Schmitt Industries, Inc. Annual Report 1998

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K(Mark One)[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the fiscal year ended: May 31, 1998 or[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from ________________ to ________________ Commission File Number: 0-23996 SCHMITT INDUSTRIES, INC. (Exact name of registrant as specified in its charter) Oregon 91-1151989 (State or other jurisdiction of (IRS Employer Identification incorporation or organization) 2765 N.W. Nicolai Street Portland, Oregon 97210 (Address of principal executive offices) (Zip Code) (503) 227-7908 (Registrant's telephone number, including area code)Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered- ------------------------------ ------------------------------------------------ None NoneSecurities registered pursuant to Section 12(g) of the Act: Common Stock - no par value (Title of each class) Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.Yes X No --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item405 of Regulation S-K is not contained herein, and will not be contained, to thebest of registrant's knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment to thisForm 10-K. [ X ] As of August 7, 1998, the aggregate market value of the registrant's CommonStock held by nonaffiliates of the registrant was $24,992,657 based on theclosing sales price of the registrant's Common Stock on the Nasdaq NationalMarket. On that date, there were 7,099,139 shares of Common Stock outstanding. Portions of the registrant's 1998 Annual Report to Shareholders areincorporated by reference into Parts II and IV hereof, and portions of theregistrant's definitive Proxy Statement for its 1998 Annual Meeting ofShareholders are incorporated by reference into Part III hereof. PART IITEM 1. BUSINESSINTRODUCTION The Company designs, assembles and markets computer-controlled balancingequipment for use primarily by the machine tool industry. Through its whollyowned subsidiary, Schmitt Measurement Systems, Inc. ("SMS"), a Montanacorporation, the Company also designs, manufactures and markets precision lasermeasurement systems. The Company was incorporated under the laws of British Columbia, Canada in1984. The name of the Company was changed to Schmitt Industries Inc. in 1987. In February 1996, the Company was "continued" from British Columbia to the stateof Wyoming and then merged into its wholly owned subsidiary, Schmitt Industries,Inc., an Oregon corporation; Schmitt Industries, Inc. was the surviving entity. The Company acquired its original balancing equipment technology pursuantto a series of agreements from 1987 through 1991. The patented technology hasbeen substantially enhanced and advanced by the Company in the past decade. In May 1995, the Company acquired TMA Technologies Inc. ("TMA"), adesigner, assembler and marketer of innovative industrial measurement systemsbased on laser light scatter technologies. For all of the outstanding shares ofTMA, the Company paid $15,000, assumed approximately $515,000 of TMA debt andagreed to make royalty payments to TMA's shareholders of 5% on sales of TMAproducts and future Company products that utilize TMA's technologies, hardware,software and existing patents, subject to a maximum royalty of $6 million. InJune 1995, TMA began operations in Portland and subsequently changed its name toSchmitt Measurement Systems, Inc. ("SMS") In June 1996, the Company formed a wholly owned subsidiary, Schmitt Europe,Ltd., under the laws of Great Britain to market and sell the Company's productsin Great Britain. In December 1996, the Company completed the acquisition of the assets ofthe grinding wheel balancer division of Hofmann Machinenbau GmbH of Germany. The Company operates this business as Schmitt Hofmann Systems GmbH, a whollyowned subsidiary of the Company ("SHS"). The Company purchased the assets fromHofmann Machinenbau GmbH for $496,000. The Company's executive offices are located at 2765 N.W. Nicolai Street,Portland, Oregon 97210, and its telephone number is (503) 227-7908.BALANCING PRODUCTS The Company's principal product is the Schmitt Dynamic Balance System (the"SBS System"). It consists of a computer control unit, sensor, spindle mountingadapter, and balance head. It was designed to be an inexpensive, yet highlyaccurate, permanent installation on grinding machines. Today, the SBS System isbeginning to be evaluated by manufacturers for additional applications includinglarge electric motors, industrial fans, industrial brushing devices, turbinesand similar devices. The SBS System is fully automated and consequently the user does not haveto pre-balance such devices as grinding wheels. This reduces the setup time ofsuch operations and ensures a smoother and more efficient operation. 2 The SBS System operates on a principle of mass compensation for wheelimbalance. The balance head contains two movable eccentric weights, each ofwhich is driven by electric motors through a precision gear train. Theseweights can be repositioned to offset any imbalance in a grinding wheel or otherapplication. Imbalance or vibration is picked up by the sensor. The signal isfed to a controller that filters the signal by revolutions per minute. Thecontroller then drives the two balance head weights in the direction thatreduces the amplitude of the vibration signal. When the weights are positionedso the lowest vibration level is reached, the balance cycle is complete. Notable features of the SBS System include its ability to fit almost allmachines, ease of installation, compact and modular construction, ability tobalance a wheel while on a machine, elimination of wheel vibration, automaticmonitor of balance, display in both English and metric systems, instrument gradecalibration, short balance process, measurement of both displacement and/orvelocity, and minimal user maintenance. Benefits to the system user include improved quality of finished parts,ease of product adaptation, minimal downtime, complete and ready installation,elimination of need for static balancing, longer life for wheels, dressings,diamonds and spindle bearings, the ability to balance within 0.2 microns and itsadaptability to all types of machines. The precision grinding industry has a worldwide presence and is establishedin all industrialized countries. In each major industrialized country there arethree major market segments: the machine tool builders, the rebuilders andgrinding machine users. The first major market segment consists of machine tool builders whoactually design and manufacture a variety of cylindrical, surface, and specialtyapplication grinding machines that are sold at home and also exported to foreignmarkets. SBS System products are distributed to a variety of world marketsthrough OEM (original equipment manufacturer) accounts, where a special pricing(20%) discount is offered to the machine builder if the designer incorporatesthe SBS System into its machine. Examples of some of well-known worldwide machine tool builders who haveoffered and/or installed the SBS System include ANCA (Australia), BryantGrinders Corporation (U.S.), Blohm Incorporated (U.S.), Blohm GmbH (Germany),Capco Machinery (U.S.), Cincinnati Milacron (U.S.), Ecotech/SMTW (China/U.S.),Gold Crown Machinery (U.S.), Gleason Works (U.S.), Litton IAS/Landis Grinding(U.S.), Micron Machinery Limited (Japan/U.S.), Normac Incorporated (U.S.), NTCToyama America (U.S./Japan), Okomoto (Japan), Okuma Machine (Japan), RoyalMaster Grinders (U.S.), Shigiya Machine (Japan), Sumitomo Heavy Industry(Japan), CETOS Hostivar (Czech Republic), TOS Holice (Czech Republic), ToyodaMachine (Japan) and Weldon Machine Tool (U.S.). One successful marketing channel to tool builders is the sale of the SBSSystem to users who purchase new machines and thereby experience the benefits ofthe SBS System and then purchase additional units for application to their oldermachines. The second major market segment consists of machine tool rebuilders who arefound in all industrial nations and who develop their business with users byoffering to completely update and refurbish older machine tools. Theserebuilders typically tear the old machine apart and install new bearings, newelectronics, and new advanced features, such as an SBS Automatic Wheel Balancer.The Company currently sells its product directly to all major machine rebuildersin the U.S. and to some countries in Western Europe. 3 Grinding machine users in industrialized countries are the third majormarket segment. Users become aware of the SBS System through trade shows, trademagazine advertising, distributors, field representatives, referrals and newmachine suppliers. Precision grinding is increasing as a worldwide method of material removaland material processing. Therefore, the Company believes that there may be anincrease in market growth and an increase in the need for automatic balancers. Precision grinding is necessary in all major manufacturing areas such as theautomotive industry (camshafts, crankshafts, valves), bearings (roller andtapered types), ceramics (precision shaping), electric motors (shafts), pumps(shafts and turbines), aircraft (engine parts), and general manufacturing. The Company's business is conducted with many customers located throughoutthe world. Examples of some of the more well known of these include Black &Decker, Briggs and Stratton, Caterpillar Inc., Daewoo International Corp., EatonCorporation, Ford Motor Company, General Electric Corp., General Motors,Ingersoll Rand, Sumitomo Heavy Industries, Texas Instruments, The TimkenCompany, Torrington, TRW Automotive Components and Westinghouse Electric Corp. The acquisition of SHS has added additional balancer designs to theCompany's worldwide product line. The SHS internal spindle balancers and ringbalancers add to the total balancer package available from the Company. Theseproven designs, along with the original water balancer, allow Schmitt to broadenits machine applications. The Company is now developing additional electroniccontrollers that will operate all Schmitt, including SHS, balancers from asingle electronic controller. In Fiscal 1996, 1997 and 1998, net sales of the Company's balancingproducts totaled $4,801,151, $6,151,473, and $7,532,112, respectively. Netsales of balancing products accounted for 68% of the Company's revenue inFiscal 1996, 58% in Fiscal 1997 and 71% in Fiscal 1998. See Note 8 toConsolidated Financial Statements. COMPETITION. Management believes that the SBS System is the only fullyautomatic balancing system marketed in the world. All other competitivebalancing products require special setup and training or calibration to thespecific machine. The Company believes that the SBS System is currently the onlybalancing product on the market that fits all machines with wheel sizes from 6to 48 inches in diameter and spindle rpm of 500 through 7,500. Competitive products include European manufacturers building waterbalancers and electromechanical balancers similar to the SBS System. Waterbalancers are currently priced at about 1.5 times the level of the SBS Systembecause of expensive plumbing and water chambers machined into the wheel hub. The machines are disassembled and parts remachined or replaced within thespindle assembly, a process that takes from one to two days. The system is"tuned" or "calibrated" to the machine by a factory service technician. Although water systems are unable to balance at low rpm, they work at mid- andhigh-speeds when properly monitored by regularly cleaning filters and checkingclearance of water jets. This technology is the oldest in the market and isemployed in the SHS-installed systems. After the acquisition of SHS in December1996, the Company considers European electromechanical balancers to be the itsmajor competition due to their established base in Europe. Electromechanical balancers similar to the SBS System are produced byseveral European companies, located primarily in Switzerland, Germany, Spain andItaly. These European balancers have deficiencies in electronics which renderthem less effective in solving essential balancing requirements. They cannotachieve the consistent low balance levels obtained by the SBS System and cannotoperate effectively at 500 rpm (low speed) or at 7,500 rpm (high speed). Inaddition, these balancers have 4inferior brush and cable assemblies which cause down time and high maintenance. None of these companies can compete effectively with the Company in providing mounting adapters for all grinding machines. The SBS System list price is $7,800 worldwide. Water balancers produced byGerman companies other than SHS are priced at $11,000 to $15,000, and theelectromechanical systems are priced at $8,000 to $10,000 worldwide. Marketsurveys by management indicate that customers perceive values of an automaticbalancer to approximately $8,000; therefore, Company pricing is geared toobtaining a dominant market position and meeting competitive supplier prices. The market strategy is to establish the SBS System as the dominant product withthe best quality, reliability and performance and superior economic value.SCHMITT MEASUREMENT SYSTEMS, INC. HISTORICAL BACKGROUND. SMS manufactures and markets a line of laser-based,precision measurement systems. In addition, SMS operates a precision lightscatter measurement laboratory which is utilized by third-party equipmentmanufacturers and others. Light scatter technology involves using lasers, optics and detectors tothrow a beam of light on a material sample and recording itsreflection/transmission. Analysis of light scatter information can determinematerial characteristics such as surface roughness and defects, withoutintroducing contaminants and causing changes to the tested material. SMS PRODUCTS. The principal products of SMS are laser-based measurementproducts and technology that can be applied to both military and industrialmarkets. Historically, TMA (now SMS) did not pursue industrial markets butinstead concentrated on military markets. The Company believes that thisstrategy was a significant contributing factor in the failure of TMA to achieveprofitable operations. The Company believes that the patents, patent applications, trademarks andother proprietary technology acquired with TMA can be successfully refocusedinto industrial markets, including electronics, computer disk manufacturers andflat-panel display manufacturers. The Company is developing a product review and marketing plan. Over thelong term, the Company expects SMS products to add to sales and profitability ofthe Company. Net sales of SMS products totaled $2,278,977 or 32% of theCompany's total revenue in Fiscal 1996, $4,390,499 or 42% of the Company's totalrevenue in Fiscal 1997, and $3,093,972 or 29% of the Company's total revenue inFiscal 1998. See Note 8 to Consolidated Financial Statements. SMS operates three businesses: a light-scatter measurement laboratory,laser-based light-scatter measurement products and other laser alignmentproducts. SMS provides a highly advanced, extremely precise measurementservices laboratory to a wide variety of industrial and commercial businesses,using advanced laser, light scatter technology. The laboratory uses three SMS CASI Scatterometers for measuring surfaceroughness. The true value of the laboratory is not only its extremely precisemeasurement capability but also that the item being tested is not altered,touched or destroyed. Thus, the laboratory is widely used by the semiconductorand computer hard disk industries, as well as manufacturers of critical opticalcomponents in aerospace and defense systems. Customers of the laboratory haveincluded Aerojet, AT&T Bell Labs, Eastman Kodak, General Electric, IBM, NASA anddozens of other industrial companies, universities and government agencies. 5 The three SMS CASI Scatterometers in the laboratory are angle-resolved BRDFmeasurement instruments providing customers with precise roughness measurementsof optical surfaces, diffuse materials, semiconductor wafers, magnetic storagemedia, precision-machined surfaces, as well as surfaces affecting the cosmeticappearance of consumer products. A Scatterometer uses ultraviolet or infraredlaser light as a nondestructive probe to measure surface quality, opticalperformance, smoothness, appearance, defects and contamination on a wide varietyof materials. The sample is mounted on stages capable of moving bidirectionally and/or inrotation. The incident angle can be set anywhere up to an 85DEG. angle fromsurface normal. The detector sweeps around the sample in the incident planemeasuring scattered and specular light. During the scan, the computer controlsgain, filter and aperture changes through user-defined parameters. Theinstrument background is measured separately and can be compared with the sampledata. The CASI Analysis Software simplifies analysis of scatter data. BRDFvalues are used to calculate total integrated scatter, PSD and RMS roughness. Annotated results print on the HP PaintJet printer as viewgraphs orpublication-ready figures. The laboratory generated approximately 2% of SMS's total revenue duringFiscal 1997 and 3% during Fiscal 1998. Total revenue for this business isexpected to rise modestly in the future while representing a smaller percentageof SMS's business. Use of the laboratory, leading to orders for SMS'slaser-based light scatter measurement products by its customers, represents thebest marketing channel for SMS's current and future products. Existing products(such as the Scan and the Model 2002 alignment laser system) and products beingdeveloped in conjunction with the measurement services laboratory are beingmarketed to a variety of industrial customers. The Scan System consists of a hand-held control unit, an interchangeablemeasurement head and a separate charging unit. To perform a measurement, theoperator places the measurement head on the objective area and presses thebutton. Each measurement takes less than five seconds. The results aredisplayed and stored in system memory. The Scan can store 700 measurements in255 files and provides the capability to program pass/fail criteria. Softwareis available for control, analysis and file conversion. From a singlemeasurement, a user can determine RMS surface roughness, reflectance and scatterlight levels (BRDF) on flat or curved surfaces under any lighting conditions. The Auto-Collimating Alignment Laser System - Model 2002 is an extremelyaccurate laser alignment system. The incorporation of a solid-state laser diodeprovides increased beam stability and eliminates warm-up time. A new unique TMASee-Thru target design completely eliminates beam displacement and power loss. The addition of an operator selectable auto-collimating feature provides one arcsecond accuracy over a large angular range. A microprocessor automates systemconfiguration. A new bus interconnect reduces setup time and allows up to sevenoperator selectable targets, reducing time required to perform measurements. Acomplete Model 2002 system consists of an auto-collimating laser, power supply,digital display, See-Thru and end targets, carrying case and cable assemblies. The Company introduced a new product, a Dual Texture Measurement machinecalled the DTM-2000, in the first half of Fiscal 1998. Using the Company'spatented non-contact light scatter process of surface measurement, the automatedDTM-2000 provides for measurements on both sides of computer hard disks at1,200 disks per hour at a measurement range of 2 angstroms to 200 angstroms. On April 23, 1998, the Company entered into a Technology Transfer Agreementwith Centerline Engineering, Inc. and several individuals for the purchase ofthe rights to a non-contact gauging 6apparatus. The $100,000 purchase included the technology, the prototype and instruction manuals, technical information, and related patent applications.BUSINESS AND MARKETING STRATEGY MARKETING. The Company designs, assembles and markets all of its products,except SMS products which are marketed through a strategic alliance with VeecoInstruments Inc. ("Veeco"). The Company's operations are divided into a numberof different areas. The production organization, which is responsible for allassembly, purchasing and production engineering, is directed by the VicePresident of Operations. The Product Marketing Division is responsible for thesale of SBS System products. This division is managed by the President/CEO andfour Marketing Managers. Three of the Marketing Managers are responsible fordomestic sales. The fourth Marketing Manager is responsible for sales inmainland China, Japan and Korea. The President/CEO is responsible for sales inboth eastern and western Europe and also oversees the efforts of the fourMarketing Managers. The technical services division is responsible forproviding technical support to customers and is managed by the Vice President ofOperations. In addition, there is a research and development group which issupervised directly by the President/CEO and the Vice President of Operations. The Company markets and sells the SBS System in a variety of ways. First,the Company uses the conventional channels provided by independentmanufacturer's representatives and distributors. There are currently 25individuals and/or organizations in the United States acting in one of thesecapacities. Independent sales agents are paid a 10% commission; distributors aresold products at a 15% discount. Second, trade shows represent a significant amount of marketing/saleseffort. These events are held throughout the world and have proven to beexcellent sources of business for the Company. A representative from theCompany, usually one of the marketing managers and/or Wayne A. Case, attendsthese events along with local Company representatives. These individuals attenda display booth that features professional products, an SBS System demonstrationstand, product literature, and technical literature. Representatives from allfacets of the market to which the Company directs its sales efforts attend thesetrade shows. Third, original equipment manufacturers often include the SBS System on themachine tools which they produce. Users thus purchase the SBS Systemconcurrently with the machine tools. The SBS Systems are also often installedby machine builders prior to displaying their own machine tools at various tradeshows. These samples often become endorsements that prove to be beneficial tothe Company's sales efforts. In the United States, most products are shipped directly to customers fromthe Company's distribution center in Portland, Oregon. Where the Company hasdistributors, the product is shipped to the distributor, who in turn pays theCompany directly and then delivers and installs the product for the end user. Western European distribution to customers is handled by shipping the productdirectly from the Company's Portland headquarters to the end users. The acquisition of SMS (formerly TMA) has resulted in revision of marketingstrategy of both the balancer business and the new measurement products. TheCompany is evaluating all products acquired through the acquisition of TMA andevaluating existing measurement product and balancing product distributors andagents to determine the most efficient mix. On February 23, 1998, the Company entered into an Exclusive DistributionAgreement, effective January 1, 1998, with Sloan Technology, Inc. (dba VeecoProcess Metrology), a subsidiary of Veeco 7(NASDAQ : VECO), pursuant to which Veeco was appointed the exclusive distributor for the promotion and sale of SMS products. Veeco is also to provide customers with after-sale services. The initial term of the agreement ends on December 31, 1999 and is automatically renewed for consecutive two-year periods unless either party notifies the other of its intention to terminate the agreement six months prior to the expiration of the then current term. This agreement replaces an earlier agreement with Veeco having similar terms and dated September 18, 1996. In fiscal 1998, approximately 24% of the Company's total revenue wasattributable to sales made to Veeco. No other customer accounted for more than10% of the Company's total revenue in fiscal 1998. The SBS System customer base consists of over 250 companies. The SMScustomer base consists of approximately 200 companies, many of which are alsopurchasers of the Company's balancing products. MANUFACTURING. The Company does not use any unique sources of supply orraw materials in its products for either SBS System balancing products or SMSmeasurement products. Essential electronic components used are available inlarge quantities from various suppliers. These electronic components areassembled into the SBS System and SMS electronic control units to meet theCompany's quality and assembly standards. Company-owned software and firmwareare coupled with the electronic components to provide the basis of the Company'svarious electronic control units. The Company believes several sources ofsupplies exist for all electronic components and assembly work that is used inits electronic control system. The Company's primary outside supplier ofelectronic assembly is Laughlin-Wilt Group, Inc. ("Laughlin-Wilt") of Beaverton,Oregon, a custom supplier of assembled electronic products for several PacificNorthwest companies. In the event of supply problems, the Company believes thattwo or three alternatives could be developed within 30 days to supplement orreplace Laughlin-Wilt. Mechanical parts for the Company's SBS System and SMS products are producedto the customers' drawings and specifications by local high quality CNC machineshops. Several such CNC machine shops exist in the local area, and the Companyis not dependent on any one supplier of mechanical components. Principalsuppliers of components for the Company's products include MacKay Manufacturingof Spokane, Washington; OEM Manufacturing of Corvallis, Oregon; Eagle Industriesof Newberg, Oregon; and Forest City Gear of Roscoe, Illinois. The Company uses in-house skilled assemblers to construct and test vendor-supplied components. Component inventory of finished vendor-supplied parts is held on the Company property to assure adequate flow of parts to meet customer order requirements. Inventory is monitored by a computer control system designed to assure timely re-ordering of components. In-house personnel assemble various products and test all finishedcomponents before placing them in the finished goods inventory. Finished goodsinventory is maintained via computer to assure timely shipment and service tocustomers. All customer shipments are from the finished goods inventory. In November 1996, the Company's Quality Control Program received full ISO-9001 certification.PATENTS AND TRADEMARKS SBS SYSTEM PRODUCTS. The Company manufactures its products under copyrightprotection in the U.S. for all electronic board designs which are also furtherprotected with encapsulation of the finished product to protect the Company'stechnologies and software. U.S. Patent No. 4951526 was issued to the 8Company in 1990 and covers both the new ring balancer and the existing SBS Balance Heads that the Company markets to the grinding industries. The trademark "SBS" is a registered trademark of the Company and is affixedto all products and literature created in the Company's balance product line. The Company pays no licenses or royalties on its balancing technologies andhas offered no concessions, labor agreements or royalty agreements on itsbalancing product lines. SMS PRODUCTS. The trademark "SMS" is a registered trademark of the Companyand is affixed to all products and literature created in the Company'smeasurement product line. The following tables include information about patents and trademarks issued and patents pending with respect to SMS products. SMS PATENTS ISSUED- ------------------------------------------------------------------------------- 5196906 1993 Scan: surface measurement 5416590 1995 GapMaster: gap and mismatch 5596403 1997 Pitch, yaw of a single laser beam system and method of measuring angular position 5625451 1997 Methods and apparatus for characterizing a surface 5661556 1997 System for measuring the total integrated scatter of a surface SMS TRADEMARKS- ------------------------------------------------------------------------------- Scan 1992 Surface measurement system CASI 1993 Surface inspection system Accunet 1994 Distance measurement NET FMS 1994 Finished measurement systems Surf-Map 1995 Surface inspection process SMS 1995 Schmitt Measurement SystemPRODUCT DEVELOPMENT Prior to Fiscal 1996, research and development activities of the Companywere focused on the enhancement of the existing product lines for balancers andon development work toward the new ring balance product. Since its May 1995acquisition of TMA, the Company has expended significant efforts evaluatingexisting and potential new products for the light-scatter precision measurementmarket. During Fiscal 1994 and 1995, the Company developed the Ring Balancer, adynamic balancer shaped as a "ring" that allows the device to be fitted "around"a rotating shaft rather than on the end of a shaft where the current Companyproducts are mounted. This mounting and configuration will allow the Company toapply its ring balancers to virtually any rotating device such as fans,turbines, large motors, centrifuges and other industrial machine tools. During the last several years, the Company has developed several new majoroffshoot products of its balancing technologies to widen market opportunities. All costs associated with these developments have been borne directly by theCompany's customers, with minimal development costs to the Company. Researchand development costs for existing product line enhancements are treated asproduct improvements and expenses, including costs toward the new Ring Balancer. 