |                         |       |   |   |   |   |

**NOTE 8**

**EMPLOYEE BENEFIT PLANS**

 

TheCompany adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan &Trust effective June 1, 1996. Employees must meet certain age and service requirements to beeligible.  Participants may contribute upto 15% of their eligible compensation which may be partially matched by theCompany.  The Company may further makeeither a profit sharing contribution or a discretionary contribution.  There were no contributions made by theCompany to this Plan during the years ended May 31, 2005, 2004 and2003.  As of June 1, 2005 theCompany resumed matching contributions in conjunction with Employeecontributions to the plan.

 

# **NOTE9**

**LONG-TERMOBLIGATIONS**

 

During Fiscal 2005, theCompany 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 purchasecontract for $78,477.  The agreementscall for monthly principal payments of $832 and $2,131 and both carry nointerest.  One lease expires in Fiscal2006 and the second in Fiscal 2007. Equipment recorded under the capital lease was $48,477, with relatedaccumulated depreciation of $21,545 at May 31, 2005.

 

As of May 31, 2005,future capital lease and purchase contract payments are:

 
| **Year Ending May 31,** | ** ** | ** ** | ** ** |
|------------------------------|------------|------------|------------|
| 2006                         |       | $          | 32,114     |   |
| 2007                         |       | $          | 14,382     |   |
| 2008                         |       | $          | 6,374      |   |

 

29

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# **NOTE10**

# **COMMITMENTSAND CONTINGENCIES**

 

In a transaction relatedto the acquisition of Schmitt Measurement Systems, Inc., formerly TMATechnologies, Inc. (TMA), the Company established a royalty pool andvested in each shareholder and debt holder of the acquired company an interestin the royalty pool equal to the amount invested or loaned including interestpayable through March 1995.  Theroyalty pool will be funded at 5% of net sales (defined as gross sales lessreturns, allowances and sales commissions) of the Company’s surface measurementproducts and future derivative products developed by Schmitt Industries, Inc.,which utilize these technologies.  Aspart of the royalty pool agreement, each former shareholder and debt holderreleased TMA from any claims with regard to the acquisition except their rightsto future royalties.  Royalty expenseapplicable to the years ended May 31, 2005, 2004 and 2003 amounted to$79,268, $41,430 and $48,517, respectively.

 

The Company has enteredinto various non-cancelable leases for facilities used to support operations inthe United Kingdom.  Rent expense for theyears ended May 31, 2005, 2004 and 2003 amounted to $41,806, $67,133 and$125,096 respectively.

 

Lease commitments underthese leases for each of the years ending May 31 are as follows:

 
| **Year Ending May 31,** | ** ** | ** ** | ** ** |
|------------------------------|------------|------------|------------|
| 2006                         |       |       | $          | 41,021 |   |
| 2007                         |       |       | $          | 41,021 |   |
| 2008                         |       |       | $          | 41,021 |   |
| Thereafter                   |       |       | $          | — |   |

 

# **NOTE11**

# **SEGMENTSOF BUSINESS**

 

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

 

## ***Segment Information***

 
| ** **                     | ** ** | **Year Ended May 31,** | ** ** |
|--------------------------------|------------|-----------------------------|------------|
| ** **                     | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                     | ** ** | **Balancer**                | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** | **Balancer** | ** ** | **Measurement** | ** ** |
| Gross sales                    |       | $                           | 8,215,458  |   | $ | 3,188,941 |   | $ | 6,644,781 |   | $ | 2,017,494 |   | $ | 6,283,987 |   | $ | 1,961,086 |   |
| Intercompany  sales            |       | $                           | (845,971   | ) | $ | (27,999 | ) | $ | (719,927 | ) | $ | (17,582 | ) | $ | (802,977 | ) | $ | (22,575 | ) |
| Net sales                      |       | $                           | 7,369,487  |   | $ | 3,160,942 |   | $ | 5,924,854 |   | $ | 1,999,912 |   | $ | 5,481,010 |   | $ | 1,938,511 |   |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss)  from operations |       | $                           | 271,044    |   | $ | 942,416 |   | $ | 2,674 |   | $ | 434,592 |   | $ | (281,900 | ) | $ | (120,517 | ) |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Intercompany  rent             |       | $                           | —     |   | $ | 30,000 |   | $ | — |   | $ | 30,000 |   | $ | — |   | $ | 30,000 |   |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  expense          |       | $                           | 137,184    |   | $ | 43,146 |   | $ | 111,282 |   | $ | 35,764 |   | $ | 119,331 |   | $ | 60,486 |   |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Amortization  expense          |       | $                           | —     |   | $ | 34,603 |   | $ | 6,665 |   | $ | 34,603 |   | $ | 20,002 |   | $ | 40,446 |   |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Capital  expenditures          |       | $                           | 103,658    |   | $ | 17,263 |   | $ | 169,295 |   | $ | 17,948 |   | $ | 38,970 |   | $ | 35,535 |   |

