Schmitt Industries, Inc.
Annual Report 2002

Plain-text annual report

QuickLinks -- Click here to rapidly navigate through this documentUNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 10-K(Mark One)ýANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934For the fiscal year ended: May 31, 2002oroTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934For the transition period from to Commission File Number: 0-23996SCHMITT INDUSTRIES, INC.(Exact name of registrant as specified in its charter)Oregon 91-1151989(State or other jurisdiction ofincorporation or organization) (IRS Employer Identification Number)2765 N.W. Nicolai StreetPortland, Oregon 97210(Address of principal executive offices) (Zip Code)(503) 227-7908(Registrant's telephone number, including area code)Securities registered pursuant to Section 12(b) of the Act:Title of each class Name of each exchange on which registeredNone 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 reports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. ý As of August 1, 2002, the aggregate market value of the registrant's Common Stock held by nonaffiliates of the registrant was 3,480,479based on the closing sales price of the registrant's Common Stock on the Nasdaq National Market. On that date, there were 7,405,274 shares ofCommon Stock outstanding. Portions of the registrant's definitive Proxy Statement for its 2002 Annual Meeting of Shareholders are incorporated by reference into Part IIIhereof. PART I  Item 1. Business Introduction The Company (an Oregon corporation) designs, assembles and markets computer-controlled balancing equipment primarily to the machinetool industry. Through its wholly owned subsidiaries, Schmitt Measurement Systems, Inc. ("SMS"), a Montana corporation and Acuity ResearchIncorporated ("ARI") a California corporation, the Company designs, manufactures and markets precision laser measurement systems. TheCompany also sells and markets its products in Europe through its wholly owned subsidiaries, Schmitt Europe Ltd. ("SEL"), located in the UnitedKingdom and Schmitt Europa GmbH ("SEG"), located in Germany. The Company's executive offices are located at 2765 N.W. Nicolai Street,Portland, Oregon 97210, and its telephone number is (503) 227-7908.Balancing Products The Company's principal product is the Schmitt Dynamic Balance System (the "SBS System"), consisting of a computer control unit,sensor, spindle-mounting adapter, and balance head. It is designed to be an inexpensive, yet highly accurate, permanent installation on grindingmachines. The Company acquired its original balancing equipment technology pursuant to a series of agreements from 1987 through 1991 andsubstantially enhanced and advanced the patented technology since that time. Since inception the targeted customer base has been operators ofgrinding machines. The SBS System is fully automated, eliminating the need to pre-balance such devices as grinding wheels. This reduces machine setup timeand ensures a smoother and more efficient operation. Operating on a principle of mass compensation for wheel imbalance, the balance headcontains two movable eccentric weights, each driven by electric motors through a precision gear train. These weights are repositioned to offsetany imbalance in a grinding wheel or other application. Imbalance or vibration is picked up by the sensor that feeds a signal to a controller thatfilters the signal by revolutions per minute. The controller then drives the balance head weights in a direction that reduces the amplitude of thevibration signal. The balance cycle is complete when the weights are positioned to achieve the lowest vibration level. Notable features of the SBS System include its ability to fit almost all machines, ease of installation, compact and modular construction,ability to balance a wheel while on a machine, virtual elimination of wheel vibration, automatic monitoring of balancing, display in both English andmetric systems, instrument grade calibration, short balance process, measurement of both displacement and/or velocity and minimal usermaintenance. Benefits to the system user include improved quality of finished parts, ease of product adaptation, minimal downtime, complete and readyinstallation, elimination of static balancing, longer life of the grinding wheel, diamond dressings and spindle bearings, the ability to balance within0.02 microns and its adaptability to all types of machines. Precision grinding is necessary in all major manufacturing areas including the automotive industry (camshafts, crankshafts, valves), bearings(roller and tapered types), ceramics (precision shaping), electric motors (shafts), pumps (shafts and turbines), aircraft (engine parts), and generalmanufacturing. Precision grinding has an established worldwide presence in all industrialized countries and is expanding as a method of materialremoval and processing. Therefore, the Company believes there may be an increase in market growth and the need for automatic balancing.Within the industry there are three major market segments:Machine Tool Builders—These companies design and manufacture a variety of cylindrical, surface and specialty application grindingmachines. SBS Systems are distributed to a variety of world2markets through OEM (original equipment manufacturer) accounts, where a special pricing (20% discount) is offered to the machine builderincorporating the SBS System into its machine.Examples of some of well-known worldwide machine tool builders who have offered and/or installed the SBS System include ANCA(Australia), Blohm Incorporated (U.S.), Blohm GmbH (Germany), Capco Machinery (U.S.), Cincinnati Milacron (U.S.), Ecotech/SMTW(China/U.S.), Gleason Works (U.S.), Litton IAS/Landis Grinding (U.S.), Micron Machinery Limited (Japan/U.S.), Normac Incorporated (U.S.),NTC Toyama America (U.S./Japan), Okomoto (Japan), Okuma Machine (Japan), Shigiya Machine (Japan), Sumitomo Heavy Industry(Japan), CETOS Hostivar (Czech Republic), TOS Holice (Czech Republic), Toyoda Machine (Japan) and Weldon Machine Tool (U.S.). TheCompany currently sells its products directly