9 During Fiscal 1998, the Company continued to develop new balancing productsand expended considerable time and effort in evaluating and developing newlaser-based measurement products. During Fiscal 1998, the Company developed andbegan marketing the DTM-2000 Automatic Disk Measurement System. During Fiscal 1996, 1997 and 1998, the Company's research and developmentexpense totaled $0, $205,800 and $379,798, respectively.INTERNATIONAL SALES The Company's sales in the last three fiscal years have been generated fromthe following geographic areas: NORTH AMERICA EUROPE ASIA ------------- ----------- --------- Fiscal 1998 $ 8,006,428 $ 2,488,344 $ 131,312 Fiscal 1997 8,664,819 1,601,369 275,394 Fiscal 1996 6,298,170 442,470 339,488BACKLOG The Company does not generally track backlog. Normally, orders are shippedwithin several weeks after receipt unless the customer requests otherwise.EMPLOYEES As of July 15, 1998, the Company employed 50 individuals worldwide on afull-time basis. There were no regular part-time employees. None of theCompany's employees is covered by a collective bargaining agreement.ITEM 2. PROPERTIES The Company's design and assembly facilities and executive offices arelocated in a 7,500-square foot building in Portland, Oregon owned by theCompany; a 33,000-square foot facility, located across the street from theexecutive offices and also owned by the Company, houses SMS's operations. Schmitt Europe Ltd. occupies a 1,893-square foot facility in Coventry, Englandpursuant to a five-year lease beginning February 1, 1997 with a basic monthlyrent of L1,708 (approximately $2,790 as of July 15, 1998). SHS occupies a5,194-square foot facility in Alsbach, Germany pursuant to a five-year leasebeginning February 1, 1997 with a basic monthly rent of DM 5,442 (approximately$3,022 as of July 15, 1998). The Company believes its facilities are adequateto meet its current needs.ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings currently pending against theCompany.ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of the Companyduring the fourth quarter ended May 31, 1998. 10 PART IIITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Since May 5, 1997, the Company's Common Stock has been traded on the NasdaqNational Market; prior to that it was traded on the Nasdaq-Small Cap Market. The Common Stock is traded under the symbol "SMIT." The following tables set forth the high and low sales prices of theCompany's Common Stock as reported on the Nasdaq-Small Cap Market and on theNasdaq National Market (since May 5, 1997) for the periods indicated. YEAR ENDED MAY 31, 1997 HIGH LOW ------------------------------------ ------- ------ First Quarter $ 13.75 $ 8.88 Second Quarter $ 11.00 $ 7.88 Third Quarter $ 11.00 $ 7.88 Fourth Quarter $ 10.25 $ 7.00 YEAR ENDED MAY 31, 1998 HIGH LOW ------------------------------------ ------- ------ First Quarter $9.75 $7.50 Second Quarter $12.00 $8.00 Third Quarter $10.13 $7.38 Fourth Quarter $8.13 $5.69 As of July 15, 1998, there were 7,099,139 shares of Common Stockoutstanding held by 129 holders of record. The number of holders does notinclude individual participants in security position listings; the Companybelieves that there are more than 2,500 individual holders of shares of CommonStock. The Company has not paid any dividends on its Common Stock since 1994. TheCompany's current policy is to retain earnings to finance the Company'sbusiness. Future dividends will be dependent upon the Company's financialcondition, results of operations, current and anticipated cash requirements,acquisition plans and plans for expansion and any other factors that theCompany's Board of Directors deems relevant. The Company has no presentintention of paying dividends on its Common Stock in the foreseeable future.ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is included in the Company's AnnualReport to Shareholders for the fiscal year ended May 31, 1998 ("Annual Report")under the heading "Selected Financial Data" and is incorporated herein byreference.ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is included in the Annual Reportunder the heading "Management's Discussion and Analysis" and is incorporatedherein by reference. 11ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and other information required by this Item areincluded in the Annual Report and are incorporated herein by reference.ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE In July 1997, the Company replaced its independent accountant, Moss AdamsLLP, with PricewaterhouseCoopers LLP. This decision was made by the AuditCommittee of the Company's Board of Directors. Moss Adams LLP's reports for the fiscal years ended May 31, 1996 andMay 31, 1997 did not contain an adverse opinion or disclaimer of opinion, norwere they qualified or modified as to uncertainty, audit scope or accountingprinciples. During Fiscal 1996 and 1997 and until Moss Adams LLP's dismissal,there were no disagreements with Moss Adams LLP on any matter of accountingprinciples or practices, financial statement disclosure or auditing scope ofprocedure, which disagreements, if not resolved to the satisfaction of MossAdams LLP, would have caused it to make reference to the subject matter of thedisagreements in connection with its report. PART III Certain information required by Part III is included in the Company'sdefinitive Proxy Statement for its 1998 Annual Meeting of Shareholders ("ProxyStatement") and is incorporated herein by reference. The Proxy Statement will befiled pursuant to Regulation 14A of the Securities Exchange Act of 1934 notlater than 120 days after the end of the fiscal year covered by this Report.ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is included in the Proxy Statementunder the heading "Proposal No.1: Election of Directors" and is incorporatedherein by reference.ITEM 11. EXECUTIVE COMPENSATION The information required by this item is included in the Proxy Statementunder the heading "Executive Compensation" and is incorporated herein byreference.ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is included in the Proxy Statementunder the heading "Principal Shareholders" and is incorporated herein byreference.ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is included in the definitive ProxyStatement under the heading "Certain Transactions" and is incorporated herein byreference. 12 PART IVITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. INDEPENDENT AUDITOR'S REPORT: To the Board of Directors and Shareholders of Schmitt Industries, Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income, of cash flows and of changes in stockholders' equity present fairly, in all material respects, the financial position of Schmitt Industries, Inc. and its subsidiaries at May 31, 1998, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. The financial statements of Schmitt Industries, Inc. for the years ended May 31, 1996 and 1997 were audited by other independent accountants whose report dated July 10, 1997 expressed an unqualified opinion on those statements. PricewaterhouseCoopers LLP Portland, Oregon July 17, 1998 2. INDEPENDENT AUDITOR'S REPORT: To the Board of Directors and Stockholders of Schmitt Industries, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheets of Schmitt Industries, Inc. and Subsidiaries as of May 31, 1997 and 1996, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, 13 evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Schmitt Industries, Inc. and Subsidiaries as of May 31, 1997 and 1996, and the results of their operations and cash flows for the years then ended in conformity with generally accepted accounting principles. Moss Adams LLP Portland, Oregon July 10, 1997 3. FINANCIAL STATEMENTS: The following financial statements required by this Item are included in the Company's Annual Report to Shareholders for the fiscal year ended May 31, 1998 and are incorporated by reference herein: Annual Report Page Number ------------- A. Consolidated Balance Sheets as of May 31, 1998 and May 31, 1997 ....................................... 10 B. Consolidated Statements of Income for each of the years ended May 31, 1998, May 31, 1997 and May 31, 1996 ............................................... 11 C. Consolidated Statements of Cash Flows for each of the years ended May 31, 1998, May 31, 1997 and May 31, 1996 ........................................... 12 D. Consolidated Statements of Changes in Stockholders' Equity for each of the years ended May 31, 1998, May 31, 1997 and May 31, 1996 ........ 13 E. Notes to Financial Statements ...................... 14 4. 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. (b) Reports on Form 8-K: None. 14 SIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized. SCHMITT INDUSTRIES, INC. By: /S/ Wayne A. Case ----------------------------------- Wayne A. Case CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER Date: August 28, 1998Pursuant to the requirements of the Securities Exchange Act of 1934, this reporthas been signed below by the following persons on behalf of the registrant andin the capacities indicated on August 28, 1998. SIGNATURE TITLE- --------- ----- /s/ Wayne A. Case Chairman of the Board, President- ---------------------------- and Chief Executive OfficerWayne A. Case (Principal Executive Officer)/s/ Annie Windsor Chief Financial Officer- ---------------------------- (Principal Financial andAnnie Windsor Accounting Officer)/s/ David L. Dotlich Director- ----------------------------David L. Dotlich/s/ David M. Hudson Director- ----------------------------David M. Hudson/s/ Trevor Nelson Director- ----------------------------Trevor Nelson/s/ Dennis T. Pixton Director- ----------------------------Dennis T. Pixton 15 INDEX TO EXHIBITSEXHIBITS DESCRIPTION- -------- --------------------------------------------------------------------- *3(i) Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the "Company") . . . . . . . . . . . . . . . . . . . . . . . . . . . *3(ii) Second Restated Bylaws of the Company . . . . . . . . . . . . . . . . *10.1 Schmitt Industries, Inc. Amended & Restated Stock Option Plan . . . . 10.2 Agreement dated April 21, 1995 between TMA Technologies, Inc. and the Company. Incorporated by reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1996 . . 10.3 Exclusive Distribution Agreement dated February 23, 1998 between Sloan Technology Inc. and the Company. Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended February 28, 1998. (Confidential treatment has been granted for certain portions of this Agreement; these confidential portions have been filed separately with the Securities and Exchange Commission.) . . . . . . . . . . . . . . . . . . . . . . 10.4 Sales Contract dated November 19, 1996 between Herr Dirk Pfeil, receiver of Hofmann Machinenbau GmbH, and Schmitt Hofmann Systems GmbH. Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended February 28, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . *10.5 Technology Transfer Agreement dated April 23, 1998 between Centerline Engineering, Inc. and the Company . . . . . . . . . . . . . . . . . . *13.1 Annual Report to Shareholders of Schmitt Industries, Inc. for fiscal year ended May 31, 1998 . . . . . . . . . . . . . . . . . . . . . . . *21.1 Subsidiaries of Schmitt Industries, Inc. . . . . . . . . . . . . . . *23.1 Consent of PricewaterhouseCoopers LLP . . . . . . . . . . . . . . . . *23.2 Consent of Moss Adams LLP . . . . . . . . . . . . . . . . . . . . . . *27.1 Financial Data Schedule . . . . . . . . . . . . . . . . . . . . . . . ______________________________* Filed herewith 16 EXHIBIT 3(i) SCHMITT INDUSTRIES, INC. SECOND RESTATED ARTICLES OF INCORPORATION ARTICLE I NAME The name of this Corporation is Schmitt Industries, Inc. ARTICLE II CAPITAL STOCK 2.1 AUTHORIZED CAPITAL. The total number of shares which this Corporationis authorized to issue is 22,000,000, consisting of 20,000,000 shares of CommonStock and 2,000,000 shares of Preferred Stock. The Common Stock is subject tothe rights and preferences of the Preferred Stock as hereinafter set forth. 2.2 ISSUANCE OF PREFERRED STOCK IN SERIES. The Preferred Stock may beissued from time to time in one or more series in any manner permitted by lawand the provisions of these Second Restated Articles of Incorporation, asdetermined from time to time by the Board of Directors and stated in theresolution or resolutions providing for the issuance thereof. The Board ofDirectors shall have the authority to fix, determine and amend, subject to theprovisions hereof, the designations, preferences, limitations and relativerights of the shares of any series that is wholly unissued or is to beestablished. Unless otherwise specifically provided in the resolutionestablishing any series, the Board of Directors shall further have theauthority, after the issuance of shares of a series whose number it hasdesignated, to amend the resolution establishing such series to decrease thenumber of shares of that series, but not below the number of shares of suchseries then outstanding. In the event that there are no issued or outstandingshares of a series of Preferred Stock which this Corporation has been authorizedto issue, unless otherwise specifically provided in the resolution establishingsuch series, the Board of Directors, without any further action on the part ofthe holders of the outstanding shares of any class or series of stock of thiscorporation, may amend these Second Restated Articles of Incorporation to deleteall reference to such series. 2.3 DIVIDENDS. The holders of shares of Preferred Stock shall be entitledto receive dividends, out of the funds of this Corporation legally availabletherefor, at the rate and at the time or times, whether cumulative ornoncumulative, as may be provided by the Page 1 - SECOND RESTATED ARTICLES OF INCORPORATIONBoard of Directors in designating a particular series of Preferred Stock. Ifsuch dividends on the Preferred Stock shall be cumulative, then if dividendsshall not have been paid, the deficiency shall be fully paid or the dividendsdeclared and set apart for payment at such rate, but without interest oncumulative dividends, before any dividends on the Common Stock shall be paid ordeclared and set apart for payment. The holders of Preferred Stock shall not beentitled to receive any dividends thereon other than the dividends referred toin this section. 2.4 REDEMPTION. The Preferred Stock may be redeemable at such price, insuch amount, and at such time or times as may be provided by the Board ofDirectors in designating a particular series of Preferred Stock. In any event,such Preferred Stock may be repurchased by this Corporation to the extentlegally permissible. 2.5 LIQUIDATION. In the event of any liquidation, dissolution or windingup of the affairs of this Corporation, whether voluntary or involuntary, then,before any distribution shall be made to the holders of Common Stock, theholders of Preferred Stock at the time outstanding shall be entitled to be paidthe preferential amount or amounts per share as may be provided by the Board ofDirectors in designating a particular series of Preferred Stock and dividendsaccrued thereon to the date of such payment. The holders of Preferred Stockshall not be entitled to receive any distributive amount upon the liquidation,dissolution or winding up of the affairs of this Corporation other than thedistributive amounts referred to in this section, unless otherwise provided bythe Board of Directors in designating a particular series of Preferred Stock. 2.6 CONVERSION. Shares of Preferred Stock may be convertible into CommonStock of this Corporation upon such terms and conditions, at such rate andsubject to such adjustments as may be provided by the Board of Directors indesignating a particular series of Preferred Stock. 2.7 VOTING RIGHTS. Holders of Preferred Stock shall have such votingrights as may be provided by the Board of Directors in designating a particularseries of Preferred Stock. ARTICLE III NO PREEMPTIVE RIGHTS Except as may otherwise be provided by the Board of Directors, no holder ofany shares of this Corporation shall have any preemptive right to purchase,subscribe for or otherwise acquire any securities of this Corporation of anyclass or kind now or hereafter authorized.Page 2 - SECOND RESTATED ARTICLES OF INCORPORATION ARTICLE IV NO CUMULATIVE VOTING There shall be no cumulative voting of shares in this Corporation. ARTICLE V DIRECTORS 5.1 NUMBER. The Corporation shall have at least one director, the actualnumber to be determined as set forth in the Bylaws. 5.2 STAGGERED TERMS. The Board of Directors shall be divided into threeclasses if the number of directors is four or more, with said classes to be asequal in number as may be possible. Any director or directors in excess of thenumber divisible by three shall be first assigned to Class 1, and any additionaldirector shall be assigned to Class 2, as the case may be. (For example, ifthere are five directors, the fourth director shall be in Class 1 and the fifthdirector in Class 2.) At the first election of directors to such classifiedBoard of Directors, each Class 1 Director shall be elected to serve until thenext ensuing annual meeting of shareholders, each Class 2 Director shall beelected to serve until the second annual meeting of shareholders and each Class3 Director, shall be elected to serve until the third ensuing annual meeting ofshareholders. At each annual meeting of shareholders following the meeting atwhich the Board of Directors is initially classified, the number of directorsequal to the number of directors in a class whose term expires at the time ofsuch meeting shall be elected to serve until the third ensuing annual meeting ofshareholders. Notwithstanding any of the foregoing provisions of this ArticleV, directors shall serve until their successors are elected and qualified oruntil their earlier death, resignation or removal from office, or until there isa decrease in the number of directors; provided, however, that no decrease inthe number of directors shall have the effect of shortening the term of anyincumbent director. 5.3 REMOVAL. The directors of this Corporation may be removed only forcause, in the manner provided in the Bylaws, by the affirmative vote of theholders of not less than two-thirds of the shares entitled to elect the directoror directors whose removal is being sought. 5.4 VACANCIES. Vacancies on the Board of Directors, including vacanciescaused by an increase in the number of Directors, shall be filled by a majorityvote of the remaining directors only, unless there are no directors remaining,in which case the vacancies shall be filled by the shareholders, and except asset forth in the Bylaws.Page 3 - SECOND RESTATED ARTICLES OF INCORPORATION ARTICLE VI LIMITATION ON DIRECTOR LIABILITY To the fullest extent permitted by the Oregon Business Corporation Act, asit exists on the date hereof or may hereafter be amended, a director of thisCorporation shall not be liable to the Corporation or its shareholders formonetary damages for his or her conduct as a director. Any amendment to orrepeal of this Article shall not adversely affect any right or protection of adirector of this Corporation with respect to any acts or omissions of suchdirector occurring prior to such amendment or repeal. ARTICLE VII INDEMNIFICATION OF DIRECTORS To the fullest extent permitted by the Oregon Business Corporation Act andthe Bylaws of this Corporation, this Corporation is authorized to indemnify anyof its officers and directors. The Board of Directors shall be entitled todetermine the terms of indemnification, including advance of expenses, and togive effect thereto through the adoption of Bylaws, approval of agreements, orby any other manner approved by the Board of Directors. Any amendment to orrepeal of this Article shall not adversely affect any right of an individualwith respect to any right to indemnification arising prior to such amendment orrepeal. ARTICLE VIII BYLAWS The Board of Directors shall have the power to adopt, amend or repeal the Bylaws of this Corporation subject to approval by a majority of the Continuing Directors (as defined in Article XI hereof); provided, however, that the Board of Directors may not repeal or amend any bylaw that the shareholders expressly have provided may not be amended or repealed by the Board of Directors. The shareholders shall also have the power to adopt, amend or repeal the Bylaws of this Corporation by the affirmative vote of the holders of not less than two-thirds of the outstanding shares entitled to vote thereon and, to the extent, if any, provided by resolution adopted by the Board of Directors authorizing the issuance of a class or series of Preferred Stock, by the affirmative vote of the holders of not less than two-thirds Page 4 - SECOND RESTATED ARTICLES OF INCORPORATIONof the outstanding shares of Common Stock and/or such class or series ofPreferred Stock, voting as separate voting groups. ARTICLE IX SPECIAL MEETINGS OF SHAREHOLDERS The President or the Board of Directors may call special meetings of theshareholders for any purpose. Further, a special meeting of the shareholdersshall be held if the holders of not less than 25% of all the votes entitled tobe cast on any issue proposed to be considered at such special meeting havedated, signed and delivered to the Secretary of this Corporation one or morewritten demands for such meeting, describing the purpose or purposes for whichit is to be held. ARTICLE X AMENDMENTS TO RESTATED ARTICLES OF INCORPORATION This Corporation reserves, and the rights of the shareholders of thisCorporation are granted subject to, the right to amend or repeal any of theprovisions contained in these Second Restated Articles of Incorporation asfollows: 10.1 SUPERMAJORITY VOTING. Except as provided in Section 10.2 of thisArticle, the Second Restated Articles of Incorporation may be amended orrepealed only upon the affirmative vote of the holders of at least two-thirds ofthe outstanding shares entitled to vote thereon and, to the extent, if any,provided by resolution adopted by the Board of Directors authorizing theissuance of a class or series of Preferred Stock, by the affirmative vote of theholders of at least two-thirds of the outstanding shares of Common Stock and/orof such class or series of Preferred Stock, voting as separate voting groups. 10.2 MAJORITY VOTING. Notwithstanding the provisions of Section 10.1 ofthis Article, if an amendment or repeal of a Section or Article of the SecondRestated Articles of Incorporation is approved by a majority of the ContinuingDirectors (as defined in Section 11.1 hereof), voting separately and as asubclass of directors, such amendment or repeal shall require the affirmativevote of the holders of at least a majority of the outstanding shares entitled tovote thereon and, to the extent, if any, provided by resolution adopted by theBoard of Directors authorizing the issuance of a class or series of PreferredStock, by the affirmative vote of the holders of at least a majority of theCommon Stock and/or of such class or series of Preferred Stock, voting asseparate voting groups.Page 5 - SECOND RESTATED ARTICLES OF INCORPORATION ARTICLE XI SPECIAL VOTING REQUIREMENTS In addition to any affirmative vote required by law, by these SecondRestated Articles of Incorporation or otherwise, any "Business Combination" (ashereinafter defined) involving this Corporation shall be subject to approval inthe manner set forth in this Article. 11.1 DEFINITIONS. For the purpose of this Article: (a) "Business Combination" means (i) a merger, share exchange orconsolidation of this Corporation or any of its Subsidiaries with any othercorporation; (ii) the sale, lease, exchange, mortgage, pledge, transfer or otherdisposition or encumbrance, whether in one transaction or a series oftransactions, by this Corporation or any of its Subsidiaries of all or asubstantial part of this Corporation's assets otherwise than in the usual andregular course of business; or (iii) any agreement, contract or otherarrangement providing for any of the foregoing transactions. (b) "Continuing Director" means any member of the Board of Directors(i) who was a member of the Board of Directors on September 26, 1997, or (ii)who is elected to the Board of Directors after September 26, 1997, after beingnominated by a majority of the Continuing Directors voting separately and as asubclass of directors on such nomination. (c) "Subsidiary" means a domestic or foreign corporation, a majorityof the outstanding voting shares of which are owned, directly or indirectly, bythis Corporation. 