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2021 Report 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 For the fiscal year ended: May 31, 1999 or[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from___________________ to _________________ Commission File Number: 0-23996 SCHMITT INDUSTRIES, INC. (Exact name of registrant as specified in its charter) Oregon 91-1151989 (State or other jurisdiction of (IRS Employer Identification Number) 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 toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant's knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. [ X ] As of August 18, 1999, the aggregate market value of the registrant'sCommon Stock held by nonaffiliates of the registrant was $8,645,079 based on theclosing sales price of the registrant's Common Stock on the Nasdaq NationalMarket. On that date, there were 8,184,889 shares of Common Stock outstanding. Portions of the registrant's 1999 Annual Report to Shareholders areincorporated by reference into Parts II and IV hereof, and portions of theregistrant's definitive Proxy Statement for its 1999 Annual Meeting ofShareholders are incorporated by reference into Part III hereof. PART IITEM 1. BUSINESS INTRODUCTIONThe 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 in 1984.The Company name was changed to Schmitt Industries Inc. in 1987. In 1996, theCompany was "continued" from British Columbia to the state of Wyoming and thenmerged into its wholly owned subsidiary, Schmitt Industries, Inc., an Oregoncorporation; Schmitt Industries, Inc. was the surviving entity.The Company acquired its original balancing equipment technology pursuant to aseries of agreements from 1987 through 1991. The patented technology has beensubstantially enhanced and advanced by the Company in the past decade.In 1995, the Company acquired all the outstanding shares of TMA TechnologiesInc. ("TMA"), a designer, assembler and marketer of innovative industrialmeasurement systems based on laser light scatter technologies. As part of thepurchase, the Company agreed to make royalty payments to TMA's shareholders of5% on sales of TMA products and future Company products that utilize TMA'stechnologies, hardware, software and existing patents, subject to a maximumroyalty of $6 million. Shortly after the acquisition, TMA began operations inPortland and subsequently changed its name to Schmitt Measurement Systems, Inc.("SMS")In 1996, the Company formed a wholly owned subsidiary, Schmitt Europe, Ltd.("SEL"), under the laws of Great Britain to market and sell the Company'sproducts in Great Britain.In 1996, the Company purchased all the assets of the grinding wheel balancerdivision of Hofmann Machinenbau GmbH of Germany. The Company operates thisbusiness as Schmitt Hofmann Systems GmbH ("SHS"), a wholly owned subsidiary ofthe Company.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 PRODUCTSThe Company's principal product is the Schmitt Dynamic Balance System (the "SBSSystem"). 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 have topre-balance such devices as grinding wheels. This reduces the setup time of suchoperations and ensures a smoother and more efficient operation. Operating on aprinciple of mass compensation for wheel imbalance, the balance head containstwo movable eccentric weights, each of which is driven by electric motorsthrough a precision gear train. These weights can be repositioned to offset anyimbalance in a grinding wheel or other 2application. Imbalance or vibration is picked up by the sensor that feeds asignal 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, automaticmonitoring of balancing, display in both English and metric systems, instrumentgrade calibration, short balance process, measurement of both displacementand/or velocity, and minimal user maintenance. Benefits to the system user include improved quality of finished parts, ease ofproduct 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 0.02 microns andits adaptability to all types of machines.The precision grinding industry has a worldwide presence and is established inall industrialized countries. In each major industrialized country there arethree major market segments: machine tool builders, rebuilders and grindingmachine users.The first major market segment consists of machine tool builders who actuallydesign 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 have offeredand/or installed the SBS System include ANCA (Australia), Bryant GrindersCorporation (U.S.), Blohm Incorporated (U.S.), Blohm GmbH (Germany), CapcoMachinery (U.S.), Cincinnati Milacron (U.S.), Ecotech/SMTW (China/U.S.), GoldCrown Machinery (U.S.), Gleason Works (U.S.), Litton IAS/Landis Grinding (U.S.),Micron Machinery Limited (Japan/U.S.), Normac Incorporated (U.S.), NTC ToyamaAmerica (U.S./Japan), Okomoto (Japan), Okuma Machine (Japan), Royal MasterGrinders (U.S.), Shigiya Machine (Japan), Sumitomo Heavy Industry (Japan), CETOSHostivar (Czech Republic), TOS Holice (Czech Republic), Toyoda Machine (Japan)and Weldon Machine Tool (U.S.).One successful marketing channel to tool builders is grinding machine users.Those customers use the SBS System and enjoy the benefits from that product.When they purchase new systems from OEM's, they often request that SBS productsbe included with the new equipment.The second major market segment consists of machine tool rebuilders found in allindustrial nations who develop their business with users by offering tocompletely update and refurbish older machine tools. These rebuilders typicallytear the old machine apart and install new bearings, electronics, and advancedfeatures, such as the Schmitt Dynamic Balancing System. The Company currentlysells its products directly to all major machine rebuilders in the U.S. and tosome countries in Western Europe.Grinding machine users in industrialized countries are the third major marketsegment. Users become aware of the SBS System through trade shows, trademagazine advertising, distributors, field representatives, referrals and newmachine suppliers. 3Precision grinding is increasing as a worldwide method of material removal andprocessing. Therefore, the Company believes there may be an increase in marketgrowth and an increase in the need for automatic balancers. Precision grindingis necessary in all major manufacturing areas such as the automotive industry(camshafts, crankshafts, valves), bearings (roller and tapered types), ceramics(precision shaping), electric motors (shafts), pumps (shafts and turbines),aircraft (engine parts), and general manufacturing.The Company's business is conducted with many customers located throughout theworld. 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 added additional balancer designs to the Company'sworldwide product line. The SHS internal spindle balancers and ring balancersadd to the total balancer package available from the Company. These provendesigns, along with the original fluid-based balancer, allow Schmitt to broadenits machine applications. In Fiscal 1997, 1998 and 1999, net sales of the Company's balancing productstotaled $6,151,473, $7,532,112 and $7,377,879, respectively. Net sales ofbalancing products accounted for 58% of the Company's revenue in Fiscal 1997,71% in Fiscal 1998 and 93% in Fiscal 1999. See Note 9 to Consolidated FinancialStatements.COMPETITION. Management believes the SBS System is the only fully automaticbalancing system marketed in the world. All other competitive balancing productsrequire special setup and training or calibration to the specific machine. TheCompany believes the SBS System is currently the only balancing product on themarket that fits all machines with wheel sizes from 6 to 48 inches in diameterand a spindle rpm of 500 through 7,500.Competitive products include European manufacturers building water balancers andelectromechanical balancers similar to the SBS System. Water balancers arecurrently priced about 1.5 times the level of the SBS System because ofexpensive plumbing and water chambers machined into the wheel hub. The machinesare disassembled and parts remachined or replaced within the spindle assembly, aprocess that takes from one to two days. The system is "tuned" or "calibrated"to the machine by a factory service technician. Although water systems areunable to balance at low rpm, they work at mid- and high-speeds when properlymonitored by regularly cleaning filters and checking clearance of water jets.This technology is the oldest in the market and is employed in the SHS-installedsystems. After the acquisition of SHS in 1996, the Company considered Europeanelectromechanical balancers as its major competition due to their establishedbase in Europe.Several European companies located primarily in Switzerland, Germany, Spain andItaly produce electromechanical balancers similar to the SBS System. TheseEuropean balancers have electronic deficiencies that render them less effectivein solving essential balancing requirements. They cannot achieve the consistentlow balance levels obtained by the SBS System and cannot operate effectively at500 rpm (low speed) or at 7,500 rpm (high speed). In addition, these balancershave inferior brush and cable assemblies that cause down time and highmaintenance. None of these companies currently can compete effectively with theCompany in providing mounting adapters for all grinding machines.The SBS System list price is $7,995 worldwide. Water balancers produced byGerman companies other than SHS are priced at $11,000 to $15,000, andelectromechanical systems are priced at $8,000 to 4$10,000 worldwide. Management market surveys indicate customers perceive thevalue of an automatic balancer to be approximately $8,000; therefore, Companypricing is geared to obtaining a dominant market position and meetingcompetitive supplier prices. The market strategy is to establish the SBS Systemas the dominant product with the best quality, reliability and performance andsuperior economic value.SCHMITT MEASUREMENT SYSTEMS, INC.SMS manufactures and markets a line of laser-based, precision measurementsystems. In addition, SMS operates a precision light scatter measurementlaboratory utilized by third-party equipment manufacturers and others.Light scatter technology involves using lasers, optics and detectors to throw abeam of light on a material sample and record its reflection/transmission.Analysis of light scatter information can determine material characteristicssuch as surface roughness and defects, without introducing contaminants andcausing changes to the tested material.The principal products of SMS are laser-based measurement products andtechnology applicable to both industrial and military markets. Historically, TMA(now SMS) did not pursue industrial markets but instead concentrated on militarymarkets. The Company believes this strategy was a significant contributingfactor in the failure of TMA to achieve profitable operations.The Company has used the patents, patent applications, trademarks and otherproprietary technology acquired with TMA to successfully refocus the marketingefforts into industrial markets, including electronics, computer diskmanufacturers and flat-panel display manufacturers. In Fiscal 1997, 1998 and 1999, net sales of SMS products totaled $4,390,499,$3,093,972 and $579,844, respectively. Net sales of SMS products accounted for42% of the Company's revenue in Fiscal 1997, 29% in Fiscal 1998 and 7% in Fiscal1999. See Note 9 to Consolidated Financial Statements.SMS operates three product lines: laser-based light-scatter measurementproducts, a light-scatter measurement laboratory and other laser alignmentproducts.The measurement products use proprietary laser light scatter technology toperform non-contact surface measurement tests that quantify surfacemicro-roughness in a rapid, accurate, repeatable and non-destructive manner.Products are sold to manufacturers of disk drives and silicon wafers, bothindustries with fabrication processes that require precise and reliablemeasurements.Computer hard disks require exact manufacturing control and a narrow toleranceband for acceptable roughness. The read/write head of the disk drive flies overthe surface on a cushion of air generated when the rough surface of the rotatingdisk pulls air under the head. If the surface is too smooth, the head may stickor bind to the disk. If it is too rough, the head will fly too far from the disksurface, causing a reduction in data density or storage capacity. The TMS andDTM product series meet the challenges of disk drive manufacturers.The original TMS-2000 (Texture Measurement System) product revolutionizeddisk-manufacturing technology by providing the fastest, most accurate,non-contact texture measurement system in the world. It is currently being usedby most major disk drive manufacturers and provides fast, accurate, repeatablemicroroughness measurements and quadruples production throughput when comparedto other testing devices. 