to all major machine rebuilders in the U.S. and Western Europe.Machine Tool Rebuilders—These customers, found in all industrial nations, develop their business by offering to completely update andrefurbish older machine tools. These rebuilders typically tear the old machine apart and install new components, such as the SBS System.The Company currently sells its products directly to major machine rebuilders in the U.S. and Western Europe.Grinding Machine Users—These end users become aware of the SBS System through trade shows, trade magazine advertising,distributors, field representatives, referrals and new machine suppliers. The Company's business is conducted worldwide with some morewell known customers including: Black & Decker, Briggs and Stratton, Caterpillar Inc., Daewoo International Corp., Eaton Corporation, FordMotor 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 SEG added the internal spindle, ring and water balancer designs to the Company's product line. These proven designsallow Schmitt to provide products to a broad range of machine applications. In Fiscal 2002, 2001 and 2000, net sales of the Company's balancing products totaled $5,275,556, $6,030,030 and $7,244,969 respectively.Net sales of balancing products accounted for 77% of the Company's revenue in Fiscal 2002, 80% in Fiscal 2001 and 82% in Fiscal 2000. SeeNote 9 to Consolidated Financial Statements.Competition: Management believes the SBS System is one of few fully automatic balancing systems marketed in the world. Most competitive productsrequire special setup and training or calibration to the specific machine. The Company believes the SBS System is currently the only balancingproduct that fits all machines with wheel sizes from 6 to 48 inches in diameter and a spindle rpm of 500 through 7,500. Competitive products come from European companies located in Switzerland, Germany, Spain and Italy. These competitors produceelectromechanical balancers similar to the SBS System and water balancers similar to the SEG system. The Company considers thesecompanies, with their established European base, to be the major competitors. These balancers have electronic deficiencies, rendering them lesseffective in solving essential balancing requirements. They cannot achieve the consistent low balance levels at 500-rpm (low speed) or at 7,500rpm (high speed) as the SBS system can. In addition, these balancers have inferior brush and cable assemblies that cause down time and highmaintenance. Finally, none of these companies can currently compete effectively with the Company in providing mounting adapters for all grindingmachines. Water balancers are the oldest on the market and are employed in the SEG-installed systems. They require expensive plumbing and waterchambers to be machined into the wheel hub while the SBS System does not. They are currently priced about 1.25 times the level of the SBSSystem. When3installed, the grinding machines must be disassembled and parts remachined or replaced within the spindle assembly. This can take two days, farlonger than required to install the SBS system. The water system is "tuned" or "calibrated" to the machine by a factory service technician whilethe SBS system can be installed by the operator. Water systems work at mid- and high-speeds but cannot balance in low rpm environments whileSBS products work in both environments. Water systems require periodic monitoring while the SBS systems require little or no operatormonitoring. The SBS System list price is generally $7,995 worldwide. Competitors electromechanical systems are priced at $8,000 to $10,000 worldwidewhile water balancers are priced at $9,000 to $11,000 worldwide. Management market surveys indicate customers perceive the value of anautomatic balancer to be approximately $8,000; therefore, Company pricing is geared to obtaining a dominant market position and meetingcompetitive supplier prices. The market strategy is to establish the SBS System as the foremost product with the best quality, reliability andperformance and superior economic value.Measurement Products The Company manufactures and markets a line of laser-based, precision measurement systems and operates a precision laser light scattermeasurement laboratory. Light scatter technology involves using lasers, optics and detectors to throw a beam of light on a material sample andrecord its reflection/transmission. Analysis of light scatter information can determine material characteristics such as surface roughness, defectsand dimensional sizing without introducing contaminants and causing changes to the tested material. The principal products are laser-basedmeasurement products and technology applicable to both industrial and military markets. The Company has used patents, patent applications,trademarks and other proprietary technology to focus marketing efforts into industrial markets, including electronics, computer disk and siliconwafer manufacturers. There are four product lines: laser-based light-scatter measurement, dimensional sizing, research and other laser alignment products plus alight-scatter measurement laboratory.Laser-based light-scatter measurement: These products use a patented laser light scatter technology to perform rapid, accurate, repeatable and non-destructive non-contact surfacemeasurement tests that quantify surface micro-roughness. Products are sold to manufacturers of disk drives and silicon wafers, both industrieswith fabrication processes that require precise and reliable measurements. Computer hard disks require exact manufacturing control and a narrow tolerance band for acceptable roughness. The read/write head fliesover the disk drive surface on a cushion of air generated when the rough surface of the rotating disk pulls air under the head. The head may stickor bind to the disk when the surface is too smooth. If it is too rough, the head will fly too far from the disk surface, causing a reduction in datadensity or storage capacity. The DUV and TMS product series meet the challenges of disk drive manufacturers. Customers include IBM, SeagateSubstrates, Western Digital and