11.2 VOTE REQUIRED FOR BUSINESS COMBINATIONS. (a) Except as provided in subsection 11.2(b) hereof, the affirmative vote of the holders of not less than two-thirds of the outstanding shares entitled to vote thereon and, to the extent, if any, provided by resolution adopted by the Board of Directors authorizing the issuance of a class or series of Preferred Stock, the affirmative vote of the holders of not less than two-thirds of the outstanding shares of Common Stock and/or of such class or series of Preferred Stock, voting as separate voting groups, shall be required for the adoption or authorization of a Business Combination. (b) Notwithstanding subsection 11.2(a) hereof, if a BusinessCombination shall have been approved by a majority of the Continuing Directors,voting separately and as a subclass of directors, such Business Combination, ifrequired to be approved by this Corporation's shareholders by the OregonBusiness Corporation Act or these Second Restated Articles of Incorporation,shall be approved only with the affirmative vote of the holders of not less thana majority of the outstanding shares entitled to vote thereon and, to theextent, if any, provided by resolution adopted by the Board of Directorsauthorizing the issuance of a class or series of Preferred Stock, theaffirmative vote of the holders of not less than a majority of the outstandingshares of Common Stock and/or such class or series of Preferred Stock, voting asPage 6 - SECOND RESTATED ARTICLES OF INCORPORATIONseparate voting groups.Page 7 - SECOND RESTATED ARTICLES OF INCORPORATION EXHIBIT 3(ii) SCHMITT INDUSTRIES, INC. SECOND RESTATED BYLAWS SECTION 1 SHAREHOLDERS AND SHAREHOLDERS' MEETINGS 1.1 ANNUAL MEETING. The annual meeting of the shareholders of thiscorporation (the "Corporation") for the election of directors and for thetransaction of such other business as may properly come before the meeting shallbe held once in each calendar year (not being more than 13 months after theholding of the last preceding annual meeting) at the principal office of theCorporation, or at some other place, all as determined by the Board ofDirectors. 1.2 SPECIAL MEETINGS. Special meetings of the shareholders for anypurpose or purposes may be called at any time by the President or Board ofDirectors. Further, a special meeting of the shareholders shall be held if theholders of not less than 25% of all votes entitled to be cast on the issueproposed to be considered at such special meeting have dated, signed anddelivered to the Secretary one or more written demands for such meeting,describing the purpose or purposes for which it is to be held. The meetingsshall be held at such time and place as the Board of Directors prescribe, or, ifnot held upon the request of the Board of Directors, at such time and place maybe established by the President or by the Secretary in the President's absence. 1.3 NOTICE OF MEETINGS. Written notice of the place, date and time of theannual shareholders' meeting and written notice of the place, date, time andpurpose or purposes of special shareholders' meetings shall be delivered notless than 10 or more than 60 days before the date of meeting, either personally,by facsimile, or by mail, or in any other manner approved by law, by or at thedirection of the President or the Secretary, to each shareholder of recordentitled to notice of such meeting. Mailed notices shall be deemed to bedelivered when deposited in the mail, first-class postage prepaid, correctlyaddressed to the shareholder's address shown in the Corporation's current recordof shareholders. Notice given in any other manner shall be deemed effectivewhen dispatched to the shareholder's address, telephone number or other numberappearing on the records of the Corporation. 1.4 WAIVER OF NOTICE. Except where expressly prohibited by law or theArticles of Incorporation, notice of the place, date, time and purpose orpurposes of any shareholders' meeting may be waived in a signed writingdelivered to the Corporation by any shareholder at any time, either before orafter the meeting. Attendance at the meeting in person or by proxy waivesobjection to lack of notice or defective notice of the meeting unless theshareholder at the beginning of the meeting objects to holding the meeting ortransacting business at the meeting. A shareholder waives objection toconsideration of a particular matter at a meeting that is not within the purposeor purposes described in the meeting notice, unless the shareholder objects toconsidering the matter when it is presented.Page 1 - SECOND RESTATED BYLAWS 1.5 SHAREHOLDERS' ACTION WITHOUT A MEETING. The shareholders may take anyaction without a meeting that they could properly take at a meeting, if one ormore written consents setting forth the action so taken are signed by all of theshareholders entitled to vote with respect to the subject matter and aredelivered to the Corporation for inclusion in the minutes or filing with thecorporate records. Actions taken under this section are effective when allconsents are in the possession of the Corporation, unless otherwise specified inthe consent. A shareholder may withdraw consent only by delivering a writtennotice of withdrawal to the Corporation prior to the time that all consents arein the possession of the Corporation. 1.6 TELEPHONE MEETINGS. Shareholders may participate in a meeting ofshareholders by means of a conference telephone or any similar communicationequipment that enables all persons participating in the meeting to hear eachother during the meeting. Participation by such means shall constitute presencein person at a meeting. 1.7 LIST OF SHAREHOLDERS. At least 10 days before any shareholders'meeting, the Secretary of the Corporation or the agent having charge of thestock transfer books of the Corporation shall have prepared an alphabetical listof the names of the shareholders on the record date who are entitled to noticeof a shareholders' meeting, arranged by voting group, and within each votinggroup, by class or series of shares, and showing the address of and number ofshares held by each shareholder. 1.8 QUORUM AND VOTING. The presence in person or by proxy of the holdersof a majority of the votes entitled to be cast on a matter at a general orspecial meeting shall constitute a quorum of shareholders for that matter. If aquorum exists, action on a matter shall be approved by a voting group if thevotes case within a voting group favoring the action exceed the votes castwithin the voting group opposing the action, unless a greater number ofaffirmative votes is required by the Articles of Incorporation or by law. Ifthe Articles of Incorporation or Oregon law provide for voting by two or morevoting groups on a matter, action on a matter is taken only when voted upon byeach of those voting group counted separately. Action may be taken by onevoting group on a matter even though no action is taken by another voting group. 1.9 ADJOURNED MEETINGS. If a shareholders' meeting is adjourned to adifferent place, date or time, whether for failure to achieve a quorum orotherwise, notice need not be given of the new place, date or time if the newplace, date or time is announced at the meeting before adjournment. When adetermination of shareholders entitled to vote at any meeting of shareholdershas been made as provided in these Bylaws, that determination shall apply to anyadjournment thereof, unless Oregon law requires fixing a new record date. IfOregon law requires that a new record date be set for the adjourned meeting,notice of the adjourned meeting must be given to shareholders as of the newrecord date. Any business may be transacted at an adjourned meeting that couldhave been transacted at the meeting as originally called. 1.10 PROXIES. A shareholder may appoint a proxy to vote or otherwise actfor the shareholder by signing an appointment form, either personally or by anagent. No Page 2 - SECOND RESTATED BYLAWSappointment shall be valid after 11 months from the date of its execution unless the appointment form expressly so provides. An appointment of a proxy is revocable unless the appointment is coupled with an interest. No revocation shall be effective until written notice thereof has actually been received by the Secretary of the Corporation or any other officer or agent authorized to tabulate votes. 1.11 BUSINESS FOR SHAREHOLDERS' MEETINGS. 1.11.1 BUSINESS AT ANNUAL MEETINGS. (a) In addition to the election of directors, other properbusiness may be transacted at an annual meeting of shareholders, provided thatsuch business is properly brought before such meeting. To be properly broughtbefore an annual meeting business must be (i) brought by or at the direction ofthe Board or (ii) brought before the meeting by a shareholder by inclusion inthe Corporation's proxy statement pursuant to the provisions of Rule 14a-8 underSection 14 of the Securities Exchange Act of 1934, as amended, or any successorprovision, when and if such Rule is applicable thereto, or if such business isnot so included in the Corporation's proxy statement, only pursuant to writtennotice thereof in accordance with subsection 1.12 hereof, and received by theSecretary not fewer than 60 nor more than 90 days prior to the date of suchannual meeting (or, if less than 60 days' notice or prior public disclosure ofthe date of the annual meeting is given or made to the shareholders, not laterthan the close of business on the tenth business day following the day on whichsuch notice of the date of the annual meeting was mailed or such publicdisclosure was made, whichever first occurs). (b) Any such shareholder notice shall set forth (i) the name and address of the shareholder proposing such business; (ii) a representation that the shareholder is entitled to vote at such meeting; (iii) a statement of the number of shares of the Corporation which are beneficially owned by the shareholder and the date upon which such shares were acquired; (iv) a representation that the shareholder intends to appear in person or by proxy at the meeting to propose such business; and (v) as to each matter the shareholder proposes to bring before the meeting, a brief description of the business desired to be brought before the meeting, the reasons for conducting such business at the meeting, the language of the proposal (if appropriate), and any material interest of the shareholder in such business. (c) No business shall be conducted at any annual meeting of shareholders except in accordance with this subsection 1.11.1. If the facts warrant, the Board, or the chairman of an annual meeting of shareholders, may determine and declare that (i) a proposal does not constitute proper business to be transacted at the meeting or (ii) the business was not properly brought before the meeting in accordance with the provisions of this subsection 1.11.1 and, if, in either case, it is so determined, any such business shall not be transacted. 1.11.2 BUSINESS AT SPECIAL MEETINGS. At any special meeting of theshareholders, only business within the purpose or purposes described in themeeting notice required by Section 1.3 may be conducted.Page 3 - SECOND RESTATED BYLAWS 1.12 NOTICE TO CORPORATION. Any written notice required to be delivered bya shareholder to the Corporation pursuant to Section 1.2 or Section 1.11 hereofmust be given, either by personal delivery or by registered or certified mail,postage prepaid, to the Secretary at the Corporation's principal office. SECTION 2 BOARD OF DIRECTORS 2.1 NUMBER AND QUALIFICATION. The business affairs and property of theCorporation shall be managed under the direction of a Board of Directors, thenumber of members of which shall be no fewer than two nor more than nine, asestablished from time to time by the Board of Directors. The Board of Directorsmay increase or decrease this number or this range by resolution. A member ofthe Board of Directors does not need to be a shareholder of the Corporation. 2.2 ELECTION--TERMS OF OFFICE. 2.2.1 The directors shall be elected by the shareholders at eachannual shareholders' meeting or at a special shareholders' meeting called forsuch purpose. 2.2.2 The Board of Directors shall be divided into three classesif the authorized number of directors is four or more, with said classes to beas equal in number as may be possible. Any director or directors in excess ofthe number divisible by three shall be first assigned to Class 1 and anyadditional director shall be assigned to Class 2, as the case may be. (Forexample, if there are five directors, the fourth director shall be in Class 1and the fifth director in Class 2.) At the first election of directors to suchclassified Board of Directors, each Class 1 Director shall be elected to serveuntil the next ensuing annual meeting of shareholders, each Class 2 Directorshall be elected to serve until the second ensuing annual meeting ofshareholders and each Class 3 Director, shall be elected to serve until thethird ensuing annual meeting of shareholders. At each annual meeting ofshareholders following the meeting at which the Board of Directors is initiallyclassified, the number of directors equal to the number of directors in theclass whose term expires at the time of such meeting shall be elected to serveuntil the third ensuing annual meeting. Notwithstanding any of the foregoingprovisions of this Section 2, directors shall serve until their successors areelected and qualified or until their earlier death, resignation or removal fromoffice, or until there is a decrease in the number of directors; provided,however, that no decrease in the number of directors shall have the effect ofshortening the term of any incumbent director. 2.2.3 The term of office of a director shall commence effectiveimmediately upon election, unless otherwise specified in a resolution approvedby the shareholders in connection with the election of such director. Directorsshall serve until their successors are elected and qualified or until theirearlier death, resignation or removal from office, or until there is a decreasein the authorized number of directors; provided, however, that no decrease inthe number of directors shall have the effect of shortening the term of anyincumbent Page 4 - SECOND RESTATED BYLAWSdirector. 2.3 NOMINATIONS. 2.3.1 Only persons who are nominated in accordance with thefollowing procedures shall be eligible for election as directors. Nominationsfor the election of directors may be made (a) by or at the direction of theBoard or (b) by any shareholder of record entitled to vote for the election ofdirectors at such meeting; provided, however, that a shareholder may nominatepersons for election as directors only if written notice (in accordance withSection 1.12 hereof) of such shareholder's intention to make such nominations isreceived by the Secretary not later than (i) with respect to an election to beheld at an annual meeting of the shareholders, not fewer than 60 nor more than90 days prior to the date of such annual meeting (or, if less than 60 days'notice or prior public disclosure of the date of the annual meeting is given ormade to the shareholders, not later than the close of business on the tenthbusiness day following the day on which such notice of the date of the annualmeeting was mailed or such public disclosure was made, whichever first occurs)and (ii) with respect to an election to be held at a special meeting of theshareholders for the election of directors, the close of business on the tenthbusiness day following the date on which notice of such meeting is first mailedto shareholders. 2.3.2 Any such shareholder's notice shall set forth (a) the nameand address of the shareholder who intends to make a nomination; (b) arepresentation that the shareholder is entitled to vote at such meeting; (c) astatement of the number of shares of the Corporation which are beneficiallyowned by the shareholder and the dates upon which such shares were acquired;(d) a representation that the shareholder intends to appear in person or byproxy at the meeting to nominate the person or persons specified in the notice;(e) as to each person the shareholder proposes to nominate for election orreelection as a director, the name and address of such person and such otherinformation regarding such nominee as would be required in a proxy statementfiled pursuant to the proxy rules of the Securities and Exchange Commission hadsuch nominee been nominated by the Board, and a description of any arrangementsor understandings between the shareholder and such nominee and any other persons(including their names) pursuant to which the nomination is to be made; and(f) the consent of each such nominee to serve as a director if elected. 2.3.3 If the facts warrant, the Board, or the chairman of ashareholders' meeting at which directors are to be elected, shall determine anddeclare that a nomination was not made in accordance with the foregoingprocedure and, if it is so determined, the defective nomination shall bedisregarded. The right of shareholders to make nominations pursuant to theforegoing procedure is subject to the rights of the holders of any class orseries of stock having a preference over the Common Stock as to dividends orupon liquidation. The procedures set forth in this Section 2.3 for nominationfor the election of directors by shareholders are in addition to, and not inlimitation of, any procedures now in effect or hereafter adopted by or at thedirection of the Board or any committee thereof.Page 5 - SECOND RESTATED BYLAWS 2.4 REMOVAL. 2.4.1 Any director or the entire Board may be removed for cause bythe holders of not less than two-thirds of the shares entitled to elect thedirector or directors whose removal is sought. Such action may only be taken ata special meeting of the shareholders called expressly for that purpose,provided that notice of the proposed removal, which shall include a statement ofthe charges alleged against the director, shall have been duly given to theshareholders together with or as a part of the notice of the meeting. 2.4.2 The vacancy created by the removal of a director under thisSection 2.4. shall be filled only by a vote of the holders of two-thirds of theshares then entitled to elect the director removed. Such vote may be taken atthe same meeting at which the removal of such director was accomplished, or atsuch later meeting, annual or special, as the shareholders may decide. 2.5 VACANCIES. Subject to the provisions of Section 2.4 hereof and unlessthe Second Restated Articles of Incorporation provide otherwise, vacancies inthe Board of Directors, whether caused by resignation, death, retirement,disqualification, increase in the number of directors, removal or otherwise, maybe filled for the remainder of the term by the Board of Directors only or, ifthe directors in office constitute less than a quorum of the Board of Directors,by an affirmative vote of a majority of the remaining directors, unless thereare no directors remaining in which case the vacancies shall be filled by theshareholders. The term of a director elected to fill a vacancy expires at thenext annual shareholders' meeting. A vacancy that will occur at a specificlater date may be filled before the vacancy occurs, but the new director may nottake office until the vacancy occurs. 2.6 QUORUM AND VOTING. At any meeting of the Board of Directors, thepresence in person (including presence by electronic means such as a telephoneconference call) of 50% of the number of directors presently in office shallconstitute a quorum for the transaction of business. Notwithstanding theforegoing, in no case shall a quorum be less than one-third of the authorizednumber of directors. If a quorum is present at the time of a vote, theaffirmative vote of a majority of the directors present at the time of the voteshall be the act of the Board of Directors and of the Corporation except as maybe otherwise specifically provided by the Articles of Incorporation, by theseBylaws, or by law. A director who is present at a meeting of the Board ofDirectors when action is taken is deemed to have assented to the action takenunless: (a) the director objects at the beginning of the meeting, or promptlyupon his or her arrival, to holding it or to transacting business at themeeting; (b) the director's dissent or abstention from the action taken isentered in the minutes of the meeting; or (c) the director delivers writtennotice of his or her dissent or abstention to the presiding officer of themeeting before its adjournment or to the Corporation within a reasonable timeafter adjournment of the meeting. The right of dissent or abstention is notavailable to a director who votes in favor of the action taken. 2.7 REGULAR MEETINGS. Regular meetings of the Board of Directors shall beheld at such place, date and time as shall from time to time be fixed byresolution of the Board.Page 6 - SECOND RESTATED BYLAWS 2.8 SPECIAL MEETINGS. Special Meetings of the Board of Directors may beheld at any place and at any time and may be called by the Chairman of theBoard, if there is one, the President or any two or more directors. 2.9 NOTICE OF MEETING. 2.9.1 Unless the Articles of Incorporation provide otherwise, anyregular meeting of the Board of Directors may be held without notice of thedate, time, place, or purpose of the meeting. Any special meeting of the Boardof Directors must be preceded by at least two days' notice of the date, time,and place of the meeting, but not of its purpose, unless the Articles ofIncorporation or these Bylaws require otherwise. Each director shall have amailing address, telephone number and facsimile number on record with theCorporation for purposes of receiving notice. 2.9.2 Notice may be given personally, by facsimile, by mail, or inany other manner allowed by law. Oral notice shall be sufficient only if awritten record of such notice is included in the Corporation's minute book. Notice shall be deemed effective at the earliest of: (a) receipt; (b) deliveryto the proper address or telephone number of the director as shown in theCorporation's records: or (c) three days after its deposit in the United Statesmail, as evidenced by the postmark, if correctly addressed and mailed withfirst-class postage prepaid. 2.9.3 Notice of any meeting of the Board of Directors may bewaived by any director at any time, by a signed writing, delivered to theCorporation for inclusion in the minutes, either before or after the meeting. Attendance or participation by a director at a meeting shall constitute a waiverof any required notice of meeting unless the director promptly objects toholding the meeting or to the transaction of any business on the grounds thatthe meeting was not lawfully convened and the director does not thereafter votefor or assent to action taken at the meeting. 2.10 DIRECTORS' ACTION WITHOUT A MEETING. The Board of Directors or acommittee thereof may take any action without a meeting that it could properlytake at a meeting if one or more written consents setting forth the action aresigned by all of the directors, or all of the members of the committee, as thecase may be, either before or after the action is taken, and if the consents aredelivered to the Corporation for inclusion in the minutes or filing with thecorporate records. Such action shall be effective upon the signing of a consentby the last director to sign, unless the consent specifies a later effectivedate. 2.11 COMMITTEES OF THE BOARD OF DIRECTORS. The Board of Directors, byresolutions adopted by a majority of the members of the Board of Directors inoffice, may create from among its members one or more committees and shallappoint the members thereof. Each such committee must have two or more members,who shall be directors and who shall serve at the pleasure of the Board ofDirectors. Each committee of the Board of Directors may exercise the authorityof the Board of Directors to the extent provided in its enabling resolution andany pertinent subsequent resolutions adopted in like manner, provided that theauthority of each such committee shall be subject to applicable law. Eachcommittee of the Board of Directors Page 7 - SECOND RESTATED BYLAWSshall keep regular minutes of its proceedings and shall report to the Board of Directors when requested to do so. 2.12 TELEPHONE MEETINGS. Members of the Board of Directors or of anycommittee appointed by the Board of Directors may participate in a meeting ofthe Board of Directors or committee by means of a conference telephone orsimilar communications equipment that enables all persons participating in themeeting to hear each other during the meeting. Participation by such meansshall constitute presence in person at a meeting. 2.13 COMPENSATION OF DIRECTORS. The Board of Directors may fix thecompensation of directors as such and may authorize the reimbursement of theirexpenses. SECTION 3 OFFICERS 3.1 OFFICERS ENUMERATED--APPOINTMENT. The officers of the Corporationshall consist of such officers and assistant officers as may be designated byresolution of the Board of Directors. The officers shall include a Presidentand a Secretary, and may include a Chairman of the Board, one or more VicePresidents, a Treasurer, and any assistant officers or other officers havingsuch designations as shall be determined by the Board of Directors. Theofficers shall hold office at the pleasure of the Board of Directors. Unlessotherwise restricted by the Board of Directors, the President may appoint anyassistant officer or other officers, the Secretary may appoint one or moreAssistant Secretaries, and the Treasurer may appoint one or more AssistantTreasurers; provided that any such appointments shall be recorded in writing inthe corporate records. 3.2 QUALIFICATIONS. None of the officers of the Corporation needs to be adirector. Any two or more corporate offices may be held by the same person. 3.3 DUTIES OF THE OFFICERS. Unless otherwise prescribed by the Board ofDirectors, the duties of the officers shall be as follows: 3.3.1 CHAIRMAN OF THE BOARD. The Chairman of the Board, if one iselected, shall preside at meetings of the Board of Directors and of theshareholders, shall be responsible for carrying out the plans and directives ofthe Board of Directors, shall report to and consult with the Board of Directorsand, if the Board so resolves, shall have such other powers and duties as theBoard of Directors may from time to time prescribe. 3.3.2 PRESIDENT. The President shall exercise the usual executivepowers pertaining to the office of President. In the absence of a Chairman ofthe Board, the President shall preside at meetings of the Board of Directors andof the shareholders, perform the other duties of the Chairman of the Boardprescribed in this section, and perform such other duties as the Board ofDirectors may from time to time designate. In addition, if there is noSecretary in office, the President shall perform the duties of the Secretary.Page 8 - SECOND RESTATED BYLAWS 3.3.3 VICE PRESIDENT. Each Vice President shall perform suchduties as the Board of Directors may from time to time designate. In addition,in the absence or disability of the President, the Vice President (or if thereis more than one Vice President, then in the order designated by the Board ofDirectors) shall perform the duties of the President, and when so acting, shallhave all the powers of and be subject to all restrictions upon the President. 