5The DTM 2000 (Dual Texture Measurement System) is the fastest, most accurate,non-contact automated texture measurement system in the world. This productprovides affordable 100% inspection and is currently being used by most majormanufacturers of computer disk drives. The advanced laser-based system isideally suited for testing in production or quality control applications. Anautomated conveyor system moves the disks on a cassette. Each disk isautomatically raised from the cassette, scanned simultaneously on both sides bytwin lasers and returned to the cassette. Testing speeds are compatible withmost in-line production processes. Customers of the DTM and TMS series includeSeagate Substrates, HMT Technology Corporation, Western Digital and Komag, Inc.The capabilities of these products were enhanced significantly in Fiscal 1999with the development and introduction of the "RC" series. This product useslight scatter technology to simultaneously measure roughness of the disk surfacein two directions. The read/write head travels over the disk in two ways,radially when moving to another disk sector and circumferentially whenprocessing information on the disk. With emerging disk technology, two separateroughness measurements averaging below one angstrom are required so the head canoperate correctly. This measurement method was not possible until developed bySchmitt and is not possible through any other measurement means that are costeffective. Surface roughness can now be measured to levels below 0.5 Angstroms(the point of a needle is 1 million angstroms in diameter).The TMS-2000W and TMS-3000W (Texture Measurement Systems) are the SMS productsthat provide fast, accurate, repeatable measurements for manufactures of siliconwafers, computer chips and memory devices. The system provides measurements to afew hundredths of an angstrom, a level unachievable by other testing devices.Silicon wafers are carefully cut and polished to provide the base upon which acomputer or memory chip is produced. Chip manufacturing is extremely dependenton the beginning surface roughness of the wafer as all silicon wafers exhibit amicroscopic level of surface roughness, stemming from chemical deposition,grinding, polishing, etching, or any number of other production techniques. Thisindustry demands manufacturing precision to increase performance and capacityand the TMS-2000W and TMS-3000W help achieve these goals. This system alsoprovides a way for SMS customers to quantify and control its manufacturingprocess.SMS provides a highly advanced, extremely precise measurement services laboratory to a wide variety of industrial and commercial businesses, usingadvanced laser light scatter technology. The laboratory uses three SMS CASIScatterometers for measuring surface roughness. The true value of the laboratoryis not only its extremely precise measurement capability but also the test itemis not altered, touched or destroyed. Thus, the laboratory is widely used by thesemiconductor and computer hard disk industries, as well as manufacturers ofcritical optical components in aerospace and defense systems. Customers of thelaboratory have included Aerojet, AT&T Bell Labs, Eastman Kodak, GeneralElectric, IBM, NASA and dozens of other industrial companies, universities andgovernment agencies.The CASI Scatterometers are angle-resolved BRDF measurement instrumentsproviding customers with precise roughness measurements of optical surfaces,diffuse materials, semiconductor wafers, magnetic storage media,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 detector sweeps around the sample in the incident plane measuringscattered and specular light. During the scan, the computer controls gain,filter and aperture changes through user-defined parameters. The instrument 6background is measured separately and can be compared with the sample data.Results print on the HP PaintJet printer as viewgraphs or publication-readyfigures.The laboratory generated approximately 2% of SMS's total revenue during Fiscal1997, 3% during Fiscal 1998 and 20% during Fiscal 1999. Total revenue for thisbusiness is expected to rise modestly in the future but to always represent asmall percentage of SMS's business. Use of the laboratory leads to orders forSMS's laser-based light scatter measurement products by its customers andtherefore represents one of the best marketing channel for SMS's current andfuture products. Existing products (such as the iScan and the Model 2002alignment laser system) and products being developed in conjunction with themeasurement services laboratory are being marketed to a variety of industrialcustomers.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 a button.Each measurement takes less than five seconds. The results are displayed andstored in system memory. The Scan can store 700 measurements in 255 files andprovides the capability to program pass/fail criteria. Software is available forcontrol, analysis and file conversion. From a single measurement, a user candetermine RMS surface roughness, reflectance and scatter light levels (BRDF) onflat or curved surfaces under any lighting conditions.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. The 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.On April 23, 1998, the Company entered into a Technology Transfer Agreement withCenterline Engineering, Inc. and several individuals for the purchase of therights to a non-contact gauging apparatus. The $100,000 purchase included thetechnology, the prototype and instruction manuals, technical information, andrelated patent applications. In Fiscal 1999, SMS developed the initial productutilizing that technology and installed the equipment at a beta-test site.Introduction of the new product is expected to occur in Fiscal 2000.BUSINESS AND MARKETING STRATEGY The Company designs, assembles and markets all of its products. The Company'soperations are divided into a number of different areas. The Vice President ofOperations directs the production organization, and is responsible for allassembly, purchasing and production engineering. The Product Marketing Divisionis responsible for the sale of SBS System products and is managed by thePresident/CEO and four Marketing Managers. Three of the Marketing Managers areresponsible for domestic sales while the fourth 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 for providingtechnical support to customers and is managed by the Vice President ofOperations. Finally, there is a research and development group superviseddirectly by the President/CEO and the Vice President of Operations.The Company markets and sells the SBS System in a variety of ways. First, theCompany uses the conventional channels provided by independent manufacturer'srepresentatives and distributors. There are 7currently 25 individuals and/or organizations in the United States acting in oneof these capacities. Independent sales agents are paid a 10% commission;distributors are sold products at a 15% discount.Second, trade shows represent a significant amount of marketing/sales effort.These events are held throughout the world and have proven to be excellentsources of business. A Company representative, usually one of the marketingmanagers and/or the President/CEO, attends these events along with local Companyrepresentatives. These individuals operate a display booth featuringprofessional products, an SBS System demonstration stand and product andtechnical literature. Representatives from all facets of the market to which theCompany directs its sales efforts attend these trade shows.Third, original equipment manufacturers often include the SBS System on themachine tools they produce. Users thus purchase the SBS System concurrently withthe machine tools. The SBS Systems are often installed by machine builders priorto displaying their own machine tools at various trade shows and these samplesoften become endorsements that prove beneficial to the Company's sales efforts.In the United States, most products are shipped directly to customers from theCompany'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 European subsidiaries,who in turn sell the products to the end users.Similar to the parent company, SMS uses a variety of methods to market and sellits products. First, a Marketing Manager who is under the direction of thePresident/CEO directs the overall marketing efforts. Second, the Company uses anindependent manufacturer's representative to work with and service customers.That agent is paid a 5% commission on units he is responsible for selling.Third, trade shows represent a significant amount of marketing/sales effort. ThePresident/CEO attends these events along with various Company representatives.These individuals operate a display booth featuring professional products, SMSproduct demonstrations and product and technical literature. Representativesfrom all facets of the market to which the Company directs its sales effortsattend these trade shows. Fourth, the Company had an Exclusive DistributionAgreement, with Sloan Technology, Inc. (dba Veeco Process Metrology), asubsidiary of Veeco Instruments, Inc. (NASDAQ : VECO). Under this agreement,Veeco was appointed the exclusive distributor for the promotion and sale of SMSproducts. Veeco was also to provide customers with after-sale services. Thisagreement was mutually terminated in December 1998. In fiscal 1999,approximately 2% of the Company's total revenue was attributable to sales madeto Veeco. No customer accounted for more than 10% of the Company's total revenuein Fiscal 1999.All SMS products are manufactured in the Portland, Oregon facility and shippeddirectly to customers around the world from that location.The SBS System customer base consists of over 250 companies and the SMS customer base consists of approximately 200 companies, many of which are also purchasersof the Company's balancing products.MANUFACTURINGThe Company does not use any unique sources of supply or raw materials in itsproducts for either SBS System balancing products or SMS measurement products.Essential electronic components used are available in large quantities fromvarious suppliers. These electronic components are assembled into the SBS Systemand SMS electronic control units to meet the Company's quality and assemblystandards. Company-owned software and firmware are coupled with the electroniccomponents to provide the basis 8of the Company's various electronic control units. The Company believes severalsources of supplies exist for all electronic components and assembly work usedin its 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 produced tothe 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 testvendor-supplied components. Component inventory of finished vendor-suppliedparts is held on Company property to assure adequate flow of parts to meetcustomer order requirements. Inventory is monitored by a computer control systemdesigned to assure timely re-ordering of components.In-house personnel assemble various products and test all finished componentsbefore placing them in the finished