Komag, Inc. The original TMS-2000 (Texture Measurement System) product, the world's fastest and most accurate non-contact texture measurementsystem, revolutionized disk-manufacturing technology. The product (used on aluminum substrates) is currently used worldwide by most major diskdrive manufacturers and provides fast, accurate and repeatable microroughness measurements and quadruples production throughput whencompared to other testing devices. Surface roughness can now be measured to levels below 0.5 Angstroms (the point of a needle is one millionAngstroms in diameter). The TMS-2000-DUV product measures the surface microroughness of glass rather than aluminum substrates. Manufacturers require thetechnology and products to measure surface roughness of these4 substrates to the same exact levels as those that measure aluminum. The Deep Ultra-violet light (DUV) technology and product uses the patentedlight scatter technology to measure the surface roughness of glass substrates to levels less than one Angstrom. Both products simultaneously measure disk surface roughness in two directions, radially, when the read/write head is moving to another disksector and circumferentially, when the read/write head is processing information on the disk. The two separate roughness levels are required forproper head operation. This measurement method is not possible through any other cost effective measurement means. The TMS-2000W and TMS-3000W provide fast, accurate, repeatable measurements for manufacturers of silicon wafers, computer chips andmemory devices. This industry demands manufacturing precision to increase performance and capacity and these products help achieve thosegoals. Silicon wafers are carefully cut and polished to provide the base upon which a computer or memory chip is produced. Therefore, chipmanufacturing is extremely dependent on the beginning surface roughness of the wafer. Since all silicon wafers exhibit a microscopic level ofsurface roughness, stemming from chemical deposition, grinding, polishing, etching, or any number of other production techniques, some methodof measuring these surface characteristics is required. The wafer measurement products provide a way for SMS customers in this industry toquantify and control their manufacturing process. The system provides measurements to a few hundredths of an Angstrom, a level unachievableby other testing devices.Dimensional Sizing Products: ARI develops and assembles laser distance sensors for industrial and OEM use. Applications include steel casting, paper production,medical imaging, crane control and micron-level part and surface inspection. Presently, there are three product lines, the AR4000 distancemeasurement sensor, the AR4000 Line Scanner and the AR600 series of triangulating laser displacement sensors. The AccuRange 4000 is an optical distance measurement sensor for most diffuse reflective surfaces. It operates by emitting a collimatedlaser beam that is reflected from the target surface and collected by a sensor. The sensor is suitable for a wide variety of distance measurementapplications that demand high accuracy and fast response times. Notable features include the operating range for most surfaces (zero to fiftyfeet), fast response time (50 kHz maximum sample rate), compact and lightweight power design and has a tightly collimated output beam for smallspot size. The product has three output beam configurations available: visible infrared, eye safe infrared and reflective tape targets. It is ideallysuited to level and position measurement, machine vision, autonomous vehicle navigation and 3D imaging applications. The AR4000 Line Scanner is used with the AccuRange 4000 to scan and collect distance data over a full circle. The scanner consists of abalanced, rotating mirror and motor with position encoder and mounting hardware for use with the AccuRange 4000. The scanner deflects the beam90 degrees, sweeping it through a full circle as it rotates. The product can scan at rates of up to 2600 lines per minute, sweeps the laser beamthrough a full 360 degrees and is both compact and lightweight. The AR600 series is a family of triangulating laser displacement sensors with excellent accuracy and sensitivity. The sensor projects a beamof visible laser light that creates a spot on the target surface. Reflected light from the surface is viewed from an angle by a line scan camera andthe target's distance is computed from the image pixel data. The line includes 11 models measuring displacements from 1/8" to 50" and accuracy'sdown to .00015" (4 microns). They can operate on all types of surfaces at speeds up to 1250 samples/second. The product is extremely sensitiveand can detect glass and liquid surfaces and also detect multiple surfaces of transparent materials, allowing great flexibility in specializedapplications.5 Research and Other Measurement Products: CASI Scatterometers are sold to companies and institutions involved in research efforts. A Scatterometer uses ultraviolet or infrared laserlight as a nondestructive probe to measure surface quality, optical performance, smoothness, appearance, defects and contamination on a widevariety of materials. These products are measurement instruments providing customers with precise roughness measurements of optical surfaces,diffuse materials, semiconductor wafers, magnetic storage media and precision-machined surfaces, as well as surfaces affecting the cosmeticappearance of consumer products. Customers include Pratt & Whitney, Boeing, The U.S. Navy and Rockwell Collins North America. The µScan System is a portable device consisting of a hand-held control unit, an interchangeable measurement head and a separatecharging unit. To perform a measurement, the operator places the measurement head on the objective area and presses a button. Eachmeasurement takes less than five seconds with results displayed and stored in system memory. The µScan can store 700 measurements in 255files and provides the capability to program pass/fail criteria. Software is available for control, analysis and file conversion. From a singlemeasurement, a