3.3.4 SECRETARY. The Secretary shall be responsible for and shallkeep, personally or with the assistance of others, records of the proceedings ofthe directors and shareholders; authenticate records of the Corporation; attestall certificates of stock in the name of the Corporation; keep the corporateseal, if any, and affix the same to certificates of stock and other properdocuments; keep a record of the issuance of certificates of stock and thetransfers of the same; and perform such other duties as the Board of Directorsmay from time to time designate. 3.3.5 TREASURER. The Treasurer shall have the care and custodyof, and be responsible for, all funds and securities of the Corporation andshall cause to be kept regular books of account. The Treasurer shall cause tobe deposited all funds and other valuable effects in the name of the Corporationin such depositories as may be designated by the Board of Directors. Ingeneral, the Treasurer shall perform all of the duties incident to the office ofTreasurer, and such other duties as from time to time may be assigned by theBoard of Directors. 3.3.6 ASSISTANT OFFICERS. Assistant officers may consist of oneor more Vice Presidents, one or more Assistant Secretaries, one or moreAssistant Treasurers and such other titles as may be designated from time totime. Each assistant officer shall perform those duties assigned to him or herfrom time to time by the Board of Directors, the President, or the officer whoappointed him or her. 3.4 VACANCIES. Vacancies in any office arising from any cause may befilled by the Board of Directors at any regular or special meeting. 3.5 REMOVAL. Any officer or agent may be removed by action of the Boardof Directors with or without cause, but any removal shall be without prejudiceto the contract rights, if any, of the person removed. Election or appointmentof an officer or agent shall not itself create any contract rights. 3.6 COMPENSATION. The compensation of all officers of the Corporationshall be fixed by the Board of Directors.Page 9 - SECOND RESTATED BYLAWS SECTION 4 SHARES AND CERTIFICATES OF SHARES 4.1 SHARE CERTIFICATES. Share certificates shall be issued in numericalorder, and each shareholder shall be entitled to a certificate signed by theChairman of the Board, President or a Vice President, and signed by theSecretary or an Assistant Secretary. Share certificates may be sealed with thecorporate seal, if any. Facsimiles of the signatures and seal may be used aspermitted by law. Every share certificate shall state: (a) the name of the Corporation; (b) that the Corporation is organized under the laws of the State of Oregon; (c) the name of the person to whom the share certificate is issued; (d) the number, class and series (if any) of shares that the certificate represents; and (e) if the Corporation is authorized to issue shares of more than one class or series, that upon written request and without charge, the Corporation will furnish any shareholder with a full statement of the designations, preferences, limitations and relative rights of the shares of each class or series, and the authority of the Board of Directors to determine variations for future series. 4.2 CONSIDERATION FOR SHARES. Shares of the Corporation may be issued forsuch consideration as shall be determined by the Board of Directors to beadequate. The consideration for the issuance of shares may be paid in whole orin part in cash, or in any tangible or intangible property or benefit to theCorporation, including but not limited to promissory notes, service performed,contracts for services to be performed, or other securities of the Corporation. Establishment by the Board of Directors of the amount of consideration receivedor to be received for shares of the Corporation shall be deemed to be adetermination that the consideration so established is adequate. 4.3 TRANSFERS. Shares may be transferred by delivery of the certificate,accompanied either by an assignment in writing on the back of the certificate,or by a written power of attorney to sell, assign and transfer the same, signedby the record holder of the certificate. Except as otherwise specificallyprovided in these Bylaws, no shares of stock shall be transferred on the booksof the Corporation until the outstanding certificate thereof has beensurrendered to the Corporation.Page 10 - SECOND RESTATED BYLAWS 4.4 LOSS OR DESTRUCTION OF CERTIFICATES. In the event of the loss ordestruction of any certificate, a new certificate may be issued in lieu thereofupon satisfactory proof of such loss or destruction, and upon the giving ofsecurity against loss to the Corporation by bond, indemnity or otherwise, to theextent deemed necessary by the Board of Directors, the Secretary, or theTreasurer. 4.5 FIXING RECORD DATE. The Board of Directors may fix in advance a dateas the record date for determining shareholders entitled: (a) to notice of or tovote at any shareholders' meeting or any adjournment thereof; (b) to receivepayment of any share dividend; or (c) to receive payment of any distribution. The Board of Directors may in addition fix record dates with respect to anyallotment or rights of conversion or exchange of any securities by their terms,or for any other proper purpose, as determined by the Board of Directors and bylaw. The record date shall be not more than 70 days and, in case of a meetingof shareholders, not less than 10 days (or such longer period as may be requiredby Oregon law) prior to the date on which the particular action requiringdetermination of shareholders is to be taken. If no record date is fixed fordetermining the shareholders entitled to notice of or to vote at a meeting ofshareholders, the record date shall be the date before the day on which noticeof the meeting is mailed. If no record date is fixed for the determination ofshareholders entitled to a distribution (other than one involving a purchase,redemption, or other acquisition of the Corporation's own shares), the recorddate shall be the date on which the Board adopted the resolution declaring thedistribution. If no record date is fixed for determining shareholders entitledto a share dividend, the record date shall be the date on which the Board ofDirectors authorized the dividend. SECTION 5 BOOKS, RECORDS AND RECORDS 5.1 RECORDS OF CORPORATE MEETINGS, ACCOUNTING RECORDS AND SHARE REGISTERS. 5.1.1 The Corporation shall keep, as permanent records, minutes ofall meetings of the Board of Directors and shareholders, and all actions takenwithout a meeting, and all actions taken by a committee exercising the authorityof the Board of Directors. The Corporation or its agents shall maintain, in aform that permits preparation of a list, a list of the names and addresses ofits shareholders, in alphabetical order by class of shares, showing the number,class, and series, if any, of shares held by each. 5.1.2 The Corporation shall also maintain appropriate accountingrecords, and at its principal place of business shall keep copies of: (a) itsArticles of Incorporation or restated Articles of Incorporation and allamendments in effect; (b) its Bylaws or restated Bylaws and all amendments ineffect; (c) minutes of all shareholders' and directors meetings and records ofall actions taken without meetings for the past three years; (d) appropriateaccounting records; (e) all written communications to shareholders generally inthe past three years; (f) a list of the names and business addresses of itscurrent officers and directors; and (g) its most recent annual report to theSecretary of State.Page 11 - SECOND RESTATED BYLAWS 5.2 COPIES OF CORPORATE RECORDS. Any person dealing with the Corporationmay rely upon a copy of any of the records of the proceedings, resolutions, orvotes of the Board of Directors or shareholders, when certified by thePresident, Vice President, Secretary or Assistant Secretary. 5.3 EXAMINATION OF RECORDS. 5.3.1 A shareholder shall have the right to inspect and copy,during regular business hours at the principal office of the Corporation, inperson or by his or her attorney or agent, the corporate records referred to insubsection 5.1.2 hereof if the shareholder gives the Corporation written noticeof the demand at least five business days before the date on which theshareholder wishes to make such inspection. 5.3.2 In addition, if a shareholder's demand is made in good faithand for a proper purpose, a shareholder may inspect and copy, during regularbusiness hours at a reasonable location specified by the Corporation, excerptsfrom minutes of any meeting of the Board of Directors, records of any action ofa committee of the Board of Directors, minutes of any meeting of theshareholders, and records of actions taken by the shareholders or the Board ofDirectors without a meeting, to the extent not subject to inspection undersubsection 5.3.1, accounting records of the Corporation, or the record ofshareholders; provided that the shareholder shall have made a demand describingwith reasonable particularity the shareholder's purpose and the records theshareholder desires to inspect, and provided further that the records aredirectly connected to the shareholder's purpose. 5.3.3 This section shall not affect any right of shareholders toinspect records of the Corporation that may be otherwise granted to theshareholders by law.Page 12 - SECOND RESTATED BYLAWS SECTION 6 FISCAL YEAR The fiscal year-end of the Corporation shall be May 31. SECTION 7 CORPORATE SEAL The corporate seal of the Corporation, if any, shall be in the form shownhere. SECTION 8 MISCELLANEOUS PROCEDURAL PROVISIONS The Board of Directors may adopt rules of procedure to govern any meetingsof shareholders or directors to the extent not inconsistent with law, theArticles of Incorporation, or these Bylaws, as they are in effect from time totime. In the absence of any rules of procedure adopted by the Board ofDirectors, the chairman of the meeting shall make all decisions regarding theprocedures for any meeting. SECTION 9 AMENDMENT OF BYLAWS The Board of Directors is expressly authorized to adopt, amend and repealthe Bylaws of the Corporation, subject to approval by a majority of theContinuing Directors (as defined in the Articles of Incorporation); provided,however, the Board of Directors may not repeal or amend any bylaws that theshareholders have expressly provided may not be amended or repealed by the Boardof Directors. The shareholders of the Corporation also have the power to adopt,amend or repeal the Bylaws of the Corporation by the affirmative vote of theholders of not less than two-thirds of the outstanding shares and, to theextent, if any, provided by resolution adopted by the Board of Directorsauthorizing the issuance of a class or series of Preferred Stock, by theaffirmative vote of the holders of not less than two-thirds of the outstandingshares of Common Stock and/or of such class or series of Preferred Stock, votingas separate voting groups.Page 13 - SECOND RESTATED BYLAWS SECTION 10 INDEMNIFICATION OF DIRECTORS AND OTHERS 10.1 GRANT OF INDEMNIFICATION. Subject to Section 10.2, each person whowas or is made a party or is threatened to be made a party to or is involved(including, without limitation, as a witness) in any threatened, pending, orcompleted action, suit or proceeding, whether formal or informal, civil,criminal, administrative or investigative (hereinafter "proceeding"), by reasonof the fact that he or she is or was a director of the Corporation or who, whilea director of the Corporation, is or was serving at the request of theCorporation as a director, officer, employee or agent of this or anothercorporation or of a partnership, joint venture, trust, other enterprise, oremployee benefit plan, whether the basis of such proceeding is alleged action inan official capacity as a director or in any other capacity while serving as adirector, officer, employee or agent, shall be indemnified and held harmless bythe Corporation to the fullest extent permitted by applicable law, as then ineffect, against all expense, liability and loss (including attorneys' fees,costs, judgments, fines, ERISA excise taxes or penalties and amounts to be paidin settlement) reasonably incurred or suffered by such person in connectiontherewith, and such indemnification shall continue as to a person who has ceasedto be a director and shall inure to the benefit of his or her heirs, executorsand administrators. 10.2 LIMITATIONS ON INDEMNIFICATION. Notwithstanding Section 10.1, noindemnification shall be provided hereunder to any such person to the extentthat such indemnification would be prohibited by the Oregon Business CorporationAct or other applicable law as then in effect, nor, except as provided inSection 10.4 with respect to proceedings seeking to enforce rights toindemnification, shall the Corporation indemnify any such person seekingindemnification in connection with a proceeding (or part thereof) initiated bysuch person except where such proceeding (or part thereof) was authorized by theBoard of Directors of the Corporation. 10.3 ADVANCEMENT OF EXPENSES. The right to indemnification conferred inthis Section 10 shall include the right to be paid by the Corporation theexpenses incurred in defending any such proceeding in advance of its finaldisposition, except where the Board of Directors shall have adopted a resolutionexpressly disapproving such advancement of expenses. 10.4 RIGHT TO ENFORCE INDEMNIFICATION. If a claim under Section 10.1 isnot paid in full by the Corporation within 60 days after a written claim hasbeen received by the Corporation, or if a claim for expenses incurred indefending a proceeding in advance of its final disposition authorized underSection 10.3 is not paid within 60 days after a written claim has been receivedby the Corporation, the claimant may at any time thereafter bring suit againstthe Corporation to recover the unpaid amount of the claim and, to the extentsuccessful in whole or in part, the claimant shall be entitled to be paid alsothe expense of prosecuting such claim. The claimant shall be presumed to beentitled to indemnification hereunder upon submission of a written claim (and,in an action brought to enforce a claim for expenses Page 14 - SECOND RESTATED BYLAWSincurred in defending any proceeding in advance of its final disposition, where the required undertaking has been tendered to the Corporation), and thereafter the Corporation shall have the burden of proof to overcome the presumption that the claimant is so entitled. It shall be a defense to any such action (other than action with respect to expenses authorized under Section 10.3) that the claimant has not met the standards of conduct which make it permissible hereunder or under the Oregon Business Corporation Act for the Corporation to indemnify the claimant for the amount claimed, but the burden of proving such defense shall be on the Corporation. 10.5 ALTERNATIVE PROCEDURES. Pursuant to ORS 60.414 or any successorprovision of the Oregon Business Corporation Act, the procedures forindemnification and advancement of expenses set forth in this section are inlieu of the procedures required by ORS 60.404 or any successor provision of theOregon Business Corporation Act. 10.6 NONEXCLUSIVITY. The right to indemnification and the advancement ofexpense conferred in this Section 10 shall not be exclusive of any other rightwhich any person may have or hereafter acquire under any statute, provision ofthe Articles of Incorporation or the Bylaws of the Corporation, general orspecific action of the Board, contract or otherwise. 10.7 INDEMNIFICATION OF OFFICERS, EMPLOYEES AND AGENTS. The Corporationmay, by action of its Board of Directors from time to time, provideindemnification and pay expenses in advance of the final disposition of aproceeding to officers, employees and agents of the Corporation on the sameterms with the same scope and effect as the provisions of this section withrespect to the indemnification and advancement of expenses of directors of theCorporation or pursuant to rights granted pursuant to, or provided by, theOregon Business Corporation Act or such other terms as the Board may deemproper. 10.8 INSURANCE AND OTHER SECURITY. The Corporation may maintain insurance,at its expense, to protect itself and any individual who is or was a director,officer, employee or agent of the Corporation or another corporation,partnership, joint venture, trust or other enterprise against any liabilityasserted against or incurred by the individual in that capacity or arising fromhis or her status as an officer, director, agent or employee, whether or not theCorporation would have the power to indemnify such person against the sameliability under the Oregon Business Corporation Act. The Corporation may enterinto contracts with any director or officer of the Corporation in furtherance ofthe provisions of this Section 10 and may create a trust fund, grant a securityinterest or use other means (including, without limitation, a letter of credit)to ensure the payment of such amounts as may be necessary to effectindemnification as provided in this Section 10. 10.9 AMENDMENT OR MODIFICATION. This Section 10 may be altered or amendedat any time as provided in these Bylaws, but no such amendment shall have theeffect of diminishing the rights of any person who is or was an officer ordirector as to any acts or omissions taken or omitted to be taken prior to theeffective date of such amendment. 10.10 EFFECT OF SECTION. The rights conferred by this section shall bedeemed to be contract rights between the Corporation and each person who is orwas a director or officer. Page 15 - SECOND RESTATED BYLAWSThe Corporation expressly intends each such person to rely on the rights conferred hereby in performing his or her respective duties on behalf of the Corporation. SECTION 11 REPRESENTATION OF SHARES OF OTHER CORPORATIONS Unless otherwise restricted by the Board of Directors, the President andany Vice President of the Corporation are each authorized to vote, represent andexercise on behalf of the Corporation all rights incident to any and all sharesof other corporations standing in the name of the Corporation. This authoritymay be exercised by such officers either in person or by a duly executed proxyor power of attorney.Page 16 - SECOND RESTATED BYLAWS EXHIBIT 10.1 SCHMITT INDUSTRIES, INC. AMENDED AND RESTATED STOCK OPTION PLAN 1. PURPOSES. The purposes of this Schmitt Industries, Inc. Amended andRestated Stock Option Plan ("Plan") are to: 1.1 Closely associate the interests of the management of Schmitt Industries, Inc. ("Company") and its subsidiaries with the shareholders of the Company by reinforcing the relationship between the participants' rewards and shareholder gains; 1.2 Provide management with an equity ownership in the Company commensurate with the Company's and its subsidiaries' performance as reflected in increased value of the Company's common shares; 1.3 Maintain competitive compensation levels; 1.4 Provide a means whereby the Company can continue to attract, motivate, and retain key employees who can contribute materially to the Company's and its subsidiaries' growth and success; and 1.5 Provide a means whereby the Company and its subsidiaries can continue to attract, motivate and retain the services of selected non-employee agents, consultants, advisors, persons involved in the sale or distribution of the Company's and its subsidiaries' products and independent contractors of the Company and its subsidiaries. 2. ADMINISTRATION. This Plan shall be administered by the Board ofDirectors of the Company ("Board") or, in the event the Board shall appointand/or authorize a committee to administer this Plan, by a committee of theBoard consisting of at least two (2) non-employee directors ("Committee"). Theadministrator of this Plan, whether the Board or Committee, shall hereinafter bereferred to as the "Plan Administrator." The Plan Administrator shalladminister the Plan in accordance with the following: 2.1 INCAPACITY OF PLAN ADMINISTRATOR. No member of the Board or the Committee shall vote with respect to the granting of an option created under this Plan ("Option(s)") to himself or herself. Any Option granted to a director for his or her services as such shall not be effective until approved by the full Board. 2.2 REGISTRATION UNDER THE SECURITIES ACT. If the Company registers any of its equity securities pursuant to Section 12(b) or 12(g) of the Securities Exchange Act of 1934, as amended ("Exchange Act") and any officers or directors are eligible to receive Options, the following provisions shall apply to the administration of this Plan with respect to grants made to directors, officers or other Optionees (as hereinafter defined) affected by Section 16(b) of the Exchange Act. The Plan Administrator shall be constituted at all times so as to meet the requirements of Section 16(b) of the Exchange Act, as amended from time to time. The members of any committee serving as Plan Administrator shall be appointed by the Board for such term as the Board may determine. The Board may from time to time remove members from, or add members to, the committee. Vacancies on the committee, however caused, may be filled by the Board. Currently, the Plan Administrator is a committee. If, at any time, an insufficient number of disinterested non-employee directors is available to serve on such committee, interested non-employee directors may serve on the committee; however, during such time, no Options shall be granted to any person if the granting of such Option would not meet the requirements of Section 16(b) of the Exchange Act. For purposes of this Section 2, a disinterested director shall be a member of the Board who meets the definition of "disinterested person" as set forth in the rules and regulations promulgated under Section 16(b) of the Exchange Act, as amended from time to time (the "16(b) Rules"). Currently, a disinterested director for purposes of this Section 2 is a member of the Board who for one (1) year prior to service as an administrator of this Plan has not been (and during service as a Plan Administrator, will not be) granted or awarded equity securities, including options for equity securities pursuant to this Plan or any other plan of the Company or its affiliates, except for certain exclusions described in Rule 16b-3. For purposes of this Section 2, a non-employee director shall be a member of the Board who meets the definition of "non-employee director" as set forth in the 16(b) Rules. Currently, a non-employee director is a member of the Board who (i) is not currently an officer of the Company or a parent or subsidiary of the Company, or otherwise currently employed by the Company or a parent or subsidiary of the Company; (ii) does not receive compensation, either directly or indirectly, from the Company or a parent or subsidiary of the Company, for services rendered as a consultant or in any capacity other than as a director, except for an amount that does not exceed the dollar amount for which disclosure would be required pursuant to Item 404(a) of Regulation S-K promulgated under the Exchange Act (("S-K"); (iii) does not possess an interest in any other transaction for which disclosure would be required pursuant to Item 404(b) of S-K; and (iv) is not engaged in a business relationship for which disclosure would be required pursuant to Item 404(b) of S-K. 2.3 PROCEDURES. The Board may designate one of the members of the Plan Administrator as chairman. The Plan Administrator may hold meetings at such times and places as it shall determine. The acts of a majority of the members of the Plan Administrator present at meetings at which a quorum exists, or acts reduced to or approved in writing by all Plan Administrator members, shall be 2 valid acts of the Plan Administrator. 2.4 RESPONSIBILITIES. Except for the terms and conditions explicitly set forth in this Plan, the Plan Administrator shall have the authority, in its discretion, to determine all matters relating to the Options, including selection of the individuals to be granted Options, the number of shares to be subject to each Option, the exercise price for such Option ("Exercise Price"), and all other terms and conditions of the Options. The interpretation and construction by the Plan Administrator of any terms or provisions of this Plan or any Option, or of any rule or regulation promulgated in connection with this Plan, shall be conclusive and binding on all interested parties, so long as such interpretation and construction with respect to incentive stock options correspond to the requirements of Section 422 of the Internal Revenue Code of 1986, as amended ("Code"), and the regulations issued thereunder, and any amendment or successor sections or regulations. 2.5 SECTION 16(b) COMPLIANCE AND BIFURCATION OF PLAN. If the Company registers any of its equity securities pursuant to Sections 12(b) and 12(g) of the Exchange Act, it is the intention of the Company that this Plan then comply in all respects with Rule 16b-3 under the Exchange Act and, if any Plan provision is later found not to be in compliance with such Section, the provision shall be deemed null and void. In all events, the Plan shall be construed in favor of its meeting the requirements of Rule 16b-3. Notwithstanding anything in the Plan to the contrary, the Board, in its absolute discretion, may bifurcate the Plan so as to restrict, limit or condition the use of any provision of the Plan to participants who are officers and directors subject to Section 16(b) of the Exchange Act without so restricting, limiting or conditioning the Plan with respect to other participants. 3. STOCK SUBJECT TO THIS PLAN. The stock subject to this Plan shall bethe Company's common stock ("Common Stock"). The Company shall have authorizedand have in reserve for issuance at the time of exercise of any Option asufficient number of shares of Common Stock to meet the Company's obligation.The maximum number of shares of Common Stock which may be issued under the Planshall be eight hundred thousand (800,000). If any Option expires or issurrendered, exchanged for another Option, cancelled or terminated for anyreason without having been exercised in full, the unpurchased shares subject tosuch Option shall again be available for purposes of this Plan, including forreplacement Options which may be granted in exchange for such expired,exchanged, surrendered, cancelled or terminated Options. 