 

30

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## ***Geographic Information***

 
|                  | ** ** | **Year Ended May 31,** | ** ** |
|-----------------------|------------|-----------------------------|------------|
| **Geographic Sales**  | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|                  |       |                        |       |   |   |   |   |
| North American  Sales |       |                        |       |   |   |   |   |
| United States         |       | $                           | 5,549,474  |   | $ | 4,320,421 |   | $ | 3,985,882 |   |
| Intercompany          |       | $                           | —     |   | $ | — |   | $ | (22,134 | ) |
|                  |       | $                           | 5,549,474  |   | $ | 4,320,421 |   | $ | 3,963,748 |   |
| Canada                |       | $                           | 220,676    |   | $ | 154,738 |   | $ | 153,022 |   |
| Mexico                |       | $                           | 41,790     |   | $ | 45,781 |   | $ | 34,027 |   |
| North America  total  |       | $                           | 5,811,940  |   | $ | 4,520,940 |   | $ | 4,150,797 |   |
|                  |       |                        |       |   |   |   |   |
| European Sales        |       |                        |       |   |   |   |   |
| Germany               |       | $                           | 552,438    |   | $ | 469,342 |   | $ | 781,375 |   |
| Intercompany          |       | $                           | —     |   | $ | — |   | $ | — |   |
| Germany total         |       | $                           | 552,438    |   | $ | 469,342 |   | $ | 781,375 |   |
|                  |       |                        |       |   |   |   |   |
| United Kingdom        |       | $                           | 1,276,968  |   | $ | 1,136,035 |   | $ | 1,253,639 |   |
| Intercompany          |       | $                           | (873,970   | ) | $ | (737,509 | ) | $ | (803,418 | ) |
| United Kingdom  total |       | $                           | 402,998    |   | $ | 398,526 |   | $ | 450,221 |   |
|                  |       |                        |       |   |   |   |   |
| Other European  Sales |       | $                           | 1,120,653  |   | $ | 909,382 |   | $ | 1,116,506 |   |
|                  |       |                        |       |   |   |   |   |
| Total Europe          |       | $                           | 2,076,089  |   | $ | 1,777,250 |   | $ | 2,348,102 |   |
|                  |       |                        |       |   |   |   |   |
| Asia                  |       | $                           | 2,122,384  |   | $ | 1,365,840 |   | $ | 849,940 |   |
| Others                |       | $                           | 520,016    |   | $ | 260,736 |   | $ | 70,682 |   |
|                  |       | $                           | 10,530,429 |   | $ | 7,924,766 |   | $ | 7,419,521 |   |

 
| ** **                     | ** ** | **Year Ended May 31,** | ** ** |
|--------------------------------|------------|-----------------------------|------------|
| ** **                     | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                     | ** ** | **United States**           | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** |
| Income (loss)  from operations |       | $                           | 1,544,349  |   | $ | (330,889 | ) | $ | 623,887 |   | $ | (186,621 | ) | $ | (292,905 | ) | $ | (109,512 | ) |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation  expense          |       | $                           | 172,903    |   | $ | 7,427 |   | $ | 137,606 |   | $ | 9,440 |   | $ | 164,877 |   | $ | 14,940 |   |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Amortization  expense          |       | $                           | 34,603     |   | $ | — |   | $ | 41,268 |   | $ | — |   | $ | 60,448 |   | $ | — |   |
|                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Capital  expenditures          |       | $                           | 120,921    |   | $ | — |   | $ | 182,094 |   | $ | 5,149 |   | $ | 68,363 |   | $ | 6,142 |   |

 

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

 
| ** **    | ** ** | **May 31, 2005** | ** ** | **May 31, 2004** | ** ** |
|---------------|------------|-----------------------|------------|-----------------------|------------|
| Segment:      |       |                  |       |                  |       |
| Balancer      |       | $                     | 1,656,783  |                  | $          | 1,041,032 |   |
| Measurement   |       | $                     | 495,728    |                  | $          | 564,495 |   |
|          |       |                  |       |                  |       |
| Geographic:   |       |                  |       |                  |       |
| United States |       | $                     | 2,124,902  |                  | $          | 1,585,021 |   |
| Europe        |       | $                     | 27,609     |                  | $          | 20,506 |   |

 

Note – Europe is definedas the European subsidiary, Schmitt Europe, Ltd.