goods inventory. Finished goods inventory ismaintained via computer to assure timely shipment and service to customers. Allcustomer shipments are from the finished goods inventory.In November 1996, the Company's Quality Control Program received full ISO-9001certification.PROPRIETARY TECHNOLOGYThe Company's success depends in part on its proprietary technology, which theCompany attempts to protect through patents, copyrights, trademarks, tradesecrets and other measures.The Company has U.S. patents covering both its SBS and SMS products, processesand methods which the Company believes provide it with a competitive advantage.The Company has a policy of seeking patents when appropriate on inventionsconcerning new products and improvements as part of its ongoing research,development and manufacturing activities. While patents provide certain legalrights of enforceability, there can be no assurance that the historical legalstandards surrounding questions of validity and enforceability will continue tobe applied or that current defenses as to issued patents will, in fact, beconsidered substantial in the future. There can be no assurance as to the degreeand range of protection any patent will afford, whether patents will issue orthe extent to which the Company may inadvertently infringe upon patents grantedto others."SBS" and "SMS" are registered trademarks and are affixed to all products andliterature created in the Company's balancer and measurement product lines,respectively. The Company also has registered trademarks covering various SMSsystems and instruments.The Company manufactures its SBS products under copyright protection in the U.S.for electronic board designs. Encapsulation of the finished product further protects the Company's technologies including software.The Company also relies upon trade secret protection for its confidential andproprietary information. There can be no assurance that others will notindependently develop substantially equivalent 9proprietary information and techniques or otherwise gain access to the Company'strade secrets or disclose such technology or that the Company can meaningfullyprotect its trade secrets.While the Company pursues patent, trademark, trade secret and copyrightprotection for products and various marks, it also relies on know-how andcontinuing technology advancement, manufacturing capabilities, affordable,high-quality products, new product introduction and direct marketing efforts todevelop and maintain its competitive position.PRODUCT DEVELOPMENTPrior to Fiscal 1996, research and development activities of the Company werefocused on the enhancement of the existing product lines for balancers and ondevelopment work toward the ring balancer product. Since its acquisition of TMA,the Company has expended significant efforts evaluating existing and potentialnew products for the light-scatter precision measurement market.In Fiscal 1997, the Company began an aggressive research and development programto expand the product lines and capabilities with the goal to enter new marketareas and enhance products in existing market areas. The goal was to reducereliance the Company had on historic market segments. During Fiscal 1999, theCompany continued to develop new balancing and laser measurement products.The new SB-4500 unit controls balancing in applications with speeds ranging from300 to 30,000 rpm compared to a range of 500 to 10,000 rpm with the priorSchmitt product. Vibrations are now measured down to 0.02 microns or 0.75millionths of an inch, a ten-fold performance improvement over the prior controlunit. Finally, customers can balance their grinding machines faster, reducingcostly down time and increasing factory throughput. The multi-function unit nowprovides the versatility to control several activities including Schmitt'smechanical and fluid based balancers and the new AEMS (Acoustical EmissionMonitoring System) product. This new generation of computer control will allowthe future addition of new Schmitt products through the insertion of electroniccontrol cards in any of the four control slots located in the SB-4500.Schmitt developed the AEMS (Acoustical Emissions Monitoring System) product tomeet the needs of its grinding customers. The product is added to the SB-4500balance control unit via insertion of an electronic control card. It monitorsthe dressing and grinding process of the customer by direct measurement ofmachine-generated acoustic signals. By monitoring the high frequency soundsignal generated by contact between the wheel and work piece, the systemautomatically determines when wheel contact is made. Users can eliminate the"gap" time from their grinding process and also automatically detect thebeginning of a wheel "crash" and immediately signal the grinder to stop beforereal damage occurs. Customers can also use the acoustic information madeavailable by the AEMS system to monitor the quality and timing of wheel contactwith either the work part or the wheel dresser, thereby further improving thewhole process. The benefits of the AEMS "gap and crash" product to the customerinclude time savings from quick and easy setups, improved dressing and grindingprocess, and elimination of expensive part and machine damage.The grinding industry is moving rapidly toward higher speed grindingapplications and the Hydrokompenser system has been redesigned to appeal tothese environments (defined as those with grinding speeds up to 20,000 rpm).Until now, the industry has not had a product that could be used in the emerginghigh speed grinding environments. This industry segment requires the mostprecise grinding and therefore control that only Schmitt products can provide.Now controlled by the SB-4500 computer control unit, the Hydrokompenserpossesses the same precise and exacting performance standards required by thehigh speed grinding industry 10 Disk drive media of the future will have greater storage capacity on the samesize disk. Increasing the density of the information stored on the disk is themain method to increase capacity. To do so, the roughness of the disk media mustbe reduced to levels below ten angstroms, the current production standard. Toassure those levels are reached and to avoid significant postproduction rejects,the customer may test 100% of all disks. Schmitt Measurement products continueto provide manufacturers with that capability and those tools were improveddramatically during the most recent fiscal year. The TMS-2000RC and DTM-2000RCare examples of technology enhancing or complementing existing products.Companies that grind the production rolls used in such industries such as steel,brass, copper, printing and paper face a long, slow manual process to assurethese rolls are ground to the dimensions and smoothness required before they canbe used in their factory. Problems experienced include the difficulty ofobtaining proper alignment of rolls during grinding, the time-consumingmeasurement of roll geometry and surface finish during grinding, the need forexpensive periodic re-grinding of used rolls and the resulting costly factorydown time. The industry has been seeking a solution to these problems that wouldautomate the process and allow grinding of rolls to an increased level ofprecisionThe solution to the dilemma faced by the roll grinding industry is to useSchmitt patented laser light scatter technology to speed up the process andreduce costs. The computer controlled system measures rolls to exact dimensionsthat are established by the customer. Evaluated are the alignment of the roll inthe grinder, the diameter of the roll compared to established levels and themircroroughness of the surface. A process that has been totally manual has nowbecome fully automated and much more accurate. This new laser-based technologyis scheduled to be introduced in the second quarter of Fiscal 2000. This newSchmitt system results in the lowest possible measurement costs to the customeryet produces by far the highest quality product, together with improveddocumentation. User costs decline because this non-contact measuring process isdesigned to allow quicker setups of the roll grinder and in-process gauging(rather than stopping the process to make measurements). The result is increasedgrinding throughput as the yield is increased due to these productionefficiencies. Rolls can be inspected on a 100% basis rather than the currentrandom test method. The product is currently under testing at a beta test sitewhere several companies within the industry have seen it and are interested inlearning more about the product.During Fiscal 1997, 1998 and 1999, the Company's research and developmentexpense totaled $205,800, $379,798 and $462,136 respectively.INTERNATIONAL SALESThe Company's sales in the last three fiscal years have been generated from thefollowing geographic areas: North America Europe Asia ----------------- -------------- ------------ Fiscal 1999 $4,901,460 $2,798,471 $257,792Fiscal 1998 8,006,428 2,488,344 131,312Fiscal 1997 8,664,819 1,601,359 275,794BACKLOGThe Company does not generally track backlog. Normally, orders are shippedwithin several weeks after receipt unless the customer requests otherwise. 11EMPLOYEESAs of July 16, 1999, the Company employed 53 individuals worldwide on afull-time basis. There were no regular part-time employees. None of the Company's employees is covered by a collective bargaining agreement.ITEM 2. PROPERTIESThe Company's design and assembly facilities and executive offices are locatedin a 7,500-square foot building in Portland, Oregon owned by the Company; a33,000-square foot facility, located across the street from the executiveoffices and also owned by the Company, houses SMS's operations. Schmitt EuropeLtd. occupies a 1,893-square foot facility in Coventry, England pursuant to afive-year lease beginning February 1, 1997 with a basic monthly rent ofL1,708 (approximately $2,737 as of July 16, 1999). 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$2,904 as of July 16, 1999). The Company believes its facilities are adequate tomeet its currently foreseeable needs.ITEM 3. LEGAL PROCEEDINGSThere are no material legal proceedings currently pending against the Company.ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNo matters were submitted to a vote of the security holders of the Companyduring the fourth quarter ended May 31, 1999. PART IIITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERSSince 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. TheCommon Stock is traded under the symbol "SMIT."The following tables set forth the high and low sales prices of the Company'sCommon Stock as reported on the Nasdaq National Market for the periodsindicated. 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 YEAR ENDED MAY 31, 1999 HIGH LOW ------------------------------- ------------ ------------ First Quarter $6.38 $3.88 Second Quarter $5.00 $3.13 Third Quarter $4.38 $3.00 Fourth Quarter $4.00 $1.94 12As of July 16, 1999, there were 8,184,889 shares of Common Stock outstandingheld by approximately 130 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 the Company'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 DATAThe information required by this Item is included in the Company's Annual Reportto Shareholders for the fiscal year ended May 31, 1999 ("Annual Report") underthe heading "Selected Financial Data" and is incorporated herein by reference.ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe information required by this Item is included in the Annual Report under theheading "Management's Discussion and Analysis" and is incorporated herein byreference.ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISKINTEREST RATE RISKThe Company does not have any derivative financial instruments as of May 31,1999. However, the Company is exposed to interest rate risk. The Company employsestablished policies and procedures to manage its exposure to changes in themarket risk of its marketable securities.The Company's interest income and expense are most sensitive to changes in thegeneral level of U.S. and European interest rates. In this regard, changes inU.S. and European interest rates affect the interest earned on the Company'scash equivalents and marketable securities as well as interest paid on debt.The Company has lines of credit and other debt whose interest rates are based onvarious published prime rates that may fluctuate over time based on economicchanges in the environment. The Company is subject to interest rate risk andcould be subject to increased interest payments if market interest ratesfluctuate. The Company does not expect any change in the interest rates to havea material adverse effect on the Company's results from operations.FOREIGN CURRENCY RISKThe Company operates subsidiaries in the United Kingdom and Germany. TheCompany's business and financial condition is, therefore, sensitive to currencyexchange rates or any other restrictions imposed on their currencies. To date,the foreign currency exchange rates have not significantly 13impacted the Company's profitability.ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAThe 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 ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREIn July 1997, the Company replaced its independent accountant, Moss Adams LLP,with PricewaterhouseCoopers LLP. The Audit Committee of the Company's Board ofDirectors made this decision.Moss Adams LLP's report for the fiscal year ended May 31, 1997 did not containan adverse opinion or disclaimer of opinion, nor was it qualified or modified asto uncertainty, audit scope or accounting principles. During Fiscal 1997 anduntil Moss Adams LLP's dismissal, there were no disagreements with Moss AdamsLLP on any matter of accounting principles or practices, financial statementdisclosure or auditing scope of procedure, which disagreements, if not resolvedto the satisfaction of Moss Adams LLP, would have caused it to make reference tothe subject matter of the disagreements in connection with its report. PART III Certain information required by Part III is included in the Company's definitiveProxy Statement for its 1999 Annual Meeting of Shareholders ("Proxy Statement")and is incorporated herein by reference. The Proxy Statement will be filedpursuant to Regulation 14A of the Securities Exchange Act of 1934 not later than120 days after the end of the fiscal year covered by this Report.ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTThe information required by this item is included in the Proxy Statement underthe heading "Election of Directors" and is incorporated herein by reference.ITEM 11. EXECUTIVE COMPENSATIONThe information required by this item is included in the Proxy Statement underthe heading "Executive Compensation" and is incorporated herein by reference.ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTThe information required by this item is included in the Proxy Statement underthe heading "Principal Shareholders" and is incorporated herein by reference.ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSThe information required by this item is included in the definitive ProxyStatement under the heading "Certain Transactions" and is incorporated herein byreference. 14 PART IVITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. REPORT OF INDEPENDENT ACCOUNTANTS: To the Board of Directors and Shareholders of Schmitt Industries, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, 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, 1999 and 1998, and the results of their operations and their cash flows for the years 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 audits. We conducted our audits 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 audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Portland, Oregon July 13, 1999 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 sheet of Schmitt Industries, Inc. and Subsidiaries as of May 31, 1997, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for the year 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, 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 15 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 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, 1999 and are incorporated by reference herein: Annual Report Page Number --------------- A. Consolidated Balance Sheets as of May 31, 1999 and May 31, 1998 ...................................... 10 B. Consolidated Statements of Operations for each of the years ended May 31, 1999, May 31, 1998 and May 31, 1997 .......................................... 11 C. Consolidated Statements of Cash Flows for each of the years ended May 31, 1999, May 31, 1998 and May 31, 1997 .......................................... 12 D. Consolidated Statements of Changes in Stockholders' Equity for each of the years ended May 31, 1999, May 31, 1998 and May 31, 1997 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. 16 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 30, 1999Pursuant 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 30, 1999.SIGNATURE TITLE--------- ----- /s/ Wayne A. Case Chairman of the Board, President and Chief-------------------------------------- Executive Officer Wayne A. Case (Principal Executive Officer) /s/ Robert C. Thompson Chief Financial Officer/Treasurer-------------------------------------- (Principal Financial and Accounting Officer)Robert C. Thompson /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/s/ John A. Rupp Director--------------------------------------John A. Rupp 17 INDEX TO EXHIBITS EXHIBITS DESCRIPTION ----------- --------------------------------------------------------------------------------------------- 3(i) Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the "Company"). Incorporated by reference to Exhibit 3(i) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1998.......................................................... 3(ii) Second Restated Bylaws of the Company Incorporated by reference to Exhibit 3(ii) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1998................. 10.1 Schmitt Industries, Inc. Amended & Restated Stock Option Plan. Incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1998.................................................................................... 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. Incorporated by reference to Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1998............................................ *13.1 Annual Report to Shareholders of Schmitt Industries, Inc. for fiscal year ended May 31, 1999 *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 18 Exhibit 13.110CONSOLIDATED BALANCE SHEETSFor the years ended May 31, 1999 and 1998 Schmitt Industries, Inc. 1999 Annual Report 1999 1998 ASSETSCURRENT ASSETSCash ....................................................... $ 268,888 $ 1,127,076Accounts receivable ........................................ 1,423,611 1,197,951Inventories ................................................ 4,444,012 4,166,755Prepaid expenses ........................................... 75,454 120,466Deferred tax asset ......................................... -- 34,623Income tax receivable ...................................... 295,964 190,806 ------------ ------------ 6,507,929 6,837,677 ------------ ------------PROPERTY AND EQUIPMENTLand ....................................................... 299,000 299,000Buildings and improvements ................................. 1,194,664 1,190,920Furniture, fixtures, and equipment ......................... 942,776 906,058Vehicles ................................................... 144,064 139,261 ------------ ------------ 2,580,504 2,535,239Less accumulated depreciation and amortization ............. 926,314 691,258 ------------ ------------ 1,654,190 1,843,981 ------------ ------------OTHER ASSETSLong-term investments ...................................... 2,135,000 --Long-term deferred tax asset ............................... 898,628 837,560Other assets ............................................... 86,667 100,000 ------------ ------------ 3,120,295 937,560TOTAL ASSETS ............................................... $ 11,282,414 $ 9,619,218 ------------ ------------ ------------ ------------LIABILITIES AND STOCKHOLDERS' EQUITYCURRENT LIABILITIESAccounts payable ........................................... $ 392,287 $ 681,524Accrued royalties .......................................... 10,535 55,335Accrued commissions ........................................ 105,080 131,154Other accrued liabilities .................................. 175,133 63,076Income taxes payable ....................................... 12,819 -- ------------ ------------ 695,854 931,089 ------------ ------------COMMITMENTS AND CONTINGENCIES (NOTE 8) ..................... -- --STOCKHOLDERS' EQUITYCommon stock, no par value, 20,000,000 shares authorized, 8,184,889 and 7,099,139 shares issued and outstanding at May 31, 1999 and 1998, respectively ................... 7,284,445 5,072,634Accumulated other comprehensive income (loss) .............. (201,781) (147,708)Retained earnings .......................................... 3,503,896 3,763,203 ------------ ------------ 10,586,560 8,688,129 ------------ ------------TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................. $ 11,282,414 $ 9,619,218 ------------ ------------ ------------ ------------ 11CONSOLIDATED STATEMENTS OF OPERATIONSFor the years ended May 31, 1999, 1998 and 1997 1999 1998 1997 Net sales .................................................. $ 7,957,723 $ 10,626,084 $ 10,541,972Cost of sales .............................................. 4,145,280 4,632,485 3,875,790 ------------ ------------ ------------ Gross profit ........................................... 3,812,443 5,993,599 6,666,182 ------------ ------------ ------------Operating expenses:General, administrative and sales expense .................. 3,841,155 4,275,059 4,164,271Research and development expense ........................... 462,136 379,798 205,800 ------------ ------------ ------------ Total operating expenses ............................... 4,303,291 4,654,857 4,370,071 ------------ ------------ ------------Operating (loss) income .................................... (490,848) 1,338,742 2,296,111 ------------ ------------ ------------Other income and expense: Interest expense ......................................... (22,736) (42,231) (16,273) Interest income .......................................... 24,364 44,581 25,007 Unrealized gain on trading securities .................... -- -- 22,400 Miscellaneous income ..................................... 93,946 259,924 25,430 ------------ ------------ ------------ Other income and expense ............................... 95,574 262,274 56,564 ------------ ------------ ------------(Loss) income before provision for income taxes ............ (395,274) 1,601,016 2,352,675 ------------ ------------ ------------(Benefit) provision for income taxes ....................... (135,967) 350,901 627,947 ------------ ------------ ------------Net (loss) income .......................................... $ (259,307) $ 1,250,115 $ 1,724,728 ------------ ------------ ------------ ------------ ------------ ------------Net (loss) income per common share, basic .................. $ (0.03) $ 0.18 $ 0.25 ------------ ------------ ------------ ------------ ------------ ------------Weighted average number of common shares, basic ............................................ 7,591,699 7,091,269 7,031,449 ------------ ------------ ------------ ------------ ------------ ------------Net (loss) income per common share, diluted ................ $ (0.03) $ 0.17 $ 0.23 ------------ ------------ ------------ ------------ ------------ ------------Weighted average number of common shares, diluted .......................................... 