4. ELIGIBILITY. An incentive stock option in accordance with Section 422of the Code ("Incentive Option") may be granted only to an individual who, atthe time the option is granted, is an employee of the Company or a relatedcorporation, as defined below, and who the Plan Administrator may from time totime select for participation in this Plan. Members of the Board shall not beeligible for grants of Incentive Options unless they are also employees of theCompany or any of its related corporations. At the discretion of the PlanAdministrator, employees, officers, directors of the Company or any of itsrelated corporations (including non-employee directors), selected non-employeeagents, consultants, advisors, persons involved in the 3sale or distribution of the Company's or related corporations' products and independent contractors of the Company or any of its related corporations also may receive stock options which are not qualified under Section 422 of the Code ("Nonqualified Option") (Qualified and Nonqualified Options are included collectively within the term "Options" as used in this Plan). Any party to whom an Option is granted shall be referred to as an "Optionee."As used in this Plan, the term "related corporation," when referring to asubsidiary corporation, shall mean any corporation (other than the Company) inan unbroken chain of corporations beginning with the Company if, at the time ofthe granting of the Option, each of the corporations other than the lastcorporation in the unbroken chain owns stock possessing fifty percent (50%) ormore of the total combined voting power of all classes of stock of one of theother corporations in such chain. When referring to a parent corporation, theterm "related corporation" shall mean any corporation (other than the Company)in an unbroken chain of corporations ending with the Company if, at the time ofgranting of the Option, each of the corporations other than the Company ownsstock possessing fifty percent (50%) or more of the total combined voting powerof all classes of stock of one of the other corporations in such chain. 5. TERMS AND CONDITIONS OF OPTIONS. Options granted under this Planshall be evidenced by written agreements which shall contain such terms,conditions, limitations and restrictions as the Plan Administrator shall deemadvisable and which are not inconsistent with this Plan. Notwithstanding theforegoing, Option agreements shall include or incorporate by reference thefollowing terms and conditions: 5.1 NUMBER OF SHARES. Each Option agreement shall state the number of shares of stock subject to the Option. 5.2 OPTION PRICE. The Option agreement shall state the Exercise Price per share, and the Plan Administrator shall act in good faith to establish the Exercise Price as follows: 5.2.1 INCENTIVE OPTIONS. Subject to subsection 5.2.3, the Exercise Price of Incentive Options shall be not less than the fair market value per share of the Common Stock at the time the Incentive Option is granted. 5.2.2 INCENTIVE OPTIONS TO GREATER THAN 10% SHAREHOLDERS. With respect to Incentive Options granted to shareholders then holding greater than ten percent (10%) of the then-issued and outstanding shares of voting stock of the Company, the Exercise Price shall be as required by Section 6. 5.2.3 FAIR MARKET VALUE. With respect to Incentive Options, the fair market value per share of the Common Stock shall be determined by the Plan Administrator in good faith at the time the Incentive Option is granted. 4 5.2.4 SUBSTITUTED OPTIONS. Options granted in substitution for outstanding Options in the Company in connection with the merger, consolidation, continuation acquisition of property or stock of the Company or a subsidiary of the Company or another corporation or any subsidiary of another corporation may be granted with an exercise price equal to the exercise price for the substituted option of the Company or other corporation, subject to any adjustment consistent with the terms of the transaction pursuant to which the substitution is to occur. 5.2.5 NONQUALIFIED OPTIONS. The Exercise Price of Nonqualified Options shall be as is determined by the Plan Administrator in good faith at the time of their issuance. 5.3 TERM, MATURITY AND VESTING. Subject to the restrictions contained in Sections 5.8 and 6, the term of each Incentive Option shall be ten (10) years from the date it is granted unless a shorter period of time is established by the Plan Administrator, but in no event shall the term of any Incentive Option exceed ten (10) years. The term of each Nonqualified Option shall also be ten (10) years from the date it is granted unless a shorter period of time is established by the Plan Administrator. The Plan Administrator shall specify which Options granted hereunder are Incentive Options and which are Nonqualified Options. No Option shall be exercisable until it has vested. The vesting schedule for each Option shall be specified by the Plan Administrator at the time of grant; PROVIDED, that if no vesting schedule is specified at the time of grant, the Option shall vest according to the following schedule: NUMBER OF YEARS PERCENTAGE OF TOTAL FOLLOWING DATE OF GRANT OPTION VESTED ----------------------- ------------------- One 25% Two 50% Three 75% Four 100% The Plan Administrator may specify a vesting schedule for all or any portion of an Option based on the achievement of performance objectives established in advance of the commencement by the Optionee of services related to the achievement of the performance objectives. Performance objectives shall be expressed in terms of one or more of the following: return on equity, return on assets, share price, market share, sales, earnings per share, costs, net earnings, net worth, inventories, cash and cash equivalents, gross margin or the Company's performance relative to its internal business plan. Performance objectives may be in respect of the performance of the Company as a whole (whether on a consolidated or unconsolidated basis), a related corporation, or a subdivision, operating unit, product or product line of either of the foregoing. Performance objectives may be absolute or relative and may be expressed in terms of a 5 progression or a range. An option which is exercisable (in whole or in part) upon the achievement of one or more performance objectives may be exercised only following written notice to the Optionee and the Company by the Plan Administrator that the performance objective has been achieved. 5.4 EXERCISE. Subject to the limitations on exercise described in subsection 5.3 above and any additional holding period required by applicable law, each Option may be exercised in whole or in part; provided, however, that only whole shares will be issued pursuant to the exercise of any Option. During an Optionee's lifetime, any Options granted under this Plan are personal to him or her and are exercisable solely by such Optionee. Options shall be exercised by delivery to the Company of a written notice of the number of shares with respect to which the Option is to be exercised, together with payment of the Exercise Price in accordance with Section 5.5. 5.5 PAYMENT OF EXERCISE PRICE. Payment of the Exercise Price shall be made in full at the time the written notice of exercise of an Option is delivered to the Company, and shall be in cash, bank certified or cashier's check or personal check (unless at the time of exercise the Plan Administrator in a particular case determines not to accept a personal check) for the Common Stock being purchased. The Plan Administrator can determine in its discretion (i) at the time an Incentive Option is granted, or (ii) at any time before exercise of Nonqualified Options that additional forms of payment will be permitted, including installment payments on such terms and over such period as the Plan Administrator may determine. To the extent permitted by the Plan Administrator and applicable laws and regulations (including, but not limited to, federal tax and securities laws and regulations and state corporate law), an option may be exercised by: 5.5.1 DELIVERY OF COMMON STOCK. Delivery of shares of Common Stock held by an Optionee having a fair market value equal to the Exercise Price, such fair market value to be determined in good faith by the Plan Administrator; 6 5.5.2 DELIVERY OF PROMISSORY NOTE. Delivery of a full-recourse promissory note executed by the Optionee; provided that (i) such note if delivered in connection with an Incentive Option shall, and such note if delivered in connection with a Nonqualified Option may, bear interest at a rate specified by the Plan Administrator, but in no case less than the rate required to avoid imputation of interest (taking into account any exceptions to the imputed interest rules) for federal income tax purposes; (ii) the Plan Administrator shall specify the term and other provisions of such note at the time an Incentive Option is granted or at any time prior to exercise of a Nonqualified Option; (iii) the Plan Administrator may require that the Optionee pledge the Optionee's shares to the Company for the purpose of securing the payment of such note, and may require that the certificate representing such shares be held in escrow to perfect the Company's security interest; (iv) the note provides that ninety (90) days following the Optionee's termination of employment with the Company or a related Corporation, the entire outstanding balance under the note shall become due and payable, if not previously due and payable; and (v) the Plan Administrator in its sole discretion may at any time after granting an Option restrict or rescind the right to pay using a promissory note upon written notification to any Optionee; 5.5.3 DELIVERY OF SALE PROCEEDS. Delivery of a properly executed written exercise notice, together with irrevocable instructions to a broker, all in accordance with the regulations of the Federal Reserve Board, to promptly deliver to the Company the amount of sale or loan proceeds to pay the exercise price and any federal, state or local withholding tax obligations that may arise in connection with the exercise; provided, that the Plan Administrator may at any time determine that this subsection 5.5.3, to the extent the instructions to the broker call for an immediate sale of the shares, shall not be available to any Optionee who is subject to Section 16(b) of the Exchange Act if such transaction would result in a violation of Section 16(b), or if such Optionee is not an employee at the time of exercise; or 5.5.4 DELIVERY OF WITHHOLDING NOTICE. Delivery of a properly executed written exercise notice together with instructions to the Company to withhold upon exercise from the shares that would otherwise be issued that number of shares having a fair market value equal to the Exercise Price. 5.6 WITHHOLDING TAX REQUIREMENT. The Company or any related entity shall have the right to retain and withhold from any payment of cash or Common Stock under this Plan the amount of taxes required by any government to be withheld or otherwise deducted and paid with respect to such payment. At its discretion, the Company may require an Optionee receiving shares of Common Stock to reimburse the Company for any such taxes required to be withheld by the Company, and may withhold any distribution in whole or in part until the 7 Company is so reimbursed. In lieu of such withholding or reimbursement, the Company shall have the right to withhold from any other cash amounts due or to become due from the Company to the Optionee an amount equal to such taxes or to retain and withhold a number of shares having a market value not less than the amount of such taxes required to be withheld by the Company to reimburse the Company for any such taxes and cancel (in whole or in part) any such shares so withheld. If required by Section 16(b) of the Exchange Act, the election to pay withholding taxes by delivery of shares held by any person who at the time of exercise is subject to Section 16(b) of the Exchange Act, shall be made during the quarterly 10-day window period required under Section 16(b) of the Exchange Act for exercises of stock appreciation rights. 5.7 TRANSFERABILITY OF OPTION. Options and the rights and privileges conferred by this Plan shall not be transferred, assigned or pledged in any manner (whether by operation of law or otherwise) other than (i) by will or by the applicable laws of descent and distribution, or (ii) by gift to members of the Optionee's family, including grandparents, parents, spouses, siblings, children, grandchildren and great-grandchildren, or trusts for the benefit of such family members or to charitable organizations, and shall not be subject to execution, attachment or similar process. Any attempt to transfer, assign, pledge or otherwise dispose of any Option or of any right or privilege conferred by this Plan, contrary to the Code or to the provisions of this Plan, or the sale or levy or any attachment or similar process upon the rights and privileges conferred by this Plan shall be null and void. Notwithstanding the foregoing, an Optionee may, during the Optionee's lifetime, designate a person who may exercise the Option after the Optionee's death by giving written notice of such designation to the Plan Administrator. Such designation may be changed from time to time by the Optionee giving written notice to the Plan Administrator revoking any earlier designation and making a new designation. In the event that no such designation is made, the executor or personal representative of the Optionee's estate shall have any rights then remaining to the Optionee or his estate under this Plan. 8 5.8 DURATION OF OPTION. Vested Options shall terminate, to the extent not previously exercised, upon the occurrence of the first of the following events: (i) the expiration of the Option, as designated by the Plan Administrator in accordance with section 5.3; (ii) the date of an Optionee's termination of employment with the Company or any related corporation for cause (as determined in the sole discretion of the Plan Administrator); (iii) the expiration of ninety (90) days from the date of an Optionee's termination of employment with the Company or any related corporation for any reason whatsoever other than cause, death or Disability (as defined below) unless, the exercise period is extended by the Plan Administrator until a date not later than the expiration date of the Option; or (iv) the expiration of one year from (A) the date of death of the Optionee or (B) cessation of an Optionee's employment by reason of Disability (as defined below) unless, the exercise period is extended by the Plan Administrator until a date not later than the expiration date of the Option. If an Optionee's employment is terminated by death, any Option held by the Optionee shall be exercisable only by the person or persons to whom such Optionee's rights under such Option shall pass by the Optionee's will or by the laws of descent and distribution of the state or county of the Optionee's domicile at the time of death. For purposes of the Plan, unless otherwise defined in the Agreement, "Disability" shall mean any physical, mental or other health condition which substantially impairs the Optionee's ability to perform his or her assigned duties for one hundred twenty (120) days or more in any two hundred forty (240) day period or that can be expected to result in death. The Plan Administrator shall determine whether an Optionee has incurred a Disability on the basis of medical evidence acceptable to the Plan Administrator. Upon making a determination of Disability, the Plan Administrator shall, for purposes of the Plan, determine the date of an Optionee's termination of employment. Unless accelerated in accordance with Section 7, unvested Options shall terminate immediately upon termination of employment of the Optionee by the Company for any reason whatsoever, including death or Disability. For purposes of this Plan, transfer of employment between or among the Company and/or any related corporation shall not be deemed to constitute a termination of employment with the Company or any related corporation. For purposes of this subsection with respect to Incentive Stock Options, employment shall be deemed to continue while the Optionee is on military leave, sick leave or other bona fide leave of absence (as determined by the Plan Administrator). The foregoing not withstanding, employment shall not be deemed to continue beyond the first ninety (90) days of such leave, unless the Optionee's re-employment rights are guaranteed by statute or by contract. 5.9 STATUS OF SHAREHOLDER. Neither the Optionee nor any party to which the Optionee's rights and privileges under the Option may pass shall be, or shall have any of the rights or privileges of, a shareholder of the Company with respect to any of the shares issuable upon the exercise of any Option unless and until such Option has been exercised. 9 5.10 RIGHT TO TERMINATE EMPLOYMENT. Nothing in this Plan or in any Option shall confer upon any Optionee any right to continue in the employ of the Company or of a related entity, or to interfere in any way with the right of the Company or of any related corporation to terminate, at will, his or her employment or other relationship with the Company at any time. 5.11 MODIFICATION AND AMENDMENT OF OPTION. Subject to the requirements of Code Section 422 with respect to Incentive Options and to the terms, conditions and limitations of this Plan, the Plan Administrator may modify or amend outstanding Options. The modification or amendment of an outstanding Option shall not, without the consent of the Optionee, impair or diminish any of his or her rights or any of the obligations of the Company under such Option. Except as otherwise provided in this Plan, no outstanding Option shall be terminated without the consent of the Optionee. Unless the Optionee agrees otherwise, any changes or adjustments made to outstanding Incentive Options shall be made in such a manner so as not to constitute a "modification" as defined in Code Section 424(h) and so as not to cause any Incentive Option to fail to continue to qualify as an "incentive stock option" as defined in Code Section 422(b). 5.12 LIMITATION ON VALUE FOR INCENTIVE OPTIONS. As to all Incentive Options, to the extent that the aggregate fair market value of the Common Stock with respect to which Incentive Options are exercisable for the first time by the Optionee during any calendar year (under this Plan and all other incentive stock option plans of the Company, a related corporation or a predecessor corporation) exceeds $100,000, those Options (or the portion of an Option) beyond the $100,000 threshold shall be treated as Nonqualified Options. If the Internal Revenue Service publicly rules, issues a private ruling to the Company, any Optionee, or any legatee, personal representative or distributee of an Optionee or issues regulations changing or eliminating such annual limit, the dollar limitation in the preceding sentence shall be adjusted correspondingly. 6. GREATER THAN 10% SHAREHOLDERS. In the case of Incentive Optionsgranted to employees who own at the time of their grant ten percent (10%) ormore of the then-issued and outstanding voting stock of the Company, thefollowing rules shall apply: 6.1 EXERCISE PRICE AND TERM OF INCENTIVE OPTIONS. If Incentive Options are granted to employees who own more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any related corporation, the term of such individual's Incentive Options shall not exceed five (5) years and the Exercise Price shall be not less than one hundred ten percent (110%) of the fair market value of the Common Stock at the time the Incentive Option is granted. This provision shall control notwithstanding any contrary terms contained in an Option agreement or any other document. 6.2 ATTRIBUTION RULE. For purposes of subsection 6.1, in determining stock 10 ownership, an employee shall be deemed to own such shares as are owned by those persons or entities defined in Code Section 424. For purposes of this Section 6, stock owned by an employee shall include all stock actually issued and outstanding immediately before the grant of the Incentive Option to the employee. 7. ADJUSTMENTS UPON CHANGES IN CAPITALIZATION. The aggregate number andclass of shares for which Options may be granted under this Plan, the number andclass of shares covered by each outstanding Option and the Exercise Price pershare thereof (but not the total price), and each such Option, shall all beproportionately adjusted for any increase or decrease in the number of issuedshares of Common Stock of the Company resulting from a split-up or consolidationof shares or any like capital adjustment, or the payment of any stock dividend. 7.1 EFFECT OF LIQUIDATION, REORGANIZATION OR CHANGE IN CONTROL. 7.1.1 CASH, STOCK OR OTHER PROPERTY FOR STOCK. Except as provided in subsection 7.1.2, upon a merger (other than a merger of the Company in which the holders of Common Stock immediately prior to the merger have the same proportionate ownership of Common Stock in the surviving corporation immediately after the merger), consolidation, acquisition of property or stock, separation, reorganization (other than a mere reincorporation or the creation of a holding company) or liquidation of the Company, as a result of which the shareholders of the Company receive cash, stock or other property in exchange for or in connection with their shares of Common Stock, any Option granted under this Plan shall terminate, but the Optionee shall have the right immediately prior to any such merger, consolidation, acquisition of property or stock, separation, reorganization or liquidation to exercise such Option in whole or in part, to the extent the vesting requirements set forth in the Option agreement have been satisfied, unless stated otherwise in the Optionee's individual Option agreement. 7.1.2 CONVERSION OF OPTIONS ON STOCK-FOR-STOCK EXCHANGE. If the shareholders of the Company receive capital stock of another corporation ("Exchange Stock") in exchange for their shares of Common Stock in any transaction involving a merger (other than a merger of the Company in which the holders of Common Stock immediately prior to the merger have the same proportionate ownership of Common Stock in the surviving corporation immediately after the merger), consolidation, acquisition of property or stock, separation or reorganization (other than a mere reincorporation or the creation of a holding company), all Options granted under this Plan shall be converted into options to purchase shares of Exchange Stock unless the Company and the Corporation issuing the Exchange Stock, in their sole discretion, determine that any or all such Options shall not be converted into options to purchase shares of Exchange Stock, but instead shall terminate in accordance with the provisions of subsection 7.1.1. The amount and price of converted options shall be 11 determined by adjusting the amount and price of the Options in the same proportion as used for determining the number of shares of Exchange Stock the holders of the Common Stock receive in such merger, consolidation, acquisition of property or stock, separation or reorganization. Unless accelerated by the Board, the exercise limitations set forth in the Option agreement and the Plan shall continue to apply for the Exchange Stock. 7.1.3 CHANGE IN CONTROL. In the event of a "Change in Control," as defined below, of the Company, unless otherwise determined by the Board prior to the occurrence of such Change in Control, any Options or portions of such Options outstanding as of the date such Change in Control is determined to have occurred that are not yet fully vested on such date shall become immediately exercisable in full. 7.1.4 DEFINITION OF "CHANGE IN CONTROL". For purposes of this Plan, a "Change in Control" shall mean (a) the first approval by the Board or by the stockholders of the Company of an Extraordinary Event, (b) a Purchase or (c) a Board Change. For purposes of the Plan, such terms shall have the following meanings: 7.1.4.1 An "Extraordinary Event" shall mean any of the following actions: (i) any consolidation or merger of the Company in which the Company is not the continuing or surviving corporation or pursuant to which shares of Common Stock would be converted into cash, securities or other property, other than a merger of the Company in which the holders of Common Stock immediately prior to the merger have the same proportionate ownership of common stock of the surviving corporation immediately after the merger; (ii) any sale, lease, exchange or other transfer (in one transaction or a series of related transactions) of all, or substantially all, the assets of the Company; or, (iii) the adoption of any plan or proposal for liquidation or dissolution of the Company. 7.1.4.2 A "Purchase" shall mean the acquisition by any person (as such term is defined in Section 13(d) of the Exchange Act) of any shares of Common Stock or securities convertible into Common Stock without the prior approval of a majority of the Continuing Directors (as defined below) of the Company, if after making such acquisition such person is the beneficial owner (as such term is defined in Rule 13d-3 under the Exchange Act) directly or indirectly of Securities of the Company representing twenty percent (20%) or more of the combined voting power of the Company's then outstanding securities (calculated as provided in paragraph (d) of such Rule 13d-3). 12 7.1.4.3 A "Board Change" shall have occurred if individuals who constitute the Board of the Company at the time of adoption of this Plan (the "Continuing Directors") cease for any reason to constitute at least a majority of the Board, provided that any person becoming a Director subsequent to the date of adoption of this Plan whose nomination for election was approved by a vote of at least a majority of the Continuing Directors (other than a nomination of an individual whose initial assumption of office is in connection with an actual threatened election contest relating to the election of the Directors of the Company, as such terms are used in Rule 14a-11 of Regulation 14A under the Exchange Act) shall be deemed to be a Continuing Director. 7.2 FRACTIONAL SHARES. In the event of any adjustment in the number of shares covered by any Option, any fractional shares resulting from such adjustment shall be disregarded and each such Option shall cover only the number of full shares resulting from such adjustment. 7.3 DETERMINATION OF BOARD TO BE FINAL. All Section 7 adjustments shall be made by the Board, and its determination as to what adjustments shall be made, and the extent of such adjustments, shall be final, binding and conclusive. Unless an Optionee agrees otherwise, any change or adjustment to an Incentive Option shall be made in such a manner so as not to constitute a "modification" as defined in Code Section 424(h) and so as not to cause his or her Incentive Option to fail to continue to qualify as an incentive stock option as defined in Code Section 422(b). 