user can determine RMS surface roughness, reflectance and scatter light levels (BRDF) on flat or curved surfaces under anylighting conditions.Testing Laboratory: The Company provides a highly advanced measurement services laboratory to a wide variety of industrial and commercial businesses thatrequire precise measurements only advanced laser light scatter technology can provide. The laboratory uses CASI Scatterometers for measuringsurface roughness. The true value of the laboratory is not only its extremely precise measurement capability but also the test item is not altered,touched or destroyed. Thus, the laboratory is widely used by manufacturers of critical optical components in aerospace and defense systems,including such companies as Aerojet, AT&T Bell Labs, Eastman Kodak, General Electric, IBM, NASA and dozens of other industrial companies,universities and government agencies. In Fiscal 2002, 2001 and 2000, net sales of Measurement products totaled $1,599,103, $1,550,124 and $1,609,287 respectively andaccounted for 23%, 20% and 18% of the Company's total sales in Fiscal 2002, 2001 and 2000 respectively. Of these totals, sales of AcuityResearch (which was acquired effective June 1, 2000) were $1,019,361 and $708,104 in Fiscal 2002 and 2001 respectively.Business and Marketing Strategy The Company designs, assembles and markets all of its products with operations divided into a number of different areas. The VicePresident of Operations directs SBS System production, and is responsible for all assembly, purchasing and production engineering as well as thetechnical services division that provides technical support to customers. The President/CEO directs the production, assembly, purchasing,engineering and technical services functions for the SMS product line. The Product Marketing Division, managed by the President/CEO, isresponsible for the sale of SBS System products. Three Marketing Managers are responsible for domestic sales while a fourth is responsible forsales in Mainland China, Taiwan and Korea. The Company also has one person who performs field service/sales. The President/CEO isresponsible for European sales and oversees the efforts of the Marketing Manager who is headquartered in the United Kingdom. Finally, there is aresearch and development group supervised directly by the President/CEO and the Vice President of Operations. The Company markets and sells the SBS System in a variety of ways. First, the Company uses the channels provided by independentmanufacturer's representatives and distributors. There are currently approximately 25 individuals and/or organizations in the United States acting inone of these capacities. Independent sales agents are paid a 10% commission; distributors are sold products at a 15% discount.6 Second, worldwide trade shows have proven to be an excellent source of business. Company representatives, usually one or more of theMarketing Managers and/or the President/CEO, attend these events along with local Company representatives. These individuals operate adisplay booth featuring an SBS System demonstration stand and product and technical literature. Representatives from all facets of theCompany's target markets attend these trade shows. Third, original equipment manufacturers (OEMs) include the SBS System on the machine tools they produce. Users thus purchase the SBSSystem concurrently with the machine tools. Conversely, end users of grinding machines that have purchased the SBS system directly from theCompany, and after enjoying the benefits of the products, often request that SBS products be included with the new equipment they order fromOEMs. The SBS Systems are often installed by machine builders prior to displaying their own machine tools at various trade shows, becomingendorsements that prove beneficial to the Company's sales efforts. In the United States, most products are shipped directly to customers from the Company's distribution center in Portland, Oregon. Where theCompany has distributors, the product is shipped to the distributor, who in turn pays the Company directly and then delivers and installs theproduct for the end user. Western European distribution to customers is handled by shipping the product directly from the Company's Portlandheadquarters to the European subsidiaries, who in turn sell and distribute the products. Similar to the parent company, SMS uses a variety of methods to market and sell its measurement products. First, a Marketing Manager,under the direction of the President/CEO, directs the overall worldwide marketing efforts. Second, the Company uses an independentmanufacturer's representative group to market and sell products to various customers in the Western United States. That group is paid a 20%commission on units they are responsible for selling. Third, the Company has a nonexclusive distribution agreement with a company in Japan forthe promotion and sale of SMS products in Japan, Korea, Malaysia, Singapore, the Philippines and Taiwan. Fourth, trade shows represent asignificant amount of marketing/sales effort. The President/CEO attends these events along with various Company representatives. Theseindividuals operate a display booth featuring SMS product demonstrations and product and technical literature. Representatives from all facets ofthe market to which the Company directs its sales efforts attend these trade shows. Finally, one of the best marketing channels is the testinglaboratory. Once customers see the capabilities of the technology, it leads to orders for the Company's laser based light scatter measurementproducts. All SMS products are assembled in the Portland, Oregon facility and shipped worldwide directly to customers. Acuity exclusively markets and sells its measurement products through a worldwide network of manufacturer's representatives anddistributors. The President of ARI, under the direction of the Company's President/CEO, directs the overall marketing efforts. There are sevenrepresentatives in North America and seven located in countries throughout the world. The United States representatives receive a 15%commission