7,591,699 7,456,172 7,561,744 ------------ ------------ ------------ ------------ ------------ ------------12CONSOLIDATED STATEMENTS OF CASH FLOWSFor the years ended May 31, 1999, 1998 and 1997 1999 1998 1997 CASH FLOWS RELATING TO OPERATING ACTIVITIESNet (loss) income .......................................... $ (259,307) $ 1,250,115 $ 1,724,728Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: Depreciation ............................................. 294,513 347,228 264,440 Amortization ............................................. 13,333 -- 72,393 Unrealized gain on trading securities .................... -- -- (22,400) Deferred taxes ........................................... (26,445) (57,183) 198,426(Increase) decrease in: Trading securities ....................................... -- 168,000 -- Accounts receivable ...................................... (225,660) 1,527,561 (1,313,707) Inventories .............................................. (277,257) (1,686,935) (235,556) Prepaid expenses ......................................... 45,012 (89,798) (14,762) Income taxes receivable .................................. 18,914 (190,806) -- Other assets ............................................. -- (9,585) (90,415)Increase (decrease) in: Accounts payable ......................................... (289,237) 150,857 185,839 Accrued liabilities, royalties, and commissions .......... 41,183 (57,246) 62,198 Income taxes payable ..................................... 12,819 (44,809) (226,186) ------------ ------------ ------------ Net cash (used in) provided by operating activities ..................................... (652,132) 1,307,399 604,998 ------------ ------------ ------------CASH FLOWS RELATING TO INVESTING ACTIVITIESPurchase of property and equipment ......................... (119,380) (514,283) (461,168)Proceeds from disposal of equipment ........................ 14,658 24,250 10,651Acquisition of assets of Hofmann Maschinenbau GmbH ........................................ -- -- (496,000) ------------ ------------ ------------ Net cash used in investing activities ................ (104,722) (490,033) (946,517) ------------ ------------ ------------CASH FLOWS RELATING TO FINANCING ACTIVITIESRepayment of long-term debt ................................ -- (179,983) (34,895)Common stock repurchased ................................... (47,261) -- --Exercise of stock options .................................. -- 96,469 409,106 ------------ ------------ ------------Net cash (used in) provided by financing activities ........ (47,261) (83,514) 374,211 ------------ ------------ ------------Effect of foreign exchange translation on cash ............. (54,073) (111,438) (36,270) ------------ ------------ ------------(DECREASE) INCREASE IN CASH ................................ (858,188) 622,414 (3,578)CASH, beginning of year .................................... 1,127,076 504,662 508,240 ------------ ------------ ------------CASH, end of year .......................................... $ 268,888 $ 1,127,076 $ 504,662 ------------ ------------ ------------ ------------ ------------ ------------SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATIONCash paid during the period for interest ................... $ 22,736 $ 42,231 $ 15,272 ------------ ------------ ------------Cash paid during the period for income taxes ............... $ 6,800 $ 405,800 $ 450,871 ------------ ------------ ------------ ------------ ------------ ------------SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIESAcquisition of long-term investment ........................ $ 2,135,000 -- --Reduction of goodwill....................................... $ -- $ (155,438) $ (215,973)Income tax benefit of stock options exercised............... $ 124,072 $ (23,754) $ (444,793) ------------ ------------ ------------ ------------ ------------ ------------ 13CONSOLIDATED STATEMENTS OFCHANGES IN STOCKHOLDERS' EQUITYFor the years ended May 31, 1999, 1998 and 1997 Accumulated other Retained Comprehensive Shares Amount Earnings Income (Loss) ------------ ------------ ------------- -------------- BALANCE, MAY 31, 1996 ......................... 6,918,139 $ 4,098,512 $ 788,360 $-- Stock options exercised ....................... 163,750 409,106 -- -- Income tax benefit from exercise of stock options ............................... -- 444,793 -- -- Net income .................................... -- -- 1,724,728 -- Cumulative foreign exchange translation adjustment ...................... -- -- -- (36,270) ------------ ------------ ------------ ------------ BALANCE, MAY 31, 1997 ......................... 7,081,889 4,952,411 2,513,088 (36,270) COMPREHENSIVE INCOME, YEAR ENDED MAY 31, 1997 ................................ Stock options exercised ....................... 17,250 96,469 -- -- Income tax benefit from exercise of stock options ............................... -- 23,754 -- -- Net income .................................... -- -- 1,250,115 -- Cumulative foreign exchange translation adjustment ...................... -- -- -- (111,438) ------------ ------------ ------------ ------------ BALANCE, MAY 31, 1998 ......................... 7,099,139 5,072,634 3,763,203 (147,708) COMPREHENSIVE INCOME, YEAR ENDED MAY 31, 1998 ................................ Stock options exercised ....................... 485,750 869,475 -- -- Income tax benefit from exercise of stock options ............................... -- 124,072 -- -- Notes received for stock options .............. -- (869,475) -- -- Stock issued for long-term investment .................................. 610,000 2,135,000 -- -- Common shares repurchased ..................... (10,000) (47,261) -- -- Net loss ...................................... -- -- (259,307) -- Cumulative foreign exchange translation adjustment ...................... -- -- -- (54,073) ------------ ------------ ------------ ------------ BALANCE, MAY 31, 1999 ......................... 8,184,889 $ 7,284,445 $ 3,503,896 $ (201,781) ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ COMPREHENSIVE (LOSS), YEAR ENDED MAY 31, 1999................................. 13 Total Comprehensive Total Income ------------ ------------ BALANCE, MAY 31, 1996 ......................... $ 4,886,872 $ --Stock options exercised ....................... 409,106 --Income tax benefit from exercise of stock options ............................... 444,793 --Net income .................................... 1,724,728 1,724,728Cumulative foreign exchange translation adjustment ...................... (36,270) (36,270)-----------------------------------------------------------------------------------------BALANCE, MAY 31, 1997 ......................... 7,429,229COMPREHENSIVE INCOME, YEAR ENDED MAY 31, 1997 ................................ $ 1,688,458Stock options exercised ....................... 96,469Income tax benefit from exercise of stock options ............................... 23,754Net income .................................... 1,250,115 1,250,115Cumulative foreign exchange translation adjustment ...................... (111,438) (111,438)-----------------------------------------------------------------------------------------BALANCE, MAY 31, 1998 ......................... 8,688,129COMPREHENSIVE INCOME, YEAR ENDED MAY 31, 1998 ................................ $ 1,138,677Stock options exercised ....................... 869,475Income tax benefit from exercise of stock options ............................... 124,072Notes received for stock options .............. (869,475)Stock issued for long-term investment .................................. 2,135,000Common shares repurchased ..................... (47,261)Net loss ...................................... (259,307) (259,307)CUMULATIVE FOREIGN EXCHANGE TRANSLATION ADJUSTMENT ...................... (54,073) (54,073)-----------------------------------------------------------------------------------------BALANCE, MAY 31, 1999 ......................... $ 10,586,560 ------------ ------------COMPREHENSIVE (LOSS), YEAR ENDED MAY 31, 1999................................. $ (313,380)14NOTE 1ORGANIZATION AND NATURE OF OPERATIONSSchmitt Industries, Inc. (the Company) is engaged in the design, assembly,marketing, and distribution of electronic and mechanical components for machinetool products and laser measurement systems worldwide. In June 1996, the Companyestablished Schmitt Europe, Ltd. (SEL). In addition, in December 1996, theCompany established Schmitt Hofmann Systems GmbH (SHS) which acquired certainassets of the grinding wheel balance division of Hofmann Maschinenbau GmbH.NOTE 2SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPRINCIPLES OF CONSOLIDATIONThe consolidated financial statements include those of the Company and itswholly-owned subsidiaries. The wholly owned subsidiaries are Schmitt MeasurementSystems, Inc. (SMS), Schmitt Europe, Ltd. (SEL) and Schmitt Hofmann Systems,GmbH (SHS). All significant intercompany accounts and transactions have beeneliminated in the preparation of the consolidated financial statements.REVENUE RECOGNITIONRevenue from product sales is recognized upon shipment. Sales are reported netof applicable cash discounts and allowances for returns.INVENTORIESInventory is valued at the lower of cost or market. Cost is determined on theaverage cost basis. As of May 31, 1999 and 1998, inventories consisted of rawmaterials ($2,292,389 and $2,502,310 respectively), work-in-process ($222,888 and $60,075 respectively), and finished goods ($1,928,735 and $1,604,370,respectively).PROPERTY AND EQUIPMENTProperty and equipment are stated at cost. Depreciation is computed using thestraight-line method over estimated useful lives of three to seven years forfurniture, fixtures, and equipment; three years for vehicles; and twenty-fiveyears for buildings and improvements.CONCENTRATION OF CREDIT RISKFinancial instruments that potentially expose the Company to concentration ofcredit risk are trade accounts receivable. Credit terms generally include adiscount of 1-1/2% if the invoice is paid within ten days, with the net amountpayable in 30 days. No allowance for doubtful accounts is considered necessary. During the year ended May 31, 1999, the Company canceled a strategicpartnership with an entity to distribute systems manufactured by SchmittMeasurement Systems, Inc. For the years ended May 31, 1999, 1998 and 1997,approximately 2%, 24% and 22% of consolidated sales respectively were made tothis customer.INCOME TAXESDeferred tax assets and liabilities are recognized for the future taxconsequences of differences between the financial statement carrying amounts ofexisting 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, 1999 and 1998.USE OF ESTIMATESThe preparation of the consolidated financial statements in conformity withgenerally accepted accounting principles requires management to make estimatesand assumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. Actual results could differ from thoseestimates.CONSOLIDATED STATEMENT OF CASH FLOWSThe Company considers short-term investments that are highly liquid, readilyconvertible into cash and have original maturities of less than three months tobe cash equivalents for purposes of the cash flows statement. 