 

**NOTE 12**

# **STOCKOPTIONS**

 

The Board of Directorsadopted a Stock Option Plan in December 1995, which plan was amended in August 1996and October 2004 and restated in August 1998.  An option granted under the Amended andRestated Stock Option Plan might be either an incentive stock option (ISO), ora nonstatutory stock option (NSO).  ISOsmay be granted only to employees and members of the Board of Directors of theCompany and are subject to certain limitations, in addition to restrictionsapplicable to all stock options under the Plan. Options not meeting these limitations will be treated as NSOs.  The purchase price of ISOs is fair marketvalue on the date of grant; the purchase price of NSOs may vary from fairmarket value.  Vesting is at thediscretion of the option committee of the Board of Directors, but is either 50%at grant date and 16.7% on each anniversary thereafter or 50% at grant date and25% on each anniversary thereafter.  TheCompany initially reserved 400,000 shares for issuance under the stock optionplan and in October 2004 the shareholders approved another 400,000 sharesfor issuance under the stock option plan. All outstanding options will expire no later than 2014.

 

31

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The following summarizesthe options outstanding as of May 31, 2005:

 
| ** **                              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Options  outstanding, May 31, 2002 |       | 244,000    |       | $                                      | 1.20       |   |
| Options granted                         |       | 6,666      |       | $                                      | 1.20       |   |
| Options  forfeited/cancelled            |       | (6,677     | )          | $                                      | 1.20       |   |
|                                    |       |       |       |                                   |       |
| Options  outstanding May 31, 2003  |       | 243,989    |       | $                                      | 1.20       |   |
|                                    |       |       |       |                                   |       |
| Options granted                         |       | —     |       | $                                      | —     |   |
| Options  exercised                      |       | (56,529    | )          | $                                      | 1.20       |   |
| Options  forfeited/cancelled            |       | (16,944    | )          | $                                      | 1.20       |   |
|                                    |       |       |       |                                   |       |
| Options  outstanding May 31, 2004  |       | 170,516    |       | $                                      | 1.20       |   |
| Options granted                         |       | 165,500    |       | $                                      | 2.30       |   |
| Options exercised                       |       | (85,226    | )          | $                                      | 1.59       |   |
| Options  forfeited/cancelled            |       | —     |       | $                                      | —     |   |
|                                    |       |       |       |                                   |       |
| Options  outstanding May 31, 2005  |       | 250,790    |       | $                                      | 1.79       |   |

 

TheCompany continues to measure compensation cost for the Plan using the method ofaccounting prescribed by APB 25.  In electingto continue to follow APB 25 for expense recognition purposes, the Company isrequired to provide the expanded disclosures required under SFAS No. 148for stock-based compensation granted, including disclosure of pro forma netincome and earnings per share, as if the fair value based method of accountingdefined in the SFAS No. 123, had been adopted.

 

TheCompany has computed, for pro forma disclosure purposes, the value of all stockoptions granted during Fiscal 2005, 2004 and 2003 using the Black-Scholesoption pricing model as prescribed by SFAS No. 123 using the followingassumptions:

 
| ** **               | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2005**  | ** ** |
|--------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Risk-free  interest rate |       | 6.00      | %          | 3.50      | %          | 3.50      | %          |
| Expected  dividend yield |       | 0         | %          | 0         | %          | 0         | %          |
| Expected life            |       | 5.3 years |       | 4.0 years |       | 4.0 years |       |
| Expected  volatility     |       | 87        | %          | 91        | %          | 119       | %          |

 

Usingthe Black-Scholes methodology, the total value of stock options granted duringFiscal 2005 and 2003 was $265,517 and $7,158 respectively, which would beamortized on a pro forma basis over the vesting period of the options.  The average fair value of the options grantedin Fiscal 2005 and 2003 was $2.30 and $1.20 respectively.  No stock options were granted during Fiscal2004.