while the foreign representatives receive a 25% commission on all units they sell. Management of both the Company and ARI willalso attend trade shows where the products are displayed and demonstrated. All ARI products are assembled in the Menlo Park, California facilityand shipped worldwide directly to customers. The SBS, SMS and ARI customer bases consist of over 250, 200 and 300 companies respectively.7Manufacturing There are no unique sources of supply or raw materials in any product lines. Essential electronic components, available in large quantitiesfrom various suppliers, are assembled into the Balancing and Measurement electronic control units under the Company's quality and assemblystandards. Company-owned software and firmware are coupled with the electronic components to provide the basis of the Company's variouselectronic control units. Management believes several supply sources exist for all electronic components and assembly work incorporated into itselectronic control systems. The primary outside supplier of electronic assemblies is Viasystems, Inc. of Beaverton, Oregon, a custom supplier ofassembled electronic products for several Pacific Northwest companies. In the event of supply problems, the Company believes that two or threealternatives could be developed within 30 days to supplement or replace Viasystems. Mechanical parts for the Company's products are produced by high quality CNC machine shops. The Company is not dependent on any onesupplier of mechanical components. Principal suppliers of components for the Company's products include MacKay Manufacturing of Spokane,Washington; OEM Manufacturing of Corvallis, Oregon; Eagle Industries of Newberg, Oregon; and Forest City Gear of Roscoe, Illinois. The Company uses in-house skilled assemblers to construct and test vendor-supplied components. Component inventory of finished vendor-supplied parts is held on Company property to assure adequate flow of parts to meet customer order requirements. Inventory is monitored by acomputer control system designed to assure timely re-ordering of components. In-house personnel assemble various products and test all finished components before placing them in the finished goods inventory. Finishedgoods inventory is maintained via computer to assure timely shipment and service to customers. All customer shipments are from the finishedgoods inventory. In November 1996, the Company's Quality Control Program received full ISO-9001 certification. This certification was renewed inJanuary 2002.Proprietary Technology The Company's success depends in part on its proprietary technology, which the Company attempts to protect through patents, copyrights,trademarks, trade secrets and other measures. The Company has U.S. patents covering its SBS, SMS and ARI products, processes and methods which the Company believes provide itwith a competitive advantage. The Company has a policy of seeking patents where appropriate on inventions concerning new products andimprovements developed as part of its ongoing research, development and manufacturing activities. While patents provide certain legal rights ofenforceability, there can be no assurance the historic legal standards surrounding questions of validity and enforceability will continue to be appliedor that current defenses as to issued patents will, in fact, be considered substantial in the future. There can be no assurance as to the degree andrange of protection any patent will afford and whether patents will be issued or the extent to which the Company may inadvertently infringe uponpatents granted to others. "SBS" and "SMS" are registered trademarks and are affixed to all products and literature created in the Company's balancer andmeasurement product lines, respectively. The Company manufactures its SBS products under copyright protection in the U.S. for electronic board designs. Encapsulation of thefinished product further protects the Company's technologies including software. The Company also relies upon trade secret protection for its confidential and proprietary information. There can be no assurance that otherswill not independently develop substantially8 equivalent proprietary information and techniques or otherwise gain access to the Company's trade secrets or disclose such technology or that theCompany can meaningfully protect its trade secrets. While the Company pursues patent, trademark, trade secret and copyright protection for products and various marks, it also relies on know-how and continuing technology advancement, manufacturing capabilities, affordable high-quality products, new product introduction and directmarketing efforts to develop and maintain its competitive position.Product Development In Fiscal 1997, the Company began an aggressive research and development program to expand the product lines and capabilities of SBSand SMS products. That policy has been incorporated into the operations of ARI as well. The goal of this program is to expand the product base inhistoric markets and to enter new market areas so as to reduce reliance on historic market segments. Since that fiscal year, the Company hascontinued to develop the following new balancing and laser measurement products. The SB-4500 unit is now a multi-function unit providing the versatility to control several activities including all of Schmitt's balancer products.It controls balancing in applications with speeds ranging from 300 to 30,000 rpm compared to a range of 500 to 10,000 rpm with the prior Schmittproduct. Vibrations are measured to 0.02 microns or 0.75 millionths of an inch, a ten-fold performance improvement over the prior control unit. Italso allows customers to balance their grinding machines faster, reducing costly down time and increasing factory throughput. This generation ofcomputer control allows the future addition of new Schmitt products currently under development. The AEMS (Acoustical Emissions Monitoring System) is controlled by the SB-4500 control unit and monitors the customers' dressing andgrinding processes by direct measurement of machine-generated acoustic signals. By monitoring