8. SECURITIES REGULATION. Shares shall not be issued with respect to anOption unless the exercise of such Option and the issuance and delivery of suchshares pursuant to the exercise of such Option shall comply with all relevantprovisions of law, including, without limitation, any applicable statesecurities laws, the Securities Act of 1933, as amended, the Exchange Act, therules and regulations promulgated thereunder, and the requirements of any stockexchange upon which the shares may then be listed, and shall be further subjectto the approval of counsel for the Company with respect to such compliance,including the availability of an exemption from registration for the issuanceand sale of any shares under this Plan. Inability of the Company to obtain fromany regulatory body having jurisdiction, the authority deemed by the Company'scounsel to be necessary for the lawful issuance and sale of any shares underthis Plan or the unavailability of an exemption from registration for theissuance and sale of any shares under this Plan shall relieve the Company of anyliability in respect of the non-issuance or sale of such shares as to which suchrequisite authority shall not have been obtained. As a condition to the exercise of any Option, the Company may require theOptionee to represent and warrant at the time of any such exercise that theshares are being purchased only for investment and without any present intentionto sell or distribute such shares if, in the opinion of counsel for the Company,such a representation is required by any relevant provision of theaforementioned laws. At the option of the Company, a stop-transfer orderagainst any shares of stock may be placed on the official stock books andrecords of the Company, and a legend 13indicating that the stock may not be pledged, sold or otherwise transferred unless an opinion of counsel is provided (concurred in by counsel for the Company) stating that such transfer is not in violation of any applicable law or regulation, may be stamped on stock certificates in order to assure exemption from registration. The Plan Administrator may also require such other action or agreement by the Optionees as may from time to time be necessary to comply with the federal and state securities laws. THIS PROVISION SHALL NOT OBLIGATE THE COMPANY TO UNDERTAKE REGISTRATION OF THE OPTIONS OR STOCK HEREUNDER. Should any of the Company's capital stock of the same class as the stock subject to Options be listed on a national securities exchange, all stock issued under this Plan if not previously listed on such exchange shall be authorized by that exchange for listing on such exchange prior to the issuance of such stock. 9. AMENDMENT AND TERMINATION. This Plan may be amended from time to timeas follows: 9.1 BOARD ACTION. The Board may at any time suspend, amend or terminate this Plan; provided, that except as set forth in Section 7, the approval of the Company's shareholders is necessary within twelve (12) months before or after the adoption by the Board of any amendment which will: 9.1.1 increase the number of shares which are to be reserved for the issuance of Options; 9.1.2 permit the granting of stock options to a class of persons other than those presently permitted to receive Options; or 9.1.3 require shareholder approval under applicable law, including Section 16(b) of the Exchange Act. Any amendment made to this Plan which would constitute a "modification" to Incentive Options outstanding on the date of such amendment, shall not be applicable to such outstanding Incentive Options, but shall have prospective effect only, unless the Optionee agrees otherwise. 9.2 AUTOMATIC TERMINATION. Unless sooner terminated by the Board, this Plan shall terminate ten (10) years from the earlier of (i) the date on which this Plan is adopted by the Board or (ii) the date on which this Plan is approved by the shareholders of the Company. No Option may be granted after such termination or during any suspension of this Plan. The amendment or termination of this Plan shall not, without the consent of the option holder, alter or impair any rights or obligations under any option previously granted under this Plan. 10. EFFECTIVENESS OF THIS PLAN. This Plan shall become effective uponadoption by the Board so long as it is approved by the Company's shareholdersany time within twelve (12) months before or after the adoption of this Plan. 14 EXHIBIT 10.5 TECHNOLOGY TRANSFER AGREEMENTTHIS AGREEMENT is made between Schmitt Industries, Inc., an Oregon corporationhaving a principal place of business at 2765 N.W. Nicolai, Portland, Oregon97210 (hereinafter "Schmitt") and Centerline Engineering, Inc., an Illinoiscorporation having a principal place of business at 1146 Beatty Mound Road,Jerseyville, Illinois 62052 and the following individuals: Michael Harms havinga principal place of residence at R. R. #2, Box 6, Dow, Illinois 62035, MichaelSmith having a principal place of residence at 1109 Reddish Drive, Jerseyville,Illinois 62052, and Nelson Miller having a principal place of residence at R. R.#4, Box 136, Jerseyville, Illinois 62052, (hereinafter "Centerline"). WHEREAS, Centerline has developed certain Technology relating to a non-contact gauging apparatus and method and has filed with the U.S. Patent andTrademark Office a Patent Application directed to the Technology; and WHEREAS, Schmitt is desirous of acquiring from Centerline all rights in andto said Technology. NOW, THEREFORE, Centerline and Schmitt, in consideration of the premisesand mutual covenants stated herein and other good and valuable consideration,the sufficiency of which is hereby acknowledged, do hereby agree as follows:I. DEFINITIONS When used in this Agreement, the following terms shall have the meaningindicated: A. Technology: Any invention, improvement, discovery, product, apparatus, method, formula or process, or patent or patent application with respect thereto, know-how or trade secret relating to the gauging of cylindrical rolls which has been developed by Centerline. B. Device: Any apparatus employing the Technology, the manufacture, use or sale of which by a third party would constitute an infringement of any claim in an issued patent (or pending application), which claim covers an invention invented solely by Centerline and relating to the Technology. C. Prototype: The measurement machine built by Centerline and employing the Technology which was disclosed to Schmitt on April 17, 1998. D. Patent Application: U.S. Patent Application Serial No. 08/844,727 filed April 18, 1997 entitled "Non-contact Gauging Apparatus And Method." E. Net Sales Price: The gross amount billed for any Devices sold, excluding Schmitt's actual cost of transporting the Devices to its customers, the actual cost 1 of installation (if any), income or business taxes paid to any governmental entity whether domestic or foreign, the actual cost of insurance paid in connection with the delivery of devices to customers, and the actual cost, not exceeding 24% of gross sales price, of any commissions or rebates given to unrelated non-user customers, distributors, or sales representatives.II. WARRANTY A. Centerline warrants that to the best of Centerline's knowledge that the Technology is secret and has not been published or otherwise publicly disclosed, or revealed to anyone not having an obligation of confidentiality to keep the Technology confidential. B. Centerline warrants that it has the right and power to enter into this Agreement and to grant, sell, assign and transfer all rights in the Technology to Schmitt. C. Centerline warrants that it has not heretofore entered into any contract in conflict with this Agreement and has not sold, granted, assigned or transferred to any third party any right, license or privilege relating to the Technology. D. Centerline warrants that it has not filed or caused to be filed any applications for letters patent in the U.S. or anywhere else in the world relating to the Technology except U.S. Provisional Patent Application Serial No. 60/015,670, filed April 19, 1996 and U.S. Patent Application Serial No. 08/844,727, filed April 18, 1997. E. Centerline warrants that it knows of no patents, trade secrets or proprietary rights of others which would be infringed or violated by the making, using, selling, testing, promoting or distributing of the Prototype by Schmitt.III. TRANSFER OF THE TECHNOLOGY A. Centerline agrees to assign to Schmitt, and hereby does assign to Schmitt, the entire right, title and interest in and to the Technology, including, without limitation, the right to file for and prosecute patent applications in the name of Schmitt relating to the Technology wherever such right may be legally exercised. B. Centerline agrees to supply to Schmitt, at no additional charge, the technical information and material in Centerline's possession required to adequately disclose the Technology, including the operation and method of manufacture of 2 the Prototype. This technical information shall include, but is not limited to, all presently existing prototypes, drawings, schematics, software code, blueprints, and test reports, relating to the performance, function, operation, design, and manufacture of the Prototype.IV. ROYALTIES, PAYMENTS AND RECORD KEEPING A. Schmitt agrees to pay to Centerline One Hundred Thousand Dollars ($100,000), said fee to be paid as follows: 1. A payment of Twenty-Five Thousand Dollars ($25,000) shall be due and payable by Schmitt to Centerline upon the execution of this Agreement by both parties. 2. A payment of Twenty-Five Thousand Dollars ($25,000) shall be due and payable by Schmitt to Centerline on or before May 11, 1998 provided that Centerline has delivered the Prototype to Schmitt or before May 11, 1998, and provided that by May 6, 1998, Centerline has: a. Obtained a new assignment of the invention disclosed and claimed in the Patent Application from all inventors to Centerline and forwarded said assignment(s) to the U.S. Patent and Trademark Office for recordation; b. Assigned the Patent Application to Schmitt and forwarded said assignment to the U.S. Patent and Trademark Office for recordation; c. Filed with the U.S. Patent and Trademark Office an amendment under Rule 312 to correct typographical errors in the Patent Application; d. Filed at Schmitt's expense with the U.S. Patent and Trademark Office a Petition to Correct Inventorship to correct the inventorship in the Patent Application; and e. Paid the Issue Fee for the Patent Application. 3. A payment of Twenty-Five Thousand Dollars ($25,000) shall be due and payable by Schmitt to Centerline on or before July 17, 1998, provided that by June 30, 1998: 3 a. Centerline personnel (including Michael Harms and Michael Smith) have cooperated with Schmitt in connection with the preparation and filing of a continuation-in-part application ("the CIP Patent Application") claiming priority to the Patent Application to be prepared by Schmitt; and b. Centerline has physically transferred to Schmitt all information and equipment relating to the Technology being assigned by this Agreement. 4. A payment of Twenty-Five Thousand Dollars ($25,000) shall be due and payable by Schmitt to Centerline on or before October 16, 1998. B. Schmitt agrees to pay to Centerline a royalty of the greater of: 1. One Thousand Dollars ($1,000) per Device; or 2. Five percent (5%) of the Net Sales Price obtained from the sale of each Device shipped by Schmitt. However, Centerline hereby waives the first Fifty Thousand Dollars ($50,000) of earned royalty after the date of this Agreement. C. The royalties provided for under this Agreement shall be paid quarterly, and Schmitt agrees to pay Centerline on or before the last day of the months of January, April, July and October the total amount of royalties due and payable under this Agreement during the calendar quarter immediately preceding said dates. D. Schmitt agrees to keep an accurate account of the operations coming under the scope of this Agreement and shall render a statement in writing to Centerline with each royalty payment indicating how many Devices have been sold and shipped during the period for which royalties are being paid.V. PATENTS A. Centerline agrees, without further consideration, to sign all lawful papers and to perform all other lawful acts which Schmitt may request, including the prompt execution of all original, divisional, substitute, reissue, and other United States and foreign patent applications on said Technology, including the Patent Application and the CIP Patent Application, and all lawful documents requested by Schmitt to further the prosecution of any of such patent applications. 4 B. Centerline agrees to cooperate at Schmitt's expense to the best of its ability in the execution of all lawful documents and the production of evidence in any nullification, reissue, extension, or infringement proceedings involving any patents covering the Technology. C. Centerline agrees that Schmitt may, at its sole discretion and at its expense, file and prosecute foreign patent applications relating to the Technology.VI. IMPROVEMENTS If, during the next ten (10) years, Centerline makes any improvements relating to the Technology, Centerline shall promptly communicate such improvement to Schmitt and give Schmitt full information regarding the improvement. Such information may be transmitted orally, in writing, and through demonstrations as the occasion requires and shall be sufficient for technical personnel of the parties to understand and apply and evaluate the subject matter. In order to facilitate such improvements, Schmitt will provide to Jerseyville Precision Inc., at 1148 Beatty Mound Road, Jerseyville, Illinois on behalf of Centerline, the most current model of the Device at no cost to Centerline or Jerseyville Precision, Inc. for improvement and demonstration. In exchange, Centerline agrees to convey and assign any such improvements to Schmitt at no additional price to Schmitt.VII. NONCOMPETE A. Centerline agrees that Michael Harms, Michael Smith, and Nelson Miller, during the term of this Agreement and thereafter for a period of two (2) years, will not directly or indirectly use any of the Technology or perform activities relating to gauging of cylindrical rolls in any business, profession, or other endeavor which is either directly or indirectly in competition with the business of Schmitt. B. Centerline agrees that during the term of this Agreement and thereafter Centerline Engineering Inc. will not directly or indirectly use any of the Technology or perform activities relating to gauging of cylindrical rolls in any business, profession, or other endeavor which is either directly or indirectly in competition with the business of Schmitt. C. If any court finds the provisions in part VII. of this Agreement to be unreasonable, the parties agree that the court may so modify this Agreement to the extent necessary to make the provisions reasonable. 5VIII. TERM AND TERMINATION A. This Agreement shall become effective from the date of its execution and shall, unless terminated earlier by one of the parties hereto in accordance with its terms, expire upon the expiration of the last patent having a claim covering the Device or method of using the Device, or in two (2) years from the date of its execution if no patent issues. B. In the event that either party defaults or breaches any of the provisions of this Agreement, the non-defaulting party reserves the right to terminate this Agreement upon sixty (60) calendar days written notice to the defaulting party; unless, however, the defaulting party within the sixty (60) calendar day period referred to, cures the default or breach.IX. GENERAL PROVISIONS A. ARBITRATION: Any controversy or claim arising out of or relating to this Agreement or the breach thereof shall be settled by arbitration in St. Louis, Missouri in accordance with the Commercial Arbitration Rules of the American Arbitration Association, and judgment upon the award rendered by the arbitrator(s) may be entered in any Court having jurisdiction thereof. B. ATTORNEY'S FEES: In the event of a dispute between the parties arising under this Agreement, the party prevailing in such dispute shall be entitled to collect such party's costs from the other party including, without limitation, court and investigation costs and reasonable attorney's fees and disbursements. C. ASSIGNMENT: This Agreement shall be binding by both parties to their successors and assignees and personal representatives, including specifically Michael Harms, Michael Smith, and Nelson Miller. D. INTERPRETATION AND CONSTRUCTION: This Agreement is written and will be administered under the laws and applicable regulations of commerce of the State of Oregon. E. SEVERABILITY: In the event any one or more of the provisions contained in this Agreement shall for any reason be held to be invalid, illegal or unenforceable in any respect, such invalidity, illegality or unenforceability shall not affect the validity of any other provision hereof and this Agreement shall be construed as if such invalid, illegal or unenforceable provision were not contained herein provided the Agreement as so modified preserves the basic intent. 6 F. WAIVER: The failure of any party at any time to require performance by any other party of any of the provisions herein shall not operate as a waiver of the right of said party to request strict performance of the same or like provisions, or any other provisions hereof, at a later date. G. ENTIRE AGREEMENT: This Agreement represents the entire agreement between the parties on the subject matter hereof and supersedes all prior discussions, agreements, and understandings of every kind and nature between them. No modification of this Agreement will be effective unless in writing and signed by both parties. IN WITNESS WHEREOF, the parties hereto intending to be legally bound havecaused the presents to be signed, in duplicate, effective as of the date of thelast signature hereto.SCHMITT INDUSTRIES, INC. CENTERLINE ENGINEERING INC./s/ Wayne A. Case /s/ Nelson Miller- ------------------------------------- -----------------------------------By: Wayne A. Case By: Nelson MillerIts: President Its: Chairman and CEODate: May 8, 1998 Date: April 23, 1998 -------------------------------- ---------------------------- INDIVIDUALLY The following undersigned individuals agree to assist Centerline in fulfilling all of its duties and obligations outlined in this Agreement. /s/ Michael Harms ----------------------------------- Michael Harms /s/ Michael Smith ----------------------------------- Michael Smith /s/ Nelson Miller ----------------------------------- Nelson Miller 7 EXHIBIT 13.1About Schmitt IndustriesSchmitt Industries designs, manufactures and markets two distinct types ofprecision measurement systems. Schmitt's automatic balancing systems forrotating machinery are used by many of the world's leading automotive, aerospaceand bearing manufacturers. The second Schmitt product line, non-contactmeasurement laser systems, are targeted to high-tech manufacturers worldwide andensure that silicon wafers and computer hard disks meet exacting standards forsurface microroughness.The company's mission is to provide the best possible products and quality for its customers, to provide challenging and rewarding employee opportunities and to provide the greatest possible return to shareholders. Schmitt recorded fiscal 1998 revenues of $10,626,084. The company currently employs 50 people in three international locations: Alsbach, Germany; Coventry, England; and at its corporate headquarters in Portland, Oregon. Company shares are traded on the NASDAQ National Market under the symbol, SMIT.Financial HighlightsIn thousands of dollars except per share information 1998 1997 1996 1995 1994 Revenues $ 10,626 $ 10,542 $ 7,080 $ 4,415 $ 2,575 Operating Income 1,339 2,296 1,509 697 313 Net Income After 1,250 1,725 1,217 249 182 Taxes Net Income Per $ .17 $ .23 $ .16 $ .04 $ .03 Share, Diluted Stockholders' 8,688 7,429 4,887 3,464 3,215 Equitya) Graph of Schmitt's Revenues, 1994-98b) Graph of Schmitt's Operating Income, 1994-98c) Graph of Schmitt's Net Income per share, 1994-98a) Photo of Wayne A. CaseTo our shareholders: ...our balance sheet remains strong, even healthier than a year ago. Schmitt Industries is debt free and assets approach $10 million. For the first six months of fiscal 1998, all signs pointed to another banner year of record sales and net profits at Schmitt Industries. Then, with little warning, the Asian financial crisis hit, precipitating a sales slump in our non-contact measurement product line that serves the high-technology industry. As a result, fiscal 1998 ended with slightly increased sales over a year ago, but profits fell short of expectations.The good news, however, is that we further strengthened our hold on the U.S. market for balancer systems for the machine-tool industry. And we are making significant strides in the European balancer market through Schmitt Hofmann Systems (SHS) and Schmitt Europe Limited (SEL). Sales were up 130% in the United Kingdom and 91% in Germany. The solid performance in our balancer product line helped offset the decline in our Asian markets.We've also taken another key step toward further solidifying our presence in the machine tool industry. We are introducing a strategic new product, the SB-4500 electronic control system, which allows multi-tasking among multiple balancers. More importantly, this controller provides a convenient integrated platform for introducing additional machine-control products. We plan to expand our product offerings to users of grinding machines and other machine tools, while continuing to support our existing and growing balancer markets.As a relatively small company, we have the capability to react rapidly to market changes and redeploy our research and development strategies when necessary. As the situation in Asia plays out, we are concentrating more on the worldwide machine-tool market, where demand remains high. To that end, we are applying non-contact measurement laser technology to a new series of dimensional gauging and microroughness measurement products, which will ship in the fourth quarter of this year.While we are shifting focus away from Asian markets, we must emphasize that this is only for the short-term. Our non-contact measurement tools, utilizing advanced laser technology, continue to make inroads in the hard-disk and silicon wafer markets. During fiscal 1998, we introduced the DTM-2000, a high-speed production-line testing system that has no equal in the industry. When the Asian markets rebound, we will be well-positioned to reap the benefits. I am pleased to report that our balance sheet remains strong, even healthier than a year ago. Schmitt Industries is debt free and assets approach $10 million. This solid bottom line provides the impetus as we confidently move forward to: aggressively research new products, study additional acquisition opportunities, and seek strategic partnerships both in the U.S. and abroad.Wayne A. CasePresident and Chairman of the BoardThe need to evolve.Schmitt's automatic balancing systems for grinding machinery are preferred by many of the world's leading manufacturers. In fact, the company has garnered a greater than 50% market share for its products in the U.S. alone. However, to further solidify its presence in the industry, Schmitt recognized the need to evolve its balancer product line into ultra-high-speed markets. At the same time, the company wanted to broaden its machine-control product offerings beyond balancers.How small is a micronA human hair is about 50 microns. Grass grows at about 5 microns a minute. One micron is to a drop of water, as a teaspoon of water is to an Olympic swimming pool.a) Photo of Schmitt's automatic balancing system components.Beyond traditional balancers.Schmitt's new SB-4500 electronic control system offers significant enhancements, including higher speed balancing, multi-functionality, improved balancer control and faster balancing cycles. Since the industry is moving toward ever increasing speed requirements and tighter tolerance control, the SB-4500 ably supports these increased market needs. The new platform allows integrated control of multiple balancers, and supports additional product functions. With this control system, Schmitt plans to expand its industrial machine-tool product lines and markets.The SB-4500 provides a common interface for several different balancer products, and it allows for multi-language capabilities, plus worldwide compatible voltage and safety specifications. The product will eventually replace Schmitt's existing controls for balancers manufactured in the U.S., as well as additional controls manufactured in Germany.Schmitt's latest technology advancement measures and controls vibrations to .04 millionths of an inch, a ten-fold improvement over the company's current balancer capability. Industry experts rate this performance as the best in the business.In its goal to tap new markets, Schmitt is broadening its product line beyond balancers. The company is developing advanced non-contact dimensional profile and surface measurement gauging for the roll-grinder industry, which will be introduced by the fourth quarter of 1998.The Schmitt Industries StoryBack in 1987, the founders of Schmitt Industries conducted comprehensive market research into industrial manufacturing. In the process, they learned that there was no simple, reliable solution for in-process balancing of grinding machines. Precision grinding is a necessary step for nearly every industrial manufacturing endeavor.Over the years, our balancer line has grown to include power transmission technology, computer controls and sensors, external balancers and adapters, internal balancers, ring balancers and hydro-kompensers. But we've never lost focus of our overriding company philosophy: we bring to market products customers want.We currently control over 50% of the U.S. balancer market, and we are continuing to make strong gains within the European marketplace. In 1995, we acquired a former competitor in Germany, and that strategic business move has accelerated our market penetration in Europe, while adding key products to our balancer line.Schmitt balancer systems are production-proven in thousands of major manufacturing installations from coast-to-coast and around the world, including many of the largest manufacturing firms. Schmitt balancer products conform to strict ISO-9001 quality and measurement standards.The latest addition to the Schmitt balancer family is the SB-4500 electronic control system. This new product enables multi-tasking among multiple balancers, and serves as an integrated platform for additional machine control products in the machine tool industry. The SB-4500 increases balancer speed and performance, and enables vibration measurements down to one-thousandth of a micron.After conducting careful market research, Schmitt acquired TMA Technologies in May 1995, and along with it the company's fledgling laser technology. Schmitt refined this technology, assembled a separate company division called Schmitt Measurement Systems (SMS), and developed a new line of non-contact surface measurement products.All smooth surfaces exhibit some degree of microroughness, even if only at the atomic level. Using proprietary light-scatter technology, Schmitt Measurement Systems provides rapid, accurate, repeatable and non-destructive surface measurements. SMS products