15STOCK-BASED COMPENSATIONStatement of Financial Accounting Standards No. 123, "Accounting for Stock-BasedCompensation," (FAS 123) encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fair value. TheCompany has chosen to continue to account for stock-based compensation using theintrinsic value method prescribed by Accounting Principles Board Opinion No. 25,"Accounting for Stock Issued to Employees," (APB 25). Accordingly, compensationcost for stock options is measured as the excess, if any, of the quoted marketprice of the Company's stock at the date of the grant over the amount anemployee must pay to acquire the stock.FOREIGN CURRENCY TRANSLATIONFinancial statements for the Company's subsidiaries outside the United Statesare translated into U.S. dollars at year-end exchange rates for assets andliabilities and weighted average exchange rates for income and expenses. Theresulting translation adjustments are recorded in a separate component ofstockholders' equity titled "Accumulated Other Comprehensive Income (Loss)."FAIR VALUE OF FINANCIAL INSTRUMENTSThe carrying amounts of financial instruments approximate their fair values atMay 31, 1999.EARNINGS PER SHARE Basic (loss) earnings per share is computed using the weighted average number ofshares outstanding. Diluted (loss) earnings per share is computed using theweighted average number of shares outstanding, adjusted for the incrementalshares attributed to outstanding options to purchase common stock. Using thetreasury stock method as required by FAS 128, incremental shares of 364,903 and530,295 in 1998 and 1997, respectively, were used in the calculation of dilutedearnings per share. In fiscal 1999, 130,245 incremental shares were excludedfrom the diluted loss per share calculation as their effect was anti-dilutive.NOTE 3COMPANY ACQUISITIONSOn December 2, 1996, the Company purchased the inventories ($462,933) andequipment ($33,067) of the grinding wheel balancer division of HofmannMaschinenbau GmbH for $496,000 and subsequently established Schmitt HofmannSystems, GmbH (see Note 1). The results of SHS are included in the accompanyingconsolidated financial statements since the date of acquisition.NOTE 4LONG-TERM INVESTMENTSIn December 1998, the Company issued 610,000 shares of its common stock toacquire 13,757,155 shares or approximately 19.5% of the outstanding shares ofAir Packaging Technologies, Inc. That company is engaged in the design,manufacture, marketing and sales of "Air Box" patented packaging systems used inthe semiconductor, electronic, medical and dental markets worldwide. Thisinvestment is considered an "Available-for-sale securities" under Statement ofFinancial Accounting Standards No. 115. As required under that statement, allunrealized gains and losses are included in Accumulated Other ComprehensiveIncome (Loss) and reported as a separate component in Other Comprehensive Income(Loss) in Stockholders' Equity until realized. At May 31, 1999 there was nosignificant difference between market value and acquisition cost of $2,135,000.16NOTE 5LINE OF CREDITThe Company has a $1.5 million unsecured short-term line of credit agreementwith a commercial bank. The line is guaranteed by the Company's wholly ownedsubsidiary, Schmitt Measurement Systems, Inc. Interest is payable at the bank'sprime rate, or LIBOR +2.50%. The line of credit is renewable annually. Nobalance was outstanding as of May 31, 1999 or 1998.NOTE 6INCOME TAXESThe (benefit) provision for income taxes was as followsYears ended May 31, 1999 1998 1997 --------- --------- --------- Current ...................... $(109,523) $ 243,264 $ 826,368Deferred ..................... (26,444) 383,887 77,824Decrease in valuation allowance .................. -- (276,250) (276,245) --------- --------- ---------Total (benefit) provision for income taxes ........... $(135,967) $ 350,901 $ 627,947 --------- --------- ---------Deferred tax assets (liabilities) are comprised of the following components: 1999 1998 ----------- ----------- Depreciation ............................. $ 31,112 $ (29,861) ----------- -----------Net operating loss carryforwards ......... 1,038,559 1,038,559Inventory basis differences .............. -- 34,623Other asset capitalization ............... 12,820 13,840Other deferred assets .................... 50,368 49,254 ----------- -----------Gross deferred tax assets ................ 1,101,747 1,136,276 ----------- -----------Deferred tax asset valuation allowance ... (234,231) (234,231) ----------- -----------Net deferred tax asset ................... $ 898,628 $ 872,184 ----------- ----------- ----------- ----------- Through the acquisition of Schmitt Measurement Systems, Inc., the Companyacquired approximately $5.5 million of U.S. federal net operating losscarryforwards. As of May 31, 1999, approximately $3 million of thesenet-operating losses remain and expire in the years 2007 through 2009. Thedeferred tax asset valuation allowance in fiscal years 1998 and 1999 isattributed to these net-operating losses. The provision for income taxes differs from the amount of income taxesdetermined by applying the U.S. statutory federal tax rate to pre-tax income dueto the following:Years ended May 31, ............. 1999 1998 1997 ------ ------ ------ Statutory federal tax rate ...... (34.0%) 34.0% 34.0%State taxes, net of federal benefit ............... (4.3) 3.2 4.4Change in deferred tax valuation allowance ........... -- (27.5) (20.9)Reduction of goodwill associated with the acquisition of Schmitt Measurement Systems, Inc. ..... -- 10.3 9.2Other permanent differences ................... 3.9 1.9 -- ------ ------ ------Effective tax rate .............. 34.4% 21.9% 26.7% ------ ------ ------ ------ ------ ------NOTE 7EMPLOYEE BENEFIT PLANSThe Company adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan &Trust effective June 1, 1996. Employees must meet certain age and servicerequirements to be eligible. Participants may contribute up to 15% of theireligible compensation that is partially matched by the Company. The Company mayfurther make either a profit sharing contribution or a discretionarycontribution. Contributions made to this Plan during the years ended May 31,1999 and 1998 were $86,899 and $135,335, respectively.NOTE 8COMMITMENTS AND CONTINGENCIESIn a transaction related to the acquisition of Schmitt Measurement Systems, Inc.(formerly TMA Technologies, Inc.), the Company established a royalty pool andvested each shareholder and debt holder in TMA Technologies, Inc. an interest inthe royalty pool equal to the amount invested or loaned including interestpayable through March 1995. The royalty pool will be funded at 5% of net sales(defined as gross sales less returns, allowances, and sales commissions) ofSchmitt Measurement Systems, Inc.'s, products and future derivative productsdeveloped by Schmitt Industries, Inc., which utilize these technologies. As partof the royalty pool agreement, each former shareholder and debt holder released TMA Technologies, Inc., for any claims with regard to the acquisition excepttheir rights to future royalties. Long-term debt of $179,983 was fully paid tocertain TMA Technologies, Inc., debt holders in fiscal year 1998. 17NOTE 9SEGMENTS OF BUSINESSThe Company operates principally in two segments of business: the manufacturingof mechanical components for the machine tool industry, and the manufacturing oflaser measurement systems. The Company also operates in two principal geographicmarkets, U.S. and foreign. The segment which manufactures mechanical componentsfor the machine tool industry reported gross sales of $8,223,308 for the yearended May 31, 1999, including inter-company sales of $845,429. This segmentreported gross sales of $8,286,243 for the year ended May 31, 1998, includinginter-company sales of $754,131 and gross sales of $6,488,348 for the year endedMay 31, 1997 including intercompany sales of $336,875. The segment whichmanufactures laser measurement systems reported gross sales of $579,844 for theyear ended May 31, 1999, with no inter-company sales. For fiscal year ended May31, 1998, the measurement products segment reported gross sales of $3,108,769including inter-company sales of $14,797, and gross sales of $4,390,499 for theyear ended May 31, 1997 with no intercompany sales. Geographically, U.S. saleswere $4,756,079, $7,873,148 and $8,728,082 for fiscal years ended May 31, 1999,1998 and 1997 respectively. Foreign sales were $4,047,073, $3,521,864 and$2,150,765 for the same years, respectively. This includes inter-company salesof $845,429 for the year ended May 31, 1999, $768,928 for the year ended May 31,1998 and $336,875 for the year ended May 31, 1997. For the years ended May 31,1999, 1998 and 1997, respectively, export sales by the U.S. segment totaled$615,212, $344,100 and $612,704. (Loss) income from operations for the years ended May 31, 1999, 1998 and1997 for the mechanical components segment was $(263,965) $363,656, and$176,927, respectively. (Loss) income from operations for the years ended May31, 1999, 1998 and 1997 of the laser measurement segment was $(226,883),$975,086, and $2,119,184, respectively. Consolidated (loss) income fromoperations includes an adjustment of $30,000 for the elimination ofinter-company rent for the year ended May 31, 1999, $90,000 for the year endedMay 31, 1998 and $30,000 for the year ended May 31, 1997. (Loss) income fromoperations for the U.S. segment was $(305,390), $1,423,502 and $2,393,558respectively, for the years ended May 31, 1999, 1998 and 1997 and for theforeign segment, losses of $(185,458), $(84,760) and $(97,447) respectively, forthe same years. Long-term assets at May 31, 1999 and 1998 were $4,097,803 and$2,004,753 for the mechanical components segment and $676,682 and $776,788 forthe laser measurement segment. Long-term assets for the U.S. segment at May 31,1999 were $4,654,796 and at May 31, 1998 were $2,634,909. Long-term assets forthe foreign segment at May 31, 1999 were $119,689 and at May 31, 1998 were$146,632. Depreciation expense incurred during the years ended May 31, 1999,1998 and 1997, by the mechanical components segment was $194,541, $206,335 and$156,374, respectively. The laser measurement segment incurred depreciationexpense of $99,972, $140,893 and $108,066, for the years ended May 31, 1999,1998 and 1997, respectively. Amortization expense incurred during the yearsended May 31, 1999, 1998 and 1997 by the mechanical components segment was$13,333, $0, and $72,393 respectively. The laser measurement segment did notincur amortization expense for years 1999, 1998 and 1997. The U.S. segmentincurred depreciation expense of $221,295, $276,102 and $226,755 during theyears ended May 31, 1999, 1998 and 1997, respectively. The foreign segmentincurred depreciation expense of $73,218, $71,126 and $37,705 respectively, forthese same years. The U.S. segment incurred amortization expense of $13,333, $0,and $72,393 in fiscal years ended May 31, 1999, 1998 and 1997. The foreignsegment has not incurred amortization expense. Capital expenditures for theyears ended May 31, 1999 and 1998, were $117,884 and $238,016 by the mechanicalcomponents segment and $1,496 and $276,267 by the laser measurement segment,respectively. Capital expenditures for the years ended May 31, 1999 and 1998,were $60,079 and $466,801 by the U.S. segment and $59,301 and $47,482 by theforeign segment, respectively. Income from operations represents sales less costs and operating expenses.In computing income from operations, all overhead expenses have been allocatedto both industry segments, as they are an integral part of profit recognitionfor each segment. Identifiable assets by segment of business are those assetsused in the Company's operations in each segment.NOTE 10 STOCK OPTIONSPrior to 1995, the Company granted stock options to officers and employees ofthe Company. Stock options for up to 10% of the outstanding shares were eligiblefor grant provided the stock options for any one individual did not exceed 5% ofthe issued and outstanding shares of common stock. The purchase price of theoptioned shares was equal to not less than the average closing price of theCompany's common stock for the ten trading days immediately preceding the grantdate of the stock options. The maximum term of each stock option did not exceedfive years and all options were vested and exercisable upon grant. Alloutstanding options were exercised in the fiscal year ended May 31, 1999. Theofficers/employees issued notes to the Company for the exercise price. The notesmature on or before December 2000 ($586,500) and January 2001 ($282,975), andcarry interest at the rate of 6% per annum. These notes are reported as areduction of stockholders equity.18 The Board of Directors adopted a 1995 Stock Option Plan in December 1995which Plan was amended in August 1996 and restated in August 1998. An optiongranted under the Amended and Restated Stock Option Plan may be either anincentive stock option (ISO), or a nonstatutory stock option (NSO). ISOs may begranted 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 purchaseprice of ISOs is fair market value on the date of grant; the purchase price ofNSOs may vary from fair market value. Vesting is generally on a cumulative basisover four years at 25% per year. The Company has 800,000 shares reserved forissuance under the stock option plan. The options expire in years 2006 through2009. The following summarizes the options outstanding as of May 31, 1999: Weighted Weighted Average Average Exercise Exercise Combined Shares Price Shares Price Shares ------- --------- ------- -------- ------- Options outstanding, May 31, 1996 .... 