the high frequency sound signal generated bycontact between the wheel and work piece, the system automatically determines when wheel contact is made. Users can eliminate the "gap" timefrom their grinding process and also automatically detect the beginning of a wheel "crash" and immediately signal the grinder to stop before realdamage occurs. The benefits of the AEMS product to the customer include time savings from quick and easy setups, improved dressing andgrinding process, and elimination of expensive part and machine damage. The disk drive industry presented the Company with the challenge of developing the technology and products to measure the surfaceroughness of glass substrates, the disk drive media of the future. Existing SMS technology was modified to produce the required light scatterinformation to provide the necessary measurements. The engineering staff developed the DUV (Deep Ultra-violet light) technology to measuresurface microroughness of glass substrates to the same precise levels as existing products and at levels required by the industry. This technologycompliments existing products and provides the Company the ability to supply solutions for all media used by the disk drive industry. During Fiscal 2002, 2001 and 2000, the Company's research and development expense totaled $217,444, $327,474 and $380,601respectively.Business Risks This annual report includes "forward-looking statements" as that term is defined in Section 21E of the Securities Exchange Act of 1934.Forward-looking statements can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "will," "should,""seeks," "approximately," "intends," "plans," "estimates," "anticipates," or "hopeful," or the negative of those terms or other comparableterminology, or by discussions of strategy, plans or intentions. For example, this section contains numerous forward-looking statements. Allforward-looking statements in this report are made based on management's current expectations and estimates, which involve risks and9 uncertainties, including those described in the following paragraphs. Among these factors are the following:•Demand for company products may change. •New products may not be developed to satisfy changes in consumer demands. •Failure to protect intellectual property rights could adversely affect future performance and growth. Failure to protect intellectual property rights could adversely affect future performance and growth. •Production time and the overall cost of products could increase if any of the primary suppliers are lost or if any primary supplierincreased the prices of raw materials. •Fluctuations in quarterly and annual operating results make it difficult to predict future performance. •The Company may not be able to reduce operating costs quickly enough if sales decline further. •The Company maintains a significant investment in inventories in anticipation of future sales. •The limited duration of the bank credit agreement could impact future liquidity. •Future success depends in part on attracting and retaining key management and qualified technical and sales personnel. •The Company faces risks from international sales and currency fluctuations. •Future operations may not generate sufficient earnings to fully realize the US Federal Tax net operating loss carryforwards. Such risks and uncertainties could cause actual results to be materially different from those in the forward-looking statements. Readers arecautioned not to place undue reliance on the forward-looking statements in this report. We assume no obligation to update such information.Demand for Company products may change: For several months, the Company has experienced soft market demand for its Balancer products. While the specific reasons are difficult topinpoint, these can generally be attributed to worldwide economic conditions, specifically those in the grinding machine industry, the primarymarket for the Company's Balancer products. Based upon analysis by management and the sales staff, the decline in sales does not appear toarise from a shift in the customer base to competitor products. Management has responded to these soft market conditions in several ways. First, it appears there is a significant portion of the marketplacethat is not using the automatic balancing products of the Company or any of its competitors. To capitalize on this opportunity, two new salespeople have been hired, one late in Fiscal 2001 and the second in May 2002. Second, the Company will devote a significant part of its R&D effortsin Fiscal 2003 and 2004 toward developing products that will both broaden the scope of products offered to the current customer base plus offerproducts for new markets thereby reducing the reliance on historic markets. Third, management initiated a restructuring plan in Europe in the fourthfiscal quarter of 2001 that was intended to increase worldwide operating efficiency. All engineering design and manufacturing operations are nowconsolidated in the United States, a step that is expected to reduce operating costs. In addition, all European operations are now focused totallyon marketing and sales. Finally, management will continue to evaluate all operating costs and seek to reduce costs where necessary. The Measurement segment has relied heavily upon sales to disk drive and silicon wafer manufacturers. Conditions in those marketsadversely affected sales beginning in Fiscal 1999 and those poor conditions continued into Fiscal 2002. Disk drive demand is largely tied to anddependent upon10 demand for personal computers. In Fiscal 2001, personal computer manufacturers warned of lower sales expectations and many initiated actionsto significantly reduce costs. These soft market conditions have continued into Fiscal 2002. Consequently, demand for drives have fallen andoperations of those companies have suffered with one result being reduced capital spending. This has resulted in minimal demand for and sales ofthe Company's TMS products. Industry forecasts are for these conditions to continue in the foreseeable future. The semiconductor industry is also currently facing