are proving invaluable to manufacturers of hard disks, hard disk drives, and silicon wafers.In 1997, SMS developed the DTM-2000, an automated production-line system that enables 100% testing of hard disks and delivers ten times the throughput of conventional systems. The SMS product line also features light-scatter measurement products, utilized by NASA and the Department of Defense for precision measuring of space optics, cameras, and telescope lenses. Schmitt Industries, by virtue of its debt-free balance sheet and $10 million in assets, continues to devote significant resources to the research and development of new products.And our company vision remains steadfast: "To provide the finest quality products for our customers, to provide challenging and rewarding employment opportunities, and to provide the greatest possible return to our shareholders."The balancer puzzle.Grinding machines--one of the world's most common machine tools--are designed for many different operations. However, all grinding machines have one feature in common: a rotating grinding wheel, which requires constant balancing. Major manufacturers, including the automotive industry, bearing companies and makers of hydraulic systems all incorporate grinding machines within their operations. The challenge is to design and fit applicable balancers on a wide variety of machines.a) Photo of Schmitt's External Balancer, Internal Balancer and Hydrokompensers.Three key answers.Schmitt Industries designs, manufactures and markets a line of balancers that covers the diverse needs of the market--both domestic and international. The balancer line is made up of three principal types of products--external balancers, internal balancers and hydrokompensers.Schmitt has become the leader in its industry by responding to market needs. Thecompany pre-engineers balancer applications, installs complete systems, offerscomprehensive customer service, and maintains ample inventory of all products.In the U.S., external balancers are far and away the optimum solution for most grinding machines. Schmitt external balancers are easy to mount, highly reliable and require little operator training, making them exceedingly popular. Internal balancers are typically specified by European manufacturers of grinding machines, and hydrokompensers fit unique applications when external and internal balancers are not appropriate. Hydrokompensers are particularly suited for ultra-high speed functions--balancing grinding wheels that rotate at more than 15,000 RPM.Together Schmitt Balance Systems (SBS) and Schmitt Hofmann Systems (SHS) offer a breadth of products that satisfies nearly any manufacturing requirement. Schmitt also customizes balancers to fit applications. As the needs of the machine-tool industry grow more sophisticated, Schmitt will maintain its focus on the market, and continue to develop products that meet the increasing process control requirements of our customers.Mitsubishi Siltec, a major supplier of silicon wafers to computer chip makers, needed an efficient, non-destructive method for testing the microroughness of its products. All silicon wafers exhibit a microscopic level of surface roughness, stemming from chemical deposition, grinding, polishing, etching, or any number of other production techniques. Silicon wafer manu-facturing processes must be very precise and controlled, and these processes heavily rely on the surface roughness of the wafer. Quantifying microroughness is critical.a) Photo of silicon wafer texture measurement system.Smoothing over market needs.In 1995, Schmitt acquired TMA Technologies, a U.S. company that researched anddeveloped laser technology. Schmitt engineers are harnessing this revolutionarytechnology within a series of products that conduct non-contact surfacemeasurements. And an entirely new company division has been created--Schmitt Measurement Systems (SMS).The flagship product of SMS--the TMS-2000W--provided an ideal solution for Mitsubishi Siltec. The TMS-2000W enables fast, repeatable non-destructive measurements down to a few hundredths of an angstrom, a level unattainable by any other testing method. This system also provides a way for Mitsubishi Siltec to quantify and control its manufacturing process. The TMS-2000W and the complementary TMS-3000W are marketed worldwide by means of a strategic partnership with Veeco Process Metrology.While the TMS-2000W represents an excellent solution for the silicon manufacturing environment, Schmitt engineers also developed the Microscan--a mobile light-scatter surface-measurement tool. The Microscan is used by the National Aeronautic and Space Administration (NASA) to measure microroughness and reflectance on mirrors and space optics.SMS product developers are aided by the world's most powerful light-scatter laboratory, including eight lasers that operate at 20 different wavelengths. Consequently, Schmitt contracts with customers to provide them with comprehensive light-scatter analysis for industrial, military and space optics applications.The 100% problem.In magnetic disk manufacturing, surface features are so small they cannot be seen visually. Traditional test methods that utilize optical and microscope technology do not provide the necessary resolution and speed to measure 100% of production.HMT, one of the world's premier suppliers of magnetic disks for hard drives, was experiencing quality errors and omissions, due to a random testing policy. The company needed to implement 100% testing, and do it afford-ably. Schmitt answered with a technological breakthrough.How small is an angstromThe point of a needle is about 1 million angstroms in diameter. Fingernailsgrow at about 50 angstroms per second. One angstrom is to a grain of sand,as a child's wading pool is to the Atlantic Ocean.a) Photo of Schmitt's non-contact texture measurement system used in the production of disks.100% success.Senior management at Schmitt Industries met with HMT representatives to discuss the development of a 100% production-test system for magnetic disks for hard drives. Schmitt Measurement Systems (SMS) engineers began research and development in earnest, and less than six months later, the company unveiled the DTM-2000. This new system utilizes light-scatter measurement technology to automatically process hard disks and render microroughness measurements at rapid speed--one every three seconds.HMT conducted extensive preliminary testing on the DTM-2000 with highly satisfactory results. The automated system provides throughput of 1,200 hard disks per hour at measurement levels as low as one-tenth of an angstrom. In addition, the DTM-2000 is the first metrology system that offers disk drive manufacturers the ability to make critical non-contact measurements on both sides of disks, simultaneously. This technology leap makes 100% inspection economically feasible.HMT purchased seven new DTM-2000 systems, each with a market value of $165,000. Schmitt is currently working with Veeco, its worldwide marketing partner, to introduce the DTM-2000 to additional prospects in the disk drive industry. According to the 1997 annual survey in Data Storage magazine, 400 million hard disks are manufactured annually, and the industry is expected to grow by 15% per year. This should result in strong future demand for SMS non-contact measurement products.Consolidated Balance SheetsMay 31, 1998 and 1997 1998 1997 AssetsCurrent assetsCash $1,127,076 $ 504,662Trading securities -- 168,000Accounts receivable 1,197,951 2,725,512Inventories 4,166,755 2,479,820Prepaid expenses 120,466 30,668Deferred tax asset 34,623 136,000Income tax receivable 190,806 -- Total current assets 6,837,677 6,044,662Property and EquipmentLand 299,000 299,000Buildings and improvements 1,190,920 1,025,868Furniture, fixtures, and equipment 906,058 760,596Vehicles 139,261 146,299 2,535,239 2,231,763Less accumulated depreciation and amortization 691,258 530,587 1,843,981 1,701,176Other AssetsLong-term deferred tax asset 837,560 679,000Other assets 100,000 90,415 937,560 769,415Total Assets $9,619,218 $8,515,253Liabilities and Stockholders' EquityCurrent LiabilitiesAccounts payable $ 681,524 $ 530,667Accrued royalties 55,335 131,983Accrued commissions 131,154 111,996Other accrued liabilities 63,076 62,832Income taxes payable -- 68,563Current portion of long-term debt -- 29,061 Total current liabilities 931,089 935,102Long-Term Debt, net of current portion -- 150,922Commitments and Contingencies(Note 7)Stockholders' EquityCommon stock, no par value, 20,000,000 shares authorized, 7,099,139 and 7,081,889 shares issued and outstandingat May 31, 1998 and 1997, respectively 5,072,634 4,952,411Cumulative foreign exchange translation adjustment (147,708) (36,270)Retained earnings 3,763,203 2,513,088 Total stockholders' equity 8,688,129 7,429,229Total Liabilities and Stockholders' Equity $9,619,218 $8,515,253 Consolidated Statements of Income For the years ended May 31, 1998, 1997 and 1996 1998 1997 1996 Net Sales $10,626,084 $10,541,972 $7,080,128 Cost of Sales 4,632,485 3,875,790 2,547,054 Gross profit 5,993,599 6,666,182 4,533,074 General, Administrative, and Sales Expense 4,275,059 4,164,271 3,023,916 Research and Development Expense 379,798 205,800 -- Operating expenses 4,654,857 4,370,071 3,023,916 Operating income 1,338,742 2,296,111 1,509,158 Other Income and Expense Interest expense (42,231) (16,273) (45,130) Interest income 44,581 25,007 27,853 Unrealized gain (loss) on trading securities -- 22,400 (61,222) Miscellaneous income 259,924 25,430 16,132 Other income and expense 262,274 56,564 (62,367) Income Before Provision for Income Taxes 1,601,016 2,352,675 1,446,791 Provision for Income Taxes 350,901 627,947 229,538 Net income $ 1,250,115 $ 1,724,728 $1,217,253 Net income per common share, basic $ .18 $ .25 $ .18 Weighted average number of common shares, basic 7,091,269 7,031,449 6,887,975 Net income per common share, diluted $ .17 $ .23 $ .16 Weighted average number of common shares, diluted 7,456,172 7,561,744 7,416,713 Consolidated Statements of Cash Flows For the years ended May 31, 1998, 1997 and 1996 1998 1997 1996 Cash Flows Relating to Operating Activities Net income $1,250,115 $1,724,728 $1,217,253 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation 347,228 264,440 196,021 Amortization -- 72,393 189,103 Unrealized (gain) loss on trading securities -- (22,400) 61,222 Deferred taxes (57,183) 198,426 (30,822) (Increase) decrease in: Trading securities 168,000 -- 150,000 Accounts receivable 1,527,561 (1,313,707) (444,024) Inventories (1,686,935) (235,556) (613,626) Prepaid expenses (89,798) (14,762) (4,004) Notes receivable -- -- 10,000 Income taxes receivable (190,806) -- 50,000 Other assets (9,585) (90,415) (121,907) Increase (decrease) in: Accounts payable 150,857 185,839 (96,215) Accrued liabilities, royalties, and (57,246) 62,198 126,784 commissions Income taxes payable (44,809) (226,186) 294,749 Net cash provided by 1,307,399 604,998 984,534 operating activities Cash Flows Relating to Investing Activities Purchase of property and equipment (514,283) (461,168) (406,675) Proceeds from disposal of equipment 24,250 10,651 -- Acquisition of assets of Hofmann (496,000) Maschinenbau GmbH Net cash used in investing activities (490,033) (946,517) (406,675) Cash Flows Relating to Financing Activities Repayment of long-term debt (179,983) (34,895) (69,131) Long-term repayments mortgage -- -- (233,920) Exercise of stock options 96,469 409,106 92,188 Net cash (used in) provided by financing (83,514) 374,211 (210,863) activities Effect of foreign exchange translation on cash (111,438) (36,270) -- Increase (Decrease) in Cash $ 622,414 $ (3,578) $ 366,996 Cash, beginning of year 504,662 508,240 141,244 Cash, end of year $1,127,076 $504,662 $508,240 Supplemental Disclosure of Cash Flow Information Cash paid during the period for interest $ 42,231 $ 15,272 $ 45,130 Cash paid during the period for income taxes $ 405,800 $ 450,871 $ 11,600 Supplemental Schedule of Noncash Investing and Financing Activities Discount associated with long-term debt $ -- $ -- $ (78,085) Reduction of goodwill $ (155,438) $ (215,973) $ (424,011) Income tax benefit of stock options exercised $ (23,754) $ (444,793) $ (113,800) Consolidated Statements of Changes in Stockholders' Equity For the years ended May 31, 1998, 1997 and 1996 Shares Amount Cumulative Retained Total Foreign Earnings Exchange (Accumulated Translation Deficit) Adjustment Balance, May 31, 1995 6,886,889 $3,892,524 $ -- $ (428,893) $3,463,631 Stock options exercised 31,250 92,188 -- -- 92,188 Income tax benefit from exercise -- 113,800 -- -- 113,800 of stock options Net income -- -- -- 1,217,253 1,217,253 Balance, May 31, 1996 6,918,139 4,098,512 -- 788,360 4,886,872 Cumulative foreign exchange -- -- (36,270) -- (36,270) translation adjustment Stock options exercised 163,750 409,106 -- -- 409,106 Income tax benefit from exercise -- 444,793 -- -- 444,793 of stock options Net income -- -- -- 1,724,728 1,724,728 Balance, May 31, 1997 7,081,889 4,952,411 (36,270) 2,513,088 7,429,229 Cumulative foreign exchange -- -- (111,438) -- (111,438) translation adjustment Stock options exercised 17,250 96,469 -- -- 96,469 Income tax benefit from exercise -- 23,754 -- -- 23,754 of stock options Net income -- -- -- 1,250,115 1,250,115 Balance, May 31, 1998 7,099,139 $5,072,634 $ (147,708) $3,763,203 $8,688,129NOTE 1 Organization and Nature of OperationsSchmitt Industries, Inc. (the Company) is engaged in the design, assembly, marketing, and distribution of electronic and mechanical components for machine tool products and laser measurement systems worldwide. On June 13, 1996, the Company established Schmitt Europe, Ltd. (SEL). In addition, on December 2, 1996, the Company established Schmitt Hofmann Systems GmbH (SHS) which acquired certain assets of the grinding wheel balance division of Hofmann Maschinenbau GmbH.NOTE 2 Summary of Significant Accounting PoliciesPrinciples of ConsolidationThe consolidated financial statements as of May 31, 1998 and 1997, and the consolidated statements of income for the years ended May 31, 1998, 1997 and 1996 include those of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the preparation of the consolidated financial statements.Revenue RecognitionRevenue from product sales is recognized upon shipment. Sales are reported net of applicable cash discounts and allowances for returns.InventoryInventory is valued at the lower of cost or market. Cost is determined on the average cost basis. As of May 31, 1998 and 1997, inventories consisted of raw materials ($2,502,310 and $1,165,554, respectively), work-in-process ($60,075 and $258,912, respectively), and finished goods ($1,604,370 and $1,055,354, respectively).Property and EquipmentProperty and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three to seven years for furniture, fixtures, and equipment; three years for vehicles; and twenty-five years for buildings and improvements.Technology RightsFrom time to time the Company acquires certain rights to technology developed by unaffiliated parties. Costs to acquire technology rights are capitalized and amortized on a straight-line basis over the estimated useful life. Any related royalty costs are expensed as related revenues are earned. Capitalized acquired technology is included in other assets net of accumulated amortization.Concentration of Credit RiskFinancial instruments which potentially expose the Company to concentration of credit risk are trade accounts receivable. Credit terms generally include a discount of 1-1/2% if the invoice is paid within ten days, with the net amount payable in 30 days. No allowance for doubtful accounts is considered necessary. For the year ended May 31, 1998, approximately 24% of consolidated saleswere made to one customer. During the year ended May 31, 1998, the Companyrenewed a strategic partnership with an entity to distribute systemsmanufactured by Schmitt Measurement Systems, Inc., for a period of two years.For the year ended May 31, 1997 and 1996, approximately 22% and 15% ofconsolidated sales were made to one customer, respectively.Income TaxesThe Company follows the method of accounting for income taxes proscribed by the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (FAS 109) whereby deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.Research and Development CostsResearch and development costs are charged to expense when incurred.Trading SecuritiesTrading securities consist of common stock and are stated at fair value, whichis estimated based on quoted market prices. Unrealized gains or losses areincluded in other income and expense. Total realized gain on trading securitiesduring fiscal 1998 was approximately $186,000 and is included in other income.No trading securities were held at May 31, 1998.Use of EstimatesThe preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.Consolidated Statement of Cash FlowsThe Company considers short-term investments which are highly liquid, readily convertible into cash, and have original maturities of less than three months to be cash equivalents for purposes of the cash flows statement.Stock-Based CompensationStatement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (FAS 123) encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," (APB 25). Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock.Foreign Currency TranslationFinancial statements for the Company's subsidiaries outside the United States are translated into U.S. dollars at year-end exchange rates for assets and liabilities and weighted average exchange rates for income and expenses. The resulting translation adjustments are recorded as a separate component of stockholders' equity titled "Cumulative Foreign Exchange Translation Adjustment."Fair Value of Financial InstrumentsThe carrying amounts of financial instruments approximate their fair values at May 31, 1998. The fair market value of long-term debt approximates carrying amounts based on discounted cash flow analyses.ReclassificationsCertain reclassifications have been made to the 1997 and 1996 consolidatedfinancial statements to conform with current year presentations.Earnings Per ShareThe Company adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share," (FAS 128), during 1998. All prior earnings per share data have been restated to conform to the provisions of this statement. Basic earnings per share is computed using the weighted average number of shares outstanding. Diluted earnings per share is computed using the weighted average number of shares outstanding, adjusted for the incremental shares attributed to outstanding options to purchase common stock. Using the treasury shares method as required by FAS 128, incremental shares of 364,903, 530,295 and 528,738 in 1998, 1997 and 1996, respectively, were used in the calculation of diluted earnings per share.New Accounting PronouncementsBetween June 1997 and June 1998, the FASB issued three pronouncements, Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," (FAS 130), Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," (FAS 131), and Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," (FAS 133), which will be effective in future reporting periods. Management has evaluated the provisions of these pronouncements and expects that their adoption will have no effect on results of operations or the financial position of the Company. NOTE 3 Company AcquisitionsOn May 23, 1995, in a business combination accounted for as a purchase, theCompany acquired TMA Technologies, Inc., which designs, manufactures, andmarkets optical quality assurance instruments. Subsequent to this acquisition,the Company changed the name of TMA Technologies, Inc., to Schmitt MeasurementSystems, Inc. (SMS), and moved the operations to Portland, Oregon. In transactions related to the acquisition, the Company established a royalty pool and has vested each shareholder and debt holder an interest in the royalty pool equal to the amount actually invested by shareholders or loaned by debt holders including interest payable through March 31, 1995. The royalty pool is funded at 5% of net sales (defined as gross sales less returns, allowances, and sales commissions) of Schmitt Measurement Systems, Inc.'s, products and future derivative products developed by Schmitt Industries, Inc., which utilize these technologies. As part of the royalty pool agreement, each of the former shareholders and debt holders released TMA Technologies, Inc., for any claims with regard to the acquisition except their rights to future royalties. Long-term debt of $179,983 was fully paid to certain TMA Technologies, Inc. debt holders in fiscal year 1998. On December 2, 1996, the Company purchased the inventories ($462,933) and equipment ($33,067) of the grinding wheel balancer division of Hofmann Maschinenbau GmbH for $496,000 and subsequently established Schmitt Hofmann Systems GmbH. (See Note 1) The results of both SHS and SMS are included in the accompanyingconsolidated financial statements since the date of acquisition.NOTE 4 Line of CreditThe Company has an unsecured short-term line of credit agreement with WellsFargo Bank, to a limit of $1,500,000. The line is guaranteed by the Company'swholly-owned subsidiary, Schmitt Measurement Systems, Inc. Interest is payableat the bank's prime rate, or LIBOR +2.50%. The line of credit is renewableannually. No balance was outstanding as of May 31, 1998 or May 31, 1997.NOTE 5 Income TaxesThe provision for income taxes was as follows: Year ended May 31, 1998 1997 1996 Current $243,264 $826,368 198,716 Deferred 383,887 77,824 312,235 Decrease in (276,250) (276,245) (281,413) valuation allowance Total provision $350,901 $627,947 $229,538 for income taxesDeferred tax assets (liabilities) are comprised of the following components: Year ended May 31, 1998 1997 Depreciation $ (29,861) $ (48,000) Net operating loss carryforwards 1,038,559 1,314,809 Inventory basis differences 34,623 16,760 Other asset capitalization 13,840 142,181 Other deferred assets 49,254 64,250 Gross deferred tax assets 1,136,276 1,538,000 Deferred tax asset valuation (234,231) (675,000) allowance Net deferred tax asset $ 872,184 $ 815,000 Through the acquisition of Schmitt Measurement Systems, Inc., the Company acquired approximately $5.5 million of U.S. federal net operating loss carryforwards. As of May 31, 1998, approximately $3 million of these net operating losses remain (which expire in the years 2007 through 2009). The deferred tax asset valuation allowance in fiscal years 1996 through 1998 is attributed to these net operating losses. A portion of the reduction in valuation allowance related to the net operating loss carryforward represented tax asset benefit that reduced intangible assets acquired with TMA (see Note 3). The provision for income taxes differs from the amount of income taxes determined by applying the U.S. statutory federal tax rate to pre-tax income due to the following: Year ended May 31, 1998 1997 1996 Statutory federal tax rate 34.0% 34.0% 34.0%State taxes, net of federal 3.2 4.4 2.2benefitChange in deferred tax (27.5) (20.9) (48.8)valuation allowanceReduction of goodwillassociated with theacquisition of Schmitt 10.3 9.2 29.3Measurement Systems, Inc.Other permanent differences 1.9 -- (0.9)Effective tax rate 21.9% 26.7% 15.8%NOTE 6 Employee Benefit PlansThe Company adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan & Trust effective June 1, 1996. Employees must meet certain age and service requirements to be eligible. Participants may contribute up to 15% of their eligible compensation which is partially matched by the Company. The Company may further make either a profit sharing contribution or a discretionary contribution. Contributions made to this Plan during the year ended May 31, 1998 and May 31, 1997 were $135,335 and $116,248, respectively. The Company adopted a Simplified Employee Pension Plan (SEP) during the year ended May 31, 1993. All permanent employees were eligible to participate once they met the age and length of employment requirements. Contributions were $41,840 during the year ended May 31, 1996. The Plan was terminated effective May 31, 1996.NOTE 7 ContingencyThe Company is party to a legal action initiated by a competitor alleging wrongful misrepresentation of the competitor's product. The claim is considered, by management and the Company's legal counsel, to be without merit. The extent of potential liability, if any, cannot be estimated at this time.NOTE 8 Segments of BusinessThe Company operates principally in two segments of business: the manufacturing of mechanical components for the machine tool industry, and the manufacturing of laser measurement systems for the computer disk and wafer industries. The segment, which manufactures mechanical components for the machine tool industry, reported gross sales of $8,286,243 for the year ended May 31, 1998. This includes inter-company sales of $754,131. This segment reported gross sales of $6,488,348 for the year ended May 31, 1997, including inter-company sales of $336,875. The segment which manufactures laser measurement systems for the computer disk and wafer industries reported gross sales of $3,108,769 for the year ended May 31,1998, which includes inter-company sales of $14,797. For fiscal year ended May 31, 1997, the measurement products segment reported gross sales of $4,390,499. There were no inter-company sales. The mechanical components segment and laser measurement segment had sales of $4,801,151 and $2,278,977, respectively, for the year ended May 31, 1996, which had no inter-company sales. Geographically, U.S. sales were $7,873,148 and $8,728,082 for fiscal years ended May 31, 1998 and 1997, respectively. Foreign sales were $3,521,864 and $2,150,765 for the same years, respectively. This includes inter-company sales of $768,928 for the year ended May 31, 1998 and $336,875 for the year ended May 31, 1997. For the years ended May 31, 1998 and 1997, respectively, export sales by the U.S. segment totaled $344,100 and $612,704. Income from operations for the years ended May 31, 1998, 1997 and 1996 for the mechanical components segment was $363,656, $176,927 and $648,777, respectively. Income from operations for the years ended May 31, 1998, 1997 and 1996 of the laser measurement segment was $975,086, $2,119,184, and $830,381, respectively. Consolidated income from operations includes an adjustment of $90,000 for the elimination of inter-company rent for the year ended May 31, 1998 and $30,000 for the years ended May 31, 1997 and 1996. Income from operations for the U.S. segment was $1,423,502 and $2,393,558, respectively, for the years ended May 31, 1998 and 1997 and for the foreign segment, losses of $84,760 and $97,447, respectively, for the same years. Identifiable assets at May 31, 1998, 1997 and 1996, were $6,235,232, $5,246,517, and $4,162,209 for the mechanical components segment and $3,383,986, $3,268,736, and $1,823,731 for the laser measurement segment. Identifiable assets at May 31, 1998 and 1997, were $8,890,325 and $7,034,431 for the U.S. segment and $728,893 and $1,480,822 for the foreign segment. Depreciation expense