 

32

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Thefollowing table summarized information about stock options outstanding at May 31,2005:

 
| **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       |                    | 115,291    |   | $ | 1.20 |   | 4.3 |   | 115,291 |   | $ | 1.20 |   |
| $                       | 2.30       |                    | 135,500    |   | $ | 2.30 |   | 6.6 |   | 52,750 |   | $ | 2.30 |   |
|                    |       | 250,791                 |       | $ | 1.79 |   | 5.3 |   | 168,041 |   | $ | 1.55 |   |

 

**NOTE 13**

# **EARNINGSPER SHARE**

 

Basicearnings per share is computed using the weighted average number of sharesoutstanding.  Diluted earnings per shareis computed using the weighted average number of shares outstanding, adjustedfor dilutive incremental shares attributed to outstanding options to purchasecommon stock.  The following table is areconciliation of the numerators and denominators of the basic and diluted pershare computations for each of the three years in the period ended May 31,2005:

 
| ** **                                   | ** ** | **Income  (Numerator)** | ** ** | **Weighted  Average  Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|----------------------------------------------|------------|------------------------|------------|
| **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 |   |
|                                         |       |                    |       |                                         |       |                   |       |
| **Year  ended May 31, 2003**            |       |                    |       |                                         |       |                   |       |
| Basic and  diluted loss per share            |       |                    |       |                                         |       |                   |       |
| Loss available  to common stockholders       |       | $                       | (1,487,131 | )                                            | 2,467,651  |                   | $          | (0.60 | ) |

 

InFiscal 2003 243,290 incremental shares were excluded from the diluted loss pershare calculation, as their effect was anti-dilutive.

 

**NOTE 14**

# **RELATEDPARTY TRANSACTIONS**

 

TheCompany has identified a potential new market segment for its Balancer productswith PulverDryer USA, Inc., a manufacturer of a specialized pulverizingand drying machine. Due to the market potential with this customer, in October 2003the Board of Directors of the Company authorized the CEO, 

 

33

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Mr. WayneCase, to actively pursue this new market segment by supporting PulverDryer inits product design, development and guidance on management.  Mr. Case thus expanded this new marketsegment by generating additional sales to the Company of over $360,000 for theperiod from July 2003 to May 2005. Mr. Case also serves on the board of directors of PulverDryer.

 

Asthese efforts expanded, effective June 1, 2004, the Company entered into acontract with PulverDryer to provide consulting services to PulverDryer,pursuant to which PulverDryer paid the Company $8,000 a month from June 2004through October 2004.  Thoseservices generated successful results, and the Company and PulverDryer extendedthe contract from November 1, 2004 forward at that same monthly feeof $8,000.  The contract may beterminated by either party upon 30 days written notice.  As of May 31, 2005 the contract was ineffect between the two companies.

 

34

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#### ***SUMMARIZED QUARTERLY FINANCIALDATA***

 

***Inthousands, except per share information***

***(unaudited)***

 

**2005 Quarter Ended**

 
| ** **                     | ** ** | **August  31** | ** ** | **November  30** | ** ** | **February  28** | ** ** | **May  31** | ** ** |
|--------------------------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|
| Sales                          |       | $              | 2,429      |             | $          | 2,432            |       | $           | 2,554      |   | $ | 3,115 |   |
| Gross Profit                   |       | $              | 1,358      |             | $          | 1,433            |       | $           | 1,456      |   | $ | 1,823 |   |
| 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 |   |

 

----

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

 

**2004 Quarter Ended**

 
| ** **                            | ** ** | **August  31** | ** ** | **November  30** | ** ** | **February  29** | ** ** | **May  31** | ** ** |
|---------------------------------------|------------|----------------|------------|------------------|------------|------------------|------------|-------------|------------|
| Sales                                 |       | $              | 1,648      |             | $          | 1,736            |       | $           | 1,773      |   | $ | 2,768 |   |
| Gross Profit                          |       | $              | 884        |             | $          | 930              |       | $           | 979        |   | $ | 1,726 |   |
| Net (Loss)  income                    |       | $              | (67        | )                | $          | 47               |       | $           | 1          |   | $ | 536 |   |
| Net (Loss)  income Per Share, Basic   |       | $              | (.03       | )                | $          | .02              |       | $           | .00        |   | $ | .22 |   |
| Net (Loss)  income Per Share, Diluted |       | $              | (.03       | )                | $          | .02              |       | $           | .00        |   | $ | .22 |   |
| Market Price of  Common Stock         |       |           |       |             |       |             |       |        |       |
| High                                  |       | $              | 1.82       |             | $          | 2.53             |       | $           | 2.69       |   | $ | 2.75 |   |
| Low                                   |       | $              | 1.24       |             | $          | 1.48             |       | $           | 1.86       |   | $ | 1.75 |   |

 

***Reportof Independent Registered Public Accounting Firm:***

 

Board of Directors andShareholders

Schmitt Industries, Inc.