595,750 $ 1.79 232,500 $ 4.42 828,250Options granted ...................... -- -- 117,500 $ 7.79 117,500Options exercised .................... (110,000) $ 1.79 (53,750) $ 4.38 (163,750)Options forfeited/cancelled .......... -- -- (14,000) $ 4.38 (14,000) ------- --------- ------- -------- -------Options outstanding, May 31, 1997 .... 485,750 $ 1.79 282,250 $ 5.83 768,000Options granted ...................... -- -- 174,000 $ 6.62 174,00Options exercised .................... -- -- (15,750) $ 5.71 (15,750)Options forfeited/cancelled .......... -- -- (151,250) $ 7.93 (151,250) ------- --------- ------- -------- -------Options outstanding, May 31, 1998 .... 485,750 $ 1.79 289,250 $ 5.22 775,000Options granted ...................... 589,250 $ 3.24 589,250Options exercised .................... (485,750) $ 1.79 -- -- (485,750)Options forfeited/cancelled .......... -- -- (426,750) $ 4.41 (426,750) ------- --------- ------- -------- -------Options outstanding May 31, 1999 ..... -- 451,750 $ 3.02 451,750 ------- --------- ------- -------- -------Options vested at May 31, 1999 ....... -- 165,125 $ 3.00 165,125 ------- --------- ------- -------- ------- For the 451,750 shares outstanding under the 1995 Stock Option Plan, theexercise price ranges from $3.00 to $3.30 per share and the remaining averagecontractual life was 7.8 years. The Company has adopted the disclosure only provisions of SFAS 123.Accordingly, no compensation cost has been recognized for the stock optionplans. Options were assumed to be exercised upon vesting for purposes of thisvaluation. Adjustments are made for options forfeited prior to vesting. For theyears ended May 31, 1999, 1998 and 1997, total value of options granted wascomputed to be $1,275,098, $877,963 and $395,740, respectively, which would beamortized on a straight-line basis over the vesting period of the options. Hadcompensation cost for the Company's stock option plans been determined based onthe fair value at the grant date for the awards in 1999, 1998 and 1997,consistent with the provisions of SFAS 123, the Company's pro forma net (loss)income for the years ended May 31, 1999, 1998 and 1997, would be ($467,573),$889,944 and $1,436,760, respectively. Pro forma basic (loss) earnings per share for the years ended May 31, 1999, 1998 and 1997 would be ($.06), $.13 and $.20,respectively. Pro forma diluted (loss) earnings per share for the years endedMay 31, 1999, 1998 and 1997 would be ($.06), $.12 and $.19, respectively. The fair value of each option granted is estimated on the date of the grantusing the Black-Scholes option and pricing model. The weighted averageassumptions used for fiscal 1999, 1998 and 1997 were a risk-free interest rateof 5.5% for 1999 and 7.5% for 1998 and 1997, an expected dividend yield of 0%for all years, an expected life of 8, 8, and 10 years, respectively, and avolatility of 65%, 52% and 51%, respectively. The effects of applying SFAS No. 123 in the proforma disclosure are notindicative of future amounts. 19MANAGEMENT'S DISCUSSION AND ANALYSISThe following information contains certain forward-looking statements thatanticipate future trends or events. These statements are based on certainassumptions that may prove to be erroneous and are subject to certain risksincluding but not limited to the uncertainties of the Company's new productintroductions, the risks of increased competetion and technological change inthe Company's industry and other factors detailed in the Company's SEC filings.Accordingly, actual results may differ, possibly materially, from thepredictions contained herein. During fiscal 1999, the measurement markets the Company serves continued adownward trend started early in calendar year 1998. This drop was particularlyevident in the disk drive and silicon wafer markets in Asia as well as theUnited States. As a result of these market changes, the Company's sales infiscal 1999 declined significantly from fiscal 1998, with virtually the entiredrop in sales of laser measurement products. The Company responded to thisindustry decline by seeking to develop new products and markets to reduce itshistoric reliance on these markets. Management expanded its research anddevelopment efforts so the Company could introduce new products for both thelaser measurement and mechanical balancer markets in fiscal 1999 and 2000. TheCompany expects new products developed in 1999 and introduced in late fiscal1999 and fiscal 2000 to increase revenues. In addition, the disk drive andsilicon wafer markets are expected to improve which will also have an upwardeffect on sales. However, there can be no assurance that the Company will returnto profitability with increased sales levels in future periods. Sales outside the United States accounted for approximately 48% of theCompany's revenues in 1999, 29% in 1998 and 23% in 1997. Some foreign customerspurchase in their own country's currencies, thereby imposing on the Company acurrency risk. All U.S. sales (52% of total sales in fiscal 1999) were in U.S.dollars and the remaining fiscal 1999 sales were in currencies other than U.S.dollars. To date, currency fluctuations have historically had little impact onrevenue realization. However, significant variations in the value of the U.S.dollar, relative to currencies of countries in which the Company has significantcompetitors, can impact future sales. The Company does not engage in currencyhedging. In addition, the longer payment cycles of international sales can havea negative impact on liquidity. The Company believes the dollar amount ofinternational sales will continue to grow in future periods. A substantial portion of the Company's revenue is derived from sales to endusers through selling agents and directly to builders of machine tools. Forfiscal 1999, sales to a single customer did not exceed 10% of total revenues, achange from prior years. In fiscal 1997 the Company entered into a strategicpartnership with Veeco Instruments Inc. (NASDAQ:VECO) to act as the exclusivesales and marketing agent for SMS's laser light scatter products. As a result ofthis agreement, 24% of consolidated fiscal 1998 sales were through Veeco. Infiscal 1999, Schmitt and Veeco reached a mutual decision to terminate thepartnership as sales by that entity had dropped dramatically (in fiscal 1999sales to Veeco were less than 2% of consolidated revenues). The Company isdependent on the sales activities of its selling agents, and there can be noassurance these agents will continue to be successful in their efforts to marketthe Company's products. The Company enjoys substantial repeat business from abroad base of customers, but there can be no assurance that these customers willcontinue to buy the Company's products in the future. The decrease in revenuesin fiscal 1999 occurred exclusively in the laser measurement products where thevolume of product shipments declined as a result of the drop in business in thetechnology industry, primarily disk drive and silicon wafer manufacturers.Increased revenues during fiscal 1997 and 1998 principally resulted fromincreased volume of product shipments. Product improvements and available features have resulted in modestly increased average product prices. The Company operates in highly competitive industries characterized byincreasingly rapid technological changes. The Company's competitive advantageand future success are therefore dependent on its ability to develop newproducts, to qualify these new products with its customers, to successfullyintroduce these products to the marketplace on a timely basis, to commenceproduction to meet customer demands and to develop new markets in the industriesfor its products and services. The successful introduction of new technology andproducts is increasingly complex. If the Company is unable, for whatever reason,to develop and introduce new products in a timely manner in response to changingmarket conditions or customer requirements, its results of operations could beadversely impacted. [GRAPH]20RESULTS OF OPERATIONSSales in fiscal 1999 decreased to $7,957,723, from $10,626,084 in fiscal 1998and $10,541,972 in fiscal 1997. Sales of Schmitt Balancing products in fiscal1999 decreased to $7,377,879 from $7,532,112 in fiscal 1998, but increased from$6,151,473 in fiscal 1997. Schmitt Measurement System (SMS) sales accounted for$579,844 in fiscal 1999 compared to sales of $3,093,972 and $4,390,499 forfiscal 1998 and 1997 respectively. The net loss for fiscal 1999 totaled $259,307compared to net income for fiscal 1998 of $1,250,115 and fiscal 1997 net incomeof $1,724,728. This decline was directly attributable to reduced sales of SMSmeasurement products. Historically the Company has enjoyed a high gross profit margins in excessof 60% on its SBS Dynamic Balancing products and its SMS measurement products.Fiscal year 1999 gross profits totaled 48%. Cost of sales as a percentage ofsales for fiscal 1997, 1998 and 1999 was 36.7%, 43.6% and 52.1%, respectively.Margins have declined for balancer products due to increased competitivepressures in all markets. With improvements to existing products and newtechnology, these results could improve in fiscal 2000 and beyond. Margins ofmeasurement products declined due to the large reduction in sales of completemeasurement systems. The fiscal 1999 and 1998 decline in sales of all lasermeasurement products resulted in a negative impact on sales and net earnings.Management expects the trends in sales and profits of both the balancer andmeasurement products to recover during fiscal 2000. Management anticipates thatcost of sales as a percentage of sales will also recover in future time periodsto achieve levels approximating the Company's historical performance. Noassurances can be made that the Company will be profitable or will generateincreased sales in future time periods. General administrative and sales expenses as a percentage of net sales were48% in fiscal 1999, 40% in fiscal 1998, and 40% in fiscal 1997. In terms ofdollars, these expenses were $3,841,155, $4,275,059 and $4,164,271 in fiscal1999, 1998 and 1997 respectively. The reduction in expenses in fiscal 1999 isdue to a concerted effort by management to decrease expenses. In future fiscalperiods, management believes the Company's costs will not increase at the samerate that sales are anticipated to increase, although there can be no suchassurance. Research and development expenses as a percentage of net sales were 5.8% infiscal 1999, 3.6% in fiscal 1998 and 2.0% in fiscal 1997. In terms of dollars,these expenses were $462,136, $379,798 and $205,800 in fiscal 1999, 1998 and1997 respectively. The Company has begun a major research and developmentprogram to develop products that will expand its market base and reduce relianceon historic market segments. This development program will continue in futurefiscal periods, with expenditures expected to approximate those levels expendedin fiscal 1999. The Company's future operating results depend, to a considerableextent, on its ability to maintain a competitive advantage in both the productsand services it provides. For this reason, the Company believes it is criticalto continue to make future investments in research and development to ensure theflow of innovative, productive, high-quality products and