incurred during the years ended May 31, 1998, 1997 and 1996, by the mechanical components segment was $206,335, $156,374 and $115,778, respectively. The laser measurement segment incurred depreciation expense of $140,893, $108,066 and $80,243, for the years ended May 31, 1998, 1997 and 1996, respectively. Amortization expense incurred during the years ended May 31, 1998, 1997 and 1996, by the mechanical components segment was $-0-, $72,393 and $91,756, respectively. The laser measurement segment did not incur amortization expense for years 1998 and 1997, but incurred amortization expense of $97,347 for the year ended May 31, 1996. The U.S. segment incurred depreciation expense of $276,102 and $226,735 during the years ended May 31, 1998 and 1997, respectively. The foreign segment incurred depreciation expense of $71,126 and $37,705, respectively, for these same years. The U.S. segment incurred amortization expense of $72,393 in fiscal year ended May 31, 1997. The foreign segment has not incurred amortization expense. Capital expenditures for the years ended May 31, 1998, 1997 and 1996, were $238,016, $297,998 and $317,861 by the mechanical components segment and $276,267, $163,170 and $88,814 by the laser measurement segment, respectively. Capital expenditures for the years ended May 31, 1998 and 1997, were $466,801 and $291,128 by the U.S. segment and $47,482 and $170,040 by the foreign segment, respectively. Income from operations represents sales less costs and operating expenses. In computing income from operations, all overhead expenses have been allocated to both industry segments, as they are an integral part of profit recognition for each segment. Identifiable assets by segment of business are those assets used in the Company's operations in each segment. There are no unallocated Company assets.NOTE 9 Stock OptionsPrior to 1995, the Company granted stock options to officers and employees of the Company. Stock options for up to 10% of the outstanding shares eligible for grant provided that the stock options for any one individual did not exceed 5% of the issued and outstanding shares of common stock. The purchase price of the optioned shares was equal to not less than the average closing price of the Company's common stock for the ten trading days immediately preceding the grant date of the stock options. The maximum term of each stock option did not exceed five years and all options were vested and exercisable upon grant. The options expire in the year 1999. A 1995 Stock Option Plan was adopted by the Board of Directors on December 19, 1995, for the benefit of employees other than officers. An option granted under the Plan may be either an incentive stock option (ISO), or a nonstatutory stock option (NSO). ISOs may be granted only to employees of the Company and are subject to certain limitations, in addition to restrictions applicable to all stock options under the Plan. Options not meeting these limitations will be treated as NSOs. The purchase price of ISOs is fair market value on the date of grant; purchase price of NSOs may vary from fair market value. Vesting is generally on a cumulative basis over four years at 25% per year. This plan, which originally provided for 300,000 shares available for option, was amended during the year ended May31, 1997, with the maximum number of available shares increased to 500,000. The options expire in years 2006 through 2008. The following summarizes the options outstanding as of May 31, 1998:For the 485,750 options granted prior to 1995, the exercise price range was $0 to $2.00, the weighted average price was $1.72 and the remaining average contractual life was 0.6 years. For the 386,750 shares granted under the 1995 Stock Option Plan, the exercise price range was $2.01 to $6.00, the weighted average price was $5.22 and the remaining average contractual life was 8.2 years. The Company has adopted the disclosure only provisions of SFAS No. 123. Accordingly, no compensation cost has been recognized for the stock option plans. Options were assumed to be exercised upon vesting for purposes of this valuation. Adjustments are made for options forfeited prior to vesting. For the years ended May 31, 1998, 1997 and 1996, total value of options granted was computed to be $877,963, $395,740 and $801,878, respectively, which would be amortized on a straight-line basis over the vesting period of the options. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for the awards in 1998, 1997 and 1996, consistent with the provisions of SFAS No. 123, the Company's pro forma net income for the years ended May 31, 1998, 1997 and 1996, would be $889,944 and $1,436,760 and $602,835, respectively. Pro forma basic earnings per share for the years ended May 31, 1998, 1997 and 1996 would be $.13, $.20 and $.09, respectively. Pro forma diluted earnings per share for the years ended May 31, 1998, 1997 and 1996 would be $.12, $.19 and $.18, respectively. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option and pricing model. The weighted average assumptions used for fiscal 1998, 1997 and 1996 were a risk-free interest rate of 5.6%, 7.5% and 7.5%, respectively, an expected dividend yield of 0%, 0% and 0%, respectively, an expected life of 8, 10, and 10 years, respectively, and a volatility of 52%, 51% and 51%, respectively. The effects of applying SFAS No. 123 in the pro forma disclosure are not indicative of future amounts. Options prior to 1995 1995 Stock Option Combined Plan Plans Weighted Weighted Average Average Exercise Exercise Combined Shares Price Shares Price Shares Options outstanding, May 31, 1995 614,500 $1.72 -- $ -- 614,500Options granted in 1996 -- $ -- 295,000 $5.83 295,000Options exercised in 1996 (18,750) $1.96 (12,500) $4.38 (31,250)Options outstanding, May 31, 1996 595,750 $1.72 282,500 $5.83 878,250Options granted in 1997 -- -- 67,500 $5.83 67,500Options exercised in 1997 (110,000) $1.72 (53,750) $4.38 (163,750)Options forfeited in 1997 -- -- (14,000) -- (14,000)Options outstanding, May 31, 1997 485,750 $1.72 282,250 $5.83 768,000Options granted in 1998 -- -- 174,000 $6.63 174,000Options exercised in 1998 -- -- (17,250) $5.59 (17,250)Options forfeited in 1998 -- -- (52,250) $8.33 (52,250)Options outstanding, May 31, 1998 485,750 $1.72 386,750 $5.22 872,500Options vested at May 31, 1998 485,750 113,000 598,750Management's Discussion and AnalysisThe following information contains certain forward-looking statements that anticipate future trends or events. These statements are based on certain assumptions that may prove to be erroneous and are subject to certain risks including but not limited to the uncertainties of the Company's industry and the risk factors listed from time to time in the Company's SEC reports, including but not limited to the Current Report on Form 8-K dated June 5, 1996. Accordingly, actual results may differ, possibly materially, from the predictions contained herein. During fiscal 1998 the measurement markets the Company serves declined, particularly in the Asian region during the third and fourth quarters. The Company has responded to this decline in demand for its products by launching new products for both the laser measurement markets and the mechanical balancer markets. As a result of these changes by management, the Company's sales in fiscal 1998 increased slightly from fiscal 1997. The Company expects current levels of product sales and profitability to continue in the near future. However, there can be no assurance that the Company will continue to be profitable with increased sales levels in future time periods. Sales outside the United States accounted for approximately 20% of the Company's revenues in each of the fiscal 1996, 1997 and 1998. Some foreign customers will purchase in their own country's currencies, thereby imposing on the Company a currency risk. All U.S. sales (74% of total sales in fiscal 1998) were in U.S. dollars and less than 10% of total sales in fiscal 1998 were in currencies other than U.S. dollars; as a result, currency fluctuations have historically had little impact on revenue realization. However, significant variations in the value of the U.S. dollar, relative to currencies of countries in which the Company has significant competitors, can impact future sales. The Company does not engage in currency hedging. In addition, the longer payment cycles of international sales can have a negative impact on liquidity. The Company believes that international sales will continue to grow in future periods. A substantial portion of the Company's revenues is derived from sales to end users through selling agents and directly to builders of machine tools. For fiscal 1997 and 1998, sales to a single customer did not exceed 10% of total balancer revenues. In fiscal 1997 the Company entered into a strategic partnership with Veeco Instruments Inc. (NASDAQ:VECO) to act as the exclusive sales and marketing agent for SMS's laser light scatter products. As a result of this agreement, 24% of consolidated fiscal 1998 sales were through Veeco as compared with 22% in fiscal 1997. The Company is dependent on the sales activities of its selling agents, and there can be no assurance that these agents will continue to be successful in their efforts to market the Company's products. The Company enjoys substantial repeat business from a broad base of customers, but there can be no assurance that these customers will continue to buy the Company's products in the future. Increased revenues during fiscal 1996, 1997 and 1998 principally have been the result of increased volume of product shipments. Product improvements and available features have resulted in modestly increased average product prices. The Company operates in a highly competitive industry characterized by increasingly rapid technological changes. The Company's competitive advantage and future success are therefore dependent on its ability to develop new products, to qualify these new products with its customers, to successfully introduce these products to the marketplace on a timely basis, to commence production to meet customer demands and to develop new markets in the industries for its products and services. The successful introduction of new technology and products is increasingly complex. If the Company is unable, for whatever reason, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, its results of operations could be adversely impacted.a) Graph of Schmitt's Shareholders' Equity, 1994-98.Results of OperationsSales in fiscal 1998 increased to $10,626,084 from $10,541,972 in fiscal 1997 and $7,080,128 in fiscal 1996. Schmitt Measurement System (SMS) sales accounted for $3,093,972 of fiscal 1998 sales compared with fiscal 1997 sales of $4,390,499. Net income for fiscal 1998 totaled $1,250,115 vs. fiscal 1997 totals of $1,724,728. This decline was directly attributable to reduced sales of SMS measurement products. Historically the Company has enjoyed a high gross profit margin in excess of 60% on its SBS Dynamic Balancing products and its SMS measurement products. Fiscal year 1998 gross profits totaled 56%. Cost of sales as a percentage of sales for fiscal 1996, 1997 and 1998 was 35.9%, 36.7% and 43.6%, respectively. The introduction of the TMS-2000 during the third quarter of fiscal 1996 had a positive impact on sales and net earnings for fiscal 1996 and 1997. The fiscal 1998 decline in sales of TMS-2000 and TMS-2000W series products resulted in a negative impact on sales and net earnings. Management expects these trends in sales and profits of the TMS series products to continue throughout the 1998 calendar year. Management anticipates that cost of sales as a percentage of sales will be similar in future time periods to the Company's historical performance. No assurances can be made that the Company will be profitable or will generate increased sales in future time periods. General selling and administrative expenses as a percentage of net sales were 40% in fiscal 1998, 40% in fiscal 1997, and 43% in fiscal 1996. During each of these fiscal years, the Company increased spending in marketing and selling programs to support the development of international markets, particularly in the European and Asia-Pacific regions, and to increase the awareness of new products. Administrative expenses have increased during each of the last three fiscal years to support the Company's growth, improve information technology capability and protect the Company's intellectual property rights. The Company has had minor variable cost increases in periods of increased sales; therefore, fixed costs have been spread over an increasing sales revenue as unit sales of SBS and SMS products increased. Even with two operating segments, management believes the Company's costs will not increase at the same rate that sales are anticipated to increase in fiscal 1999 and beyond, although there can be no such assurance. Net income for fiscal 1998 decreased to $1,250,511, a 28% decrease from fiscal 1997 and 3% increase over fiscal 1996. Net income per basic share decreased to $0.18 in fiscal 1998 from $0.25 in fiscal 1997 and remained the same as fiscal 1996. The Company's future operating results depend, to a considerable extent, on its ability to maintain a competitive advantage in both the products and services it provides. For this reason, the Company believes it is critical to continue to make future investments in research and development to ensure the flow of innovative, productive, high-quality products and support services. Accordingly, the Company expects research and development expenses to continue to increase in the immediate future.a) Graph of Schmitt's Total Assets, 1994-98.Liquidity and Capital ResourcesThe Company's financial condition remained very strong, with a ratio of current assets to current liabilities of 7.3:1 at May 31, 1998, compared with 6.5:1 at May 31, 1997. As of May 31, 1998, the Company had $1,127,076 in cash, and trading securities, compared with $672,662 at May 31, 1997. Accounts receivable have decreased as revenue growth has slowed. At May 31,1998, accounts receivable totaled $1,197,951 compared with $2,725,512 at May 31,1997. At May 31, 1998, none of the Company's accounts receivable were considered a doubtful collection. The Company generally experiences a payment cycle of 30-80 days on invoices. Management believes its credit policies and collection policies are effective and appropriate for the marketplace that it serves and the Company has had no bad debt write-offs since its inception in 1986. There can be no assurance that the Company's collection procedures will continue to be successful. Working capital increased from $5,109,560 at May 31, 1997 to $5,906,588 at May 31, 1998. During fiscal 1997 the Company spent $496,000 to acquire certain assets of a former European competitor, Hofmann Maschinenbau GmbH (SHS). Additionally the Company spent $461,168 on the purchase of worldwide corporate assets of property and equipment in fiscal 1997. During fiscal 1998 the Company spent $514,283 to acquire certain worldwide corporate assets of property and equipment to assist in production and product development. Although the Company has no current material commitments for capital expenditures, product development to extend SBS products to new markets and to bring SMS products to advanced commercial status is expected to result in increased capital expenditures for equipment in fiscal 1999. The Company maintains levels of inventory sufficient to satisfy normal customer demands, plus an increasing short-term delivery requirement for a majority of its products. Additionally, inventories are periodically adjusted according to management's forecast for future business activity. Management believes its ability to provide prompt deliveries gives it a competitive advantage for certain sales. It is expected that current inventory levels will be maintained or increased as new products are introduced. The average finished goods inventory turnover ratio for fiscal 1996, 1997 and 1998 was 1.7, 2.1 and 1.4, respectively. The acquisition of SMS resulted in a tax loss carryforward in excess $5 million, which is available to offset earnings from SMS through the year 2010. As of May 31, 1998 the Company's gross deferred tax asset balance was $3,233,155.a) Graph of Schmitt's Return on Equity (in percent), 1994-98. The Company has completed an evaluation of Year 2000 computer information processing problems and Year 2000 program requirements for internal operations and Company products and does not expect to experience Year 2000 problems in those areas. A survey analysis of external vendors is in process and is anticipated to be complete by December 31, 1998. The Company's Year 2000 compliance evaluation will then be complete. The Company does not believe it has significant exposure to Year 2000 problems with significant vendors, customers and financial institutions and does not expect that Year 2000 will have a material cost or impact on Company operations. However, there can be no assurance that the systems of other companies on which the Company relies will not have an adverse effect on the Company's systems. Management believes that its cash flows from operations, available credit resources and its improving cash position will provide adequate funds on both a short-term and long-term basis to cover currently foreseeable debt payments, lease commitments and payments under existing and anticipated supplier agreements. Management believes that such cash flow (without the raising of external funds) is sufficient to finance current operations, projected capital expenditures, anticipated long-term sales agreements and other expansion-related contingencies during fiscal 1998.b) Graph of Schmitt's Working Capital, 1994-98.Summarized Quarterly Financial DataIn thousands, except per share information (unaudited)1998 Quarter Ended August 31 November 30 February 28 May 31 Sales $2,666,941 $3,220,475 $2,372,320 $2,366,348Gross Profit 1,504,589 1,833,637 1,059,200 1,596,173Net Income 354,551 695,449 101,794 98,321Net Income Per Share, 0.05 0.10 0.01 0.01BasicNet Income Per Share, 0.05 0.09 0.01 0.01DilutedMarket Price of CommonStock Low 7.50 8.00 7.38 5.69 High 9.75 12.00 10.13 8.131997 Quarter Ended August 31* November 30* February 28* May 31* Sales $1,793,698 $2,738,314 $2,918,912 $3,091,048Gross Profit 1,069,558 1,725,676 1,827,858 2,043,090Net Income 140,276 607,344 458,655 518,453Net Income Per Share, 0.02 0.09 0.07 0.07BasicNet Income Per Share, 0.02 0.08 0.06 0.07DilutedMarket Price of CommonStock Low 8.88 7.88 7.88 7.00 High 13.75 11.00 11.00 10.75*Quarterly data have been restated to account for inter-company transactions.Common Stock Information and Dividend PolicyAs of July 15, 1998, there were 7,099,139 shares of Common Stock outstanding held by approximately 129 holders of record. The number of holders does not include individual participants in security position listings. Management estimates that there are over 2,500 shareholders who own the Company's stock. The Company has not paid any dividends on its Common Stock since 1994. The Company's present policy is to retain earnings to finance the Company's business. Any future dividends will be dependent upon the Company's financial condition, results of operations, current anticipated cash requirements, acquisition plans and plans for expansion, and any other factors that the Company's Board of Directors deems relevant. The Company has no present intention of paying dividends on its Common Stock in the foreseeable future. The sum of quarterly earnings per share does not equal annual earnings per share as a result of the computation of quarterly versus annual average shares outstanding.Selected Financial DataIn thousands, except per share informationYear Ended 5/31/98 5/31/97 5/31/96 5/31/95 5/31/94 Sales $10,626 $10,542 $7,080 $4,415 $2,575Net Income $ 1,250 $ 1,725 $1,217 $ 249 $ 182Net Income Per $ 0.18 $ 0.25 $ 0.18 $ 0.04 $ 0.03Share, BasicWeighted Average Number of Shares 7,091 7,031 6,888 6,887 5,978(000)Net Income Per $ 0.17 $ 0.23 $ 0.16 $ 0.04 $ 0.03Share, DilutedWeighted Average Number of Shares 7,456 7,562 7,417 7,116 6,203(000)Stockholders' $ 8,688 $ 7,429 $4,887 $3,464 $3,215EquityTotal Assets $ 9,619 $ 8,515 $5,986 $4,619 $4,232Report of Independent AccountantsTo the Board of Directors and Shareholders ofSchmitt Industries, Inc.In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income, of cash flows and of changes in stockholders' equity present fairly, in all material respects, the financial position of Schmitt Industries, Inc. and its subsidiaries at May 31, 1998, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. The financial statements of Schmitt Industries, Inc. for the years ended May 31, 1996 and 1997 were audited by other independent accountants whose report dated July 10, 1997 expressed an unqualified opinion on those statements.PricewaterhouseCoopers LLPPortland, OregonJuly 17, 1998Schmitt Worldwide CustomersAdam Opel AGAkashic Memories CorporationAllied Signal Aerospace CompanyAllison Engine CompanyAmerican AxelAmerican Koyo Bearing Mfg. Corp.American NTN Bearing CompanyAsahi KomagAtlas Copco Airpower N.V.Audi AGBarden CorporationBlack & Decker CorporationBlohm Maschinenbau GmbhBMW Motoren GmbHBoeing CompanyBriggs & StrattonBryant Grinder CorporationCaterpillar Belgium S.A.Caterpillar IncorporatedChrysler CorporationCincinnati MilacronCummins Engine CompanyDaewoo International CorporationDaimler BenzDana CorporationDeere & CompanyDiesel Technology CorporationDresser-RandEaton CorporationEmerson Power TransmissionErwin JunkerFAG Bearing Ltd.Federal Mogul CorporationFiatFord France S.A.Ford Motor CompanyFuji ElectricGeneral Electric CorporationGeneral Motors CorporationGoldcrown MachineryGreenfield IndustriesGyhring AutomationHarley-Davidson Motor CompanyHMT Technology CorporationHonda Motor Company, Honda Of AmericaIBM DeutschlandINA Bearing CorporationJones & Shipman, Inc.Komag, Inc.Koube SteelKoyo Machinery USALandis, Landis LundLockheed MartinMercedes Benz AGMilwaukee Electric ToolMitsubishi ChemicalMitsubishi Material SiliconMitsubishi Motor Company Ltd.NASANavistar International TransportationNew Venture GearNissan Motors Ltd.Normac, Inc.Norton CompanyOkamoto CorporationOkunia Machinery, Inc.Opel Austria GmbHParker Hannifin CorporationPratt & WhitneyRaytheonReliance Electric CompanyRexnord CorporationReynolds MetalsRobert Bosch CorporationRobert Bosch GmbHSaturn CorporationSeagate SubstratesSEH America, Inc.Siemens Automotive SystemsSKF Bearing IndustriesSKF GmbHSumitomo Heavy IndustriesTexas InstrumentsThe Timken CompanyThe Torrington CompanyTimken FranceToyoda Machinery USA, Toyoda Machinery, Ltd.TRW Automotive ComponentsUnited Grinding TechnologiesUniversity Of Connecticut Grinding Research CenterVolkswagen AGVolvoWeldon Machine ToolWestern DigitalWeyburn-BartelCorporate OfficesSchmitt Industries, Inc.2765 NW Nicolai St.Portland, OR 97210Phone: (503) 227-7908Fax: (503) 223-1258Web: www.schmitt-ind.comSchmitt Europe Ltd.University of Warwick Science ParkSir William Lyons RoadCoventry, England CV4 7EZPhone: 44-1203-697192Fax: 44-1203-412697Schmitt Hofmann Systems GmbHSchwingungsmesstechnikBirkenweg 8 (Gewerbegebiet)D - 64665 Alsbach, GermanyPhone: 49-6257-9351-21Fax: 49-6257-9351-23Transfer Agent & RegistrarInterwest Transfer CompanySalt Lake City, Utah U.S.A.Banking ReferenceWells Fargo BankPortland, Oregon U.S.A.Certified Public AccountantsPricewaterhouseCoopers, LLPPortland, Oregon U.S.A.Stock ListingNASDAQ National MarketSymbol: SMITOfficersWayne A. CasePresident & Chief Executive OfficerDavid W. CaseVice President of OperationsAnnie N. WindsorChief Financial OfficerLinda M. CaseCorporate SecretaryDirectorsWayne A. CasePresident & Chief Executive OfficerSchmitt IndustrtiesMaynard BrownPartner, Brown McCue, AttorneysDavid L. Dotlich, Ph.D.Faculty, University of MichiganBusiness School, Business ConsultantDavid M. HudsonPresident, Coldstream Holdings, Inc.Trevor NelsonFinancial ConsultantThe Stewart Thomas GroupDennis T. PixtonPresident, Chief Operating OfficerMichaels of Oregon Co.John A. RuppBusiness Executive - Self EmployedForm 10-K AvailableA copy of the Company's Form 10-K as filed with the Securities and Exchange Commission is available to shareholders free of charge upon request addressed to the Secretary at the Company's Corporate Offices.Annual MeetingThe annual meeting of shareholders will be held Friday, October 9, 1998 at 3:00 p.m. at the Corporate Offices.Forward-looking StatementsThis summary annual report, other than the historical financial information, contains statements regarding future sales and earnings growth and projects or processes currently under development which are forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statements, including delays in technology or product developments, shipment or cancellation of orders, timing of future orders, customer reorganizations, fluctuations in demand and the other risks detailed from time-to-time in the Company's reports which are filed with the Securities and Exchange Commission.Schmitt Industries, Inc.2765 NW Nicolai StreetPortland, Oregon 97210Phone: (503) 227-7908Fax: (503) 223-1258Web: www.schmitt-ind.com EXHIBIT 21.1 SUBSIDIARIES OF SCHMITT INDUSTRIES, INC. AS OF MAY 31, 1998 State of Incorporation or Subsidiary Country in Which Organized --------------------------------- -------------------------- Schmitt Measurement Systems, Inc. Montana Schmitt Hoffman Systems GmbH Germany Schmitt Europe, Ltd. United Kingdom EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTSWe hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-3910) of Schmitt Industries, Inc. of our report dated July 17, 1998 appearing on page 13 of this Form 10-K.PricewaterhouseCoopers LLPPortland, OregonAugust 27, 1998 EXHIBIT 23.2 CONSENT OF INDEPENDENT AUDITORSWe consent to the inclusion in this Annual Report on Form 10-K, and to the inclusion in the Form S-8 Registration Statement No. 333-3910, of our report dated July 10, 1997, on our audits of the consolidated financial statements of Schmitt Industries, Inc., and its subsidiaries.Moss Adams LLPPortland, OregonAugust 28, 1998

5THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SCHMITTINDUSTRIES, INC. INDEPENDENT AUDITOR'S REPORT AND CONSOLIDATED FINANCIALSTATEMENTS MAY 31, 1998, 1997, 1996 AND IS QUALIFIED IN ITS ENTIRETY BYREFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR MAY-31-1998 JUN-01-1997 MAY-31-1998 1127 0 1198 0 4167 6838 2535 691 9619 913 0 0 0 5073 3615 9619 10626 10626 4632 4655 (262) 0 42 1601 351 0 0 0 0 1250 .18 .17

5 1,000 YEAR MAY-31-1997 JUN-01-1996 MAY-31-1997 505 168 2726 0 2480 6045 2232 531 8515 935 151 0 0 4952 2477 8515 10542 10542 3876 4370 (57) 0 16 2353 628 0 0 0 0 1725 .25 .23

5 1,000 YEAR MAY-31-1996 JUN-01-1995 MAY-31-1996 508 146 1412 0 1781 4033 1794 312 5986 925 0 0 0 4099 788 5986 7080 7080 2547 3024 62 0 45 1447 230 0 0 0 0 1217 .18 .16

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Schmitt Industries, Inc. Annual Report 1998

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Schmitt Industries, Inc.
Annual Report 1998