 

We have audited theaccompanying consolidated balance sheet of Schmitt Industries, Inc. andits subsidiaries as of May 31, 2005 and 2004, and the related consolidatedstatements of operations, changes in stockholders’ equity and cash flows foreach of the three years in the period ended May 31, 2005.  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.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  The Company is not requiredto have, nor were we engaged to perform an audit of its internal control overfinancial reporting.  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 audit provides 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.and its subsidiaries as of May 31, 2005 and 2004, and the consolidatedresults of their operations and their consolidated cash flows for each of thethree years in the period ended May 31, 2005, in conformity withaccounting principles generally accepted in the United States of America.

 

 
|   | /s/ GRANT  THORNTON LLP |   |
|--------|-------------------------|--------|

 

Portland, Oregon

 

July 19, 2005

 

35

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

 

**Not applicable**

 

**Item 9A.****         Controlsand Procedures**

 

(a)                                  Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rules 13a-15(e) and 15d – 15(e) promulgated under theSecurities Exchange Act of 1934, as amended, as of the end of the periodcovered by this report.  Based on theirevaluation, our principal executive officer and principal financial officerconcluded that our disclosure controls and procedures are effective as of theend of the period covered 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 9A.****         OtherInformation**

 

**None**

 

**PART III**

 

Certain informationrequired by Part III is included in the Company’s definitive ProxyStatement for its 2005 Annual Meeting of Shareholders (“Proxy Statement”) andis incorporated herein by reference. The Proxy Statement will be filed pursuantto Regulation 14A of the Securities Exchange Act of 1934 not later than 120days after the end of the Fiscal year covered by this Report.

 

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

 

The information requiredby these items is included in the Proxy Statement under the headings “Management”,“Executive Compensation,” “Summary Compensation Table,” “Options Grants inFiscal 2005,” “Aggregated Option Expenses in Fiscal 2005 and Fiscal Year-EndOption Values,” and “Section 16(a) Beneficial Ownership ReportingCompliance” and “Code of Ethics” and is incorporated herein by reference.

 

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

 

The information requiredby this item is included in the Proxy Statement under the heading “SecurityOwnership of Certain Beneficial Owners” and is incorporated herein byreference.

 

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

 

The information requiredby this item is included in the Proxy Statement under the heading “CertainRelationships and Related Transactions” and is incorporated herein byreference.

 

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

 

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

 

36

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**PART IV**

 

**Item 15.****                            Exhibitsand Financial Statement Schedules**

 

*(a)**                               FinancialStatements:*

 
| (1)    |     | Consolidated  Balance Sheets as of May 31, 2005 and 2004                                                                                                                                                                |
|--------|----------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |     |                                                                                                                                                                                                                         |
|   |     | Consolidated  Statements of Operations for the years ended May 31, 2005, 2004 and 2003                                                                                                                                  |
|   |     |                                                                                                                                                                                                                         |
|   |     | Consolidated  Statements of Changes in Stockholders’ Equity for the years ended  May 31, 2005, 2004 and 2003                                                                                                       |
|   |     |                                                                                                                                                                                                                         |
|   |     | Consolidated  Statements of Cash Flows for the years ended May 31, 2005, 2004 and 2003                                                                                                                                  |
|   |     |                                                                                                                                                                                                                         |
|   |     | Notes to  Consolidated Financial Statements for the years ended May 31, 2005, 2004  and 2003                                                                                                                            |
|   |     |                                                                                                                                                                                                                         |
|   |     | 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 39 of the Exhibits filed with this report.                                                                                                                            |

 

37

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**SIGNATURES**

 

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

 
|   | **SCHMITT  INDUSTRIES, INC.** |
|--------|-------------------------------|
|   | ** **                    |
|   |                          |
|   | By:                           |   /s/  Wayne A. Case |   |
|   |                          | Wayne A. Case |
|   |                          |   | *Chairman  of the Board, President* |
|   |                          |   | *and  Chief Executive Officer* |
|   |                          |
|   | Date:  August 29, 2005   |
|        |                               |  |  |  |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities indicated on August 29, 2005.

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

 

38

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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 |
|         |       |            |   |
| **21.1       |       |            | Subsidiaries of Schmitt Industries, Inc. as of  May 31, 2005 |
|         |       |            |   |
| **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 orcompensatory plan.

 

**Filed herewith

 

39

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