a down cycle. Beginning in fiscal 2001 the semiconductor industry experienced backlogcancellations, resulting in slower revenue growth and these conditions continued into Fiscal 2002. The result is similar to disk drive manufacturersin that capital spending has declined significantly and consequently so has demand for and sales of the Company's wafer products. Forecasts forthat industry are for only small improvement in market conditions through the end of calendar 2002 with increasing growth thereafter. Management will continue to market these products to these historic markets as it appears no other technology has been introduced thatwould make the TMS products technologically obsolete. There is the belief that once market conditions improve in the disk drive and silicon wafermarkets, demand for the Company's products and technology will increase. Also, there are other uses for the Company's laser light scattertechnology and efforts will be directed toward the R&D efforts to develop new products and introduce them to the marketplace.New products may not be developed to satisfy changes in consumer demands: The failure to develop new technologies, or react to changes in existing technologies, could materially delay development of new products,which could result in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design,develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. New productopportunities may not be identified and developed and brought to market in a timely and cost-effective manner. Products or technologiesdeveloped by other companies may render products or technologies obsolete or noncompetitive or a fundamental shift in technologies in theproduct markets could have a material adverse effect on the Company's competitive position within historic industries.Failure to protect intellectual property rights could adversely affect future performance and growth: Failure to protect existing intellectual property rights may result in the loss of valuable technologies or having to pay other companies forinfringing on their intellectual property rights. The Company relies on patent, trade secret, trademark and copyright law to protect suchtechnologies. There can be no assurance that any of the Company's U.S. patents will not be invalidated, circumvented, challenged or licensed toother companies.Production time and the overall cost of products could increase if any of the primary suppliers are lost or if a primary supplier increased the pricesof raw materials: Manufacturing operations depend upon obtaining adequate supplies of raw materials on a timely basis. The results of operations could beadversely affected if adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increasedsignificantly.Fluctuations in quarterly and annual operating results make it difficult to predict future performance: Quarterly and annual operating results are likely to fluctuate in the future due to a variety of factors, some of which are beyondmanagement's control. As a result of quarterly operating fluctuations, it is important to realize quarter-to-quarter comparisons of operating resultsare not necessarily meaningful and should not be relied upon as indicators of future performance11 The Company may not be able to reduce operating costs quickly enough if sales decline: Operating expenses are generally fixed in nature and largely based on anticipated sales. During the second quarter of Fiscal 2002,Management responded to declining sales by instituting an expense reduction program that significantly reduced the break-even sales point.However, should sales decline, there is no guarantee management could take actions that would further reduce operating expenses in either atimely manner or without seriously impacting the operations of the Company.The Company maintains a significant investment in inventories in anticipation of future sales: The Company has always sought to maintain a competitive advantage by shipping product to its customers more rapidly than itscompetitors. As a result, the Company has a significant investment in finished goods and raw materials inventories. These inventories arerecorded using the lower-of-cost or market method, which requires management to make certain estimates. Management evaluates the recordedinventory values based on customer demand, market trends and expected future sales and changes these estimates accordingly. A significantshortfall of sales may result in carrying higher levels of inventories of finished goods and raw materials thereby increasing the risk of inventoryobsolescence and corresponding inventory write-downs. As a result, the Company may not carry adequate reserves to offset such write-downs.The limited duration of the bank credit agreement could impact future liquidity: The short-term credit line expires on February 1, 2003 and there is no guarantee the arrangement will be renewed beyond that date. Shouldthe credit line not be renewed, Management would seek such an arrangement from other sources. While management believes it could securecredit from another source, there is no guarantee this can be accomplished or, if it is accomplished, the terms will be as favorable as those underthe current line of credit.Future success depends in part on attracting and retaining key management and qualified technical and sales personnel: Future success depends on the efforts and continued services of key management, technical and sales personnel. Significant competitionexists for such personnel and there is no assurance key technical and sales personnel can be retained nor assurances there will be the ability toattract, assimilate and retain other highly qualified technical and sales personnel as required. There is also no guarantee key employees will notleave and subsequently compete against the Company. The inability to retain key personnel could adversely impact the business, financialcondition and results of operations.The Company faces risks from international sales and currency fluctuations: The Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to accountfor a significant portion of future