support services.Accordingly, the Company expects research and development expenses to continueto increase in the immediate future. The company realized a net loss of $259,307 in fiscal 1999 compared to netincome for fiscal 1998 of $1,250,115 and fiscal 1997 net income of $1,724,728.Net loss per basic share was $(0.03) compared to earnings per share of $0.18 infiscal 1998 from $0.25 in fiscal 1997. LIQUIDITY AND CAPITAL RESOURCESThe Company's financial condition remains very strong, with a ratio of currentassets to current liabilities of 9.4 to 1 at May 31, 1999 compared to 7.3 to 1at May 31, 1998. As of May 31, 1999, the Company had $268,888 in cash comparedto $1,127,076 at May 31, 1998. Accounts receivable balance at May 31, 1999 was $1,423,611 compared to$1,197,951 at May 31, 1998. This change from prior years is not significant asaccounts receivable in fiscal 1999 turned 6.1 times per year compared to 5.4times in fiscal 1998. At May 31, 1999, none of the Company's accounts receivablewere considered a doubtful collection. The Company generally experiences apayment cycle of 30-80 days on invoices. Management believes its credit policiesand collection policies are effective and appropriate for the marketplace thatit serves and the Company has had no significant bad debt write-offs since itsinception in 1986. There can be no assurance that the Company's collectionprocedures will continue to be successful.TOTAL ASSETSIN THOUSANDS OF DOLLARS[GRAPH] 21 Working capital decreased slightly from $5,906,588 at May 31, 1998 to$5,812,075 at May 31, 1999. During fiscal 1999 and 1998, the Company spent$119,380 and $514,283 respectively to acquire certain worldwide corporate assetsof property and equipment to assist in production and product development.Although the Company has no current material commitments for capitalexpenditures, product development to extend SBS and SMS products to new marketsare expected to result in increased capital expenditures for equipment in fiscal2000. The Company maintains levels of inventory sufficient to satisfy normalcustomer demands, plus an increasing short-term delivery requirement for amajority of its products. Additionally, inventories are periodically adjustedaccording to management's forecast for future business activity. Managementbelieves its ability to provide prompt deliveries gives it a competitiveadvantage for certain sales. It is expected that current inventory levels willbe decreased as market conditions improve in the technology industry (disk driveand silicon wafer segments) and new products are introduced. Despite theintroduction of new products, this new technology will utilize existing rawmaterials, thereby mitigating the level of additional inventory purchases infiscal 2000. The average finished goods inventory turnover ratio for fiscal1997, 1998 and 1999 was 1.8, 1.4 and 1.0 times, respectively. During the third quarter of fiscal 1997, two officers/employees exercisedstock options for 485,750 shares at an average exercise price of $1.79 pershare. The officers/employees issued notes to the Company for the exerciseprice. The notes mature on or before December 2000 ($586,500) and January 2001($282,975), and carry interest at the rate of 6% per annum. The notes arereported as a reduction of stockholders' equity. The company issued 610,000 shares of its common stock to acquire 13,757,155shares or approximately 19.5% of the outstanding shares of Air PackagingTechnologies, Inc. (APTI). That company is engaged in the design, manufacture,marketing and sales of "Air Box" patented packaging systems used in thesemiconductor, electronic, medical and dental markets worldwide. The Companymade this investment as the philosophy of APTI is similar to its own - toprovide products that make its customers more profitable either throughincreased productivity or reduced operating costs. The acquisition of SMS in fiscal 1995 resulted in a tax loss carryforwardin of excess $5 million, which is available to offset earnings from SMS throughthe year 2009. As of May 31, 1999, approximately $3 million of thesenet-operating losses remain. The Company has completed an assessment of the impact of the year 2000issue on its internal systems and equipment, on its products and on the systemsof its significant vendors. Costs to complete that assessment were less thanone-half of one percent of fiscal 1999 revenues. Based on this assessment, theCompany believes its internal systems have been updated to address the Year 2000issue, its products will properly recognize calendar dates beginning in the Year2000, and its significant vendors are appropriately addressing the Year 2000issue. Accordingly, the Company believes it is Year 2000 ready and does notexpect that the Year 2000 will have a material impact on the Company's business,results of operations or financial condition. However, there can be no assurancethat the systems of other companies on which the Company relies will not have anadverse effect on the Company's systems. Management believes its cash flows from operations, available creditresources and its cash position will provide adequate funds on both a short-termand long-term basis to cover currently foreseeable debt payments, leasecommitments 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 contingenciesduring fiscal 2000. RETURN ON EQUITYIN PERCENT[GRAPH]NET (LOSS) INCOME PER SHAREIN DOLLARS[GRAPH]22SUMMARIZED QUARTERLY FINANCIAL DATAFiscal year ended May 31, 1999 and 1998In thousands, except per share information (unaudited)Fiscal 1999 Quarter Ended 8/31/98 11/30/98 2/28/99 5/31/99 ---------- ---------- ---------- ---------- Sales $1,984,671 $2,161,653 $1,767,427 $2,043,972Gross Profit 961,503 985,628 997,700 867,612Net (Loss) Income (51,457) (115,618) 16,844 (109,075)Net (Loss) Income Per Share, Basic $(0.01) $(0.02) $0.00 $(0.01)Net (Loss) Income Per Share, Diluted $(0.01) $(0.02) $0.00 $(0.01)Market Price of Common Stock Low $3.88 $3.13 $3.00 $1.94 High $6.38 $5.00 $4.38 $4.00 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------Fiscal 1998 Quarter Ended 8/31/97 11/30/97 2/28/98 5/31/98 ---------- ---------- ---------- ----------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, Basic $0.05 $0.10 $0.01 $0.01Net Income Per Share, Diluted $0.05 $0.09 $0.01 $0.01Market Price of Common Stock Low $7.50 $ 8.00 $7.38 $5.69 High $9.75 $12.00 $10.13 $8.13 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------COMMON STOCK INFORMATION AND DIVIDEND POLICYAs of July 16, 1999, there were 8,184,889 shares of Common Stock outstandingheld by approximately 130 holders of record. The number of holders does notinclude individual participants in security position listings. Managementestimates 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. TheCompany's present policy is to retain earnings to finance the Company'sbusiness. Any future dividends will be dependent upon the Company's financialcondition, results of operations, current 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. The sum of quarterly earnings per share does not equal annual earnings pershare as a result of the computation of quarterly versus annual average sharesoutstanding. WORKING CAPITALIN DOLLARS[GRAPH] 23SELECTED FINANCIAL DATAIn thousands, except per share informationFISCAL YEAR ENDED MAY 31, 1999 AND 1998Fiscal Year Ended 5/31/99 5/31/98 5/31/97 5/31/96 5/31/95 ------- ------- ------- ------- ------- Sales $ 7,958 $10,626 $10,542 $7,080 $4,415Net (Loss) Income (259) 1,250 1,725 1,217 249Net (Loss) Income Per Share, Basic (0.03) 0.18 0.25 0.18 0.04Weighted Average. Number Shares (000), Basic 7,592 7,091 7,031 6,888 6,887Net (Loss) Income Per Share, Diluted (0.03) 0.17 0.23 0.16 0.04Weighted Average Number Shares (000), Diluted 7,592 7,456 7,562 7,417 7,116Stockholders' Equity $10,587 $ 8,688 $ 7,429 $4,887 3,464Total Assets $11,282 $ 9,619 $ 8,515 $5,986 $4,619 ------- ------- ------- ------- ------- ------- ------- ------- ------- -------REPORT OF INDEPENDENT ACCOUNTANTSTo the Board of Directors and Shareholders ofSchmitt Industries, Inc.In our opinion, the accompanying consolidated balance sheets and the relatedconsolidated statements of operations, of cash flows and of changes instockholders' equity present fairly, in all material respects, the financialposition of Schmitt Industries, Inc. and its subsidiaries at May 31, 1999 andMay 31, 1998, and the results of their operations and their cash flows for theyears 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 basedon our audits. We conducted our audits of these statements in accordance withgenerally accepted auditing standards, which require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare 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 bymanagement, and evaluating the overall financial statement presentation. Webelieve that our audits provide a reasonable basis for the opinion expressedabove. The financial statements of Schmitt Industries, Inc. as of May 31, 1997and for the year then ended were audited by other independent accountants whosereport dated July 10, 1997 expressed an unqualified opinion on those statements.PricewaterhouseCoopers LLPPortland, OregonJuly 13, 1999 24SCHMITT WORLDWIDE CUSTOMERS Adam Opel AG Allied Signal Aerospace Company Allison Engine Company American Axel American Koyo Bearing Mfg. Corp. American NTN Bearing Company Asahi Komag Atlas Copco Airpower N.V. Audi AG Barden Corporation Black & Decker Corporation Blohm Maschinenbau Gmbh BMW Motoren GmbH Boeing Company Briggs & Stratton Bryant Grinder Corporation Caterpillar Belgium S.A. Caterpillar Incorporated Chrysler Corporation Cincinnati Milacron Cummins Engine Company Daewoo International Corporation Daimler Benz Dana Corporation Deere & Company Diesel Technology Corporation Dresser-Rand Eaton Corporation Emerson Power Transmission Erwin Junker FAG Bearing Ltd. Federal Mogul Corporation Fiat Ford France S.A. Ford Motor Company Fuji Electric General Electric Corporation General Motors Corporation Goldcrown Machinery Greenfield Industries Guhring Automation Harley-Davidson Motor Company HMT Technology Corporation Honda Motor Company, Honda Of America IBM Deutschland INA Bearing Corporation Jones &Shipman, Inc. Komag, Inc. Koube Steel Koyo Machinery USA Landis, Landis Lund Lockheed Martin Mercedes Benz AG Milwaukee Electric Tool Mitsubishi Chemical Mitsubishi Material Silicon Mitsubishi Motor Company Ltd. NASA Navistar International Transportation New Venture Gear Nissan Motors Ltd. Normac, Inc. Norton Company Okamoto Corporation Okunia Machinery, Inc. Opel Austria GmbH Parker Hannifin Corporation Pratt & Whitney Raytheon Reliance Electric Company Rexnord Corporation Reynolds Metals Robert Bosch Corporation Robert Bosch GmbH Saturn Corporation Seagate Substrates SEH America, Inc. Siemens Automotive Systems SKF Bearing Industries SKF GmbH Sumitomo Heavy Industries Texas Instruments The Timken Company The Torrington Company Timken France Toyoda Machinery USA, Toyoda Machinery, Ltd. TRW Automotive Components United Grinding Technologies University Of Connecticut Grinding Research Center Volkswagen AG Volvo Weldon Machine Tool Western Digital Weyburn-Bartel EXHIBIT 21.1 SUBSIDIARIES OF SCHMITT INDUSTRIES, INC. AS OF MAY 31, 1999 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 [LETTERHEAD] 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 13, 1999 relating to the financial statements, which appears in the Annual Report to Shareholders, which is incorporated in this Annual Report on Form 10-K.PricewaterhouseCoopers LLPPortland, OregonAugust 27, 1999 Exhibit 23.2 [LETTERHEAD] CONSENT OF INDEPENDENT AUDITORSWe consent to the inclusion in this Annual Report on Form 10-K, and to theinclusion in the Form S-8 Registration Statement No. 333-3910, of our reportdated July 10, 1997, on our audits of the consolidated financial statements ofSchmitt Industries, Inc., and its subsidiaries./s/ Moss Adams LLPPortland, OregonAugust 27, 1999
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