revenue. International sales are subject to a number of risks, including: the imposition of governmental controls;trade restrictions; difficulty in collecting receivables; changes in tariffs and taxes; difficulties in staffing and managing international operations;political and economic instability; general economic conditions; and fluctuations in foreign currencies. No assurances can be given these factorswill not have a material adverse effect on future international sales and operations and, consequently, on business, financial condition and resultsof operations.12 The Company maintains a significant investment in another publicly held company where the fair market value of the stock is below acquisitioncost: The Company maintains an investment in Air Packaging Technologies, Inc. (AIRP). As required under Statement of Financial AccountingStandards No. 115, this investment is classified as "Available-for-sale securities" with all unrealized gains and losses (net of taxes) included inAccumulated Other Comprehensive Loss and reported as a separate component in Other Comprehensive Loss in Stockholders' Equity untilrealized. Management reviews the investment each quarter in order to evaluate if the unrealized loss is temporary or a permanent impairment invalue. If conditions lead to the conclusion the difference appears to be "other than temporary", the investment is required to be written down to theestimated fair market value with the loss included in earnings. As of May 31, 2002 management believed the decline in value from historic costwas "other than temporary" and therefore this asset was written down to the fair market value at that date. There can be no guarantees in futureperiods that additional write-downs of this asset will not be required.Future operations may not generate sufficient earnings to fully realized the US Federal Tax net operating loss carryforwards: As of May 31, 2002, the Company has a net deferred tax asset of $636,006 that relates to net operating loss carryforwards from priorperiods. These net operating loss carryforwards will provide a benefit in future periods by reducing the liability for Federal taxes on income.However, to the extent there is no income through the expiration of the NOLs, (currently through 2009) the deferred tax asset could be worthless.The prospects for future earnings are therefore evaluated by Management each quarter so as to properly assess the likelihood there will besufficient operating income (for US Federal income tax purposes) to fully utilize this asset. As of May 31, 2002 the assessment by Managementconcluded there appeared to be sufficient earnings potential through the year ended May 31, 2009 so that these NOLs and therefore the deferredtax asset could be utilized. However, there can be no guarantees that future analysis by Management will lead to the same conclusion.International Sales The Company's sales in the last three fiscal years by geographic areas are: North America Europe Asia and OthersFiscal 2002 $4,337,917 $1,627,203 $909,539Fiscal 2001 $5,041,830 $1,950,395 $587,929Fiscal 2000 $6,063,284 $2,238,085 $552,887Backlog The Company does not generally track backlog. Normally, orders are shipped within a few days after receipt unless the customer requestsotherwise.Employees As of July 5, 2002, the Company employed 41 individuals worldwide on a full-time basis. There were no regular part-time employees. None ofthe Company's employees is covered by a collective bargaining agreement. Item 2. Properties The Company's design and assembly facilities and executive offices are located in a 7,500-square foot Company-owned building in Portland,Oregon and SMS operations are in a 33,000-square foot Company-owned facility located across the street from the executive offices. SELoccupies a13 1,893-square foot facility in Coventry, England pursuant to a three-year lease beginning June 1, 2002 with a basic monthly rent of £1,875(approximately $2,750 as of July 5, 2002). SEG occupies a 620 square foot facility in Pfungstadt, Germany pursuant to a five-year lease beginningDecember 1, 2001 with a basic monthly rent of 560 Euros (approximately $500 as of July 5, 2002). ARI occupies a 3,670 square foot facility inMenlo Park, California pursuant to a one-year lease beginning November 1, 2001 with a basic monthly rent of $7,487 as of July 5, 2002.Management believes its facilities are adequate to meet its currently foreseeable needs. Item 3. Legal Proceedings There are no material legal proceedings currently pending against the Company. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the security holders of the Company during the fourth quarter ended May 31, 2002.14 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's Common Stock is traded on the Nasdaq SmallCap Market under the symbol "SMIT." The following tables set forth the high and low sales prices of the Company's Common Stock as reported on the Nasdaq National Market andThe Nasdaq Smallcap Market (after May 23, 2002) for the periods indicated.Year Ended May 31, 2002 High LowFirst Quarter $1.09 $0.71Second Quarter $0.92 $0.29Third Quarter $0.56 $0.35Fourth Quarter $0.72 $0.34Year Ended May 31, 2001 High LowFirst Quarter $3.47 $2.13Second Quarter $3.00 $2.00Third Quarter $2.38 $0.88Fourth Quarter $1.24 $0.63 As of July 5, 2002, there were 7,405,274 shares of Common Stock outstanding held by approximately 130 holders of record. The number ofholders does not include individual participants in security position listings; the Company believes that there are more than 2,500 individual holdersof shares of Common Stock. The Company has not paid any dividends on its Common Stock since 1994. The Company's current policy is to retain earnings to finance theCompany's business. Future dividends will be dependent upon the Company's financial condition, results of operations, current and anticipatedcash requirements, acquisition plans and plans for expansion and any other factors that the Company's Board of Directors deems relevant. TheCompany has no present intention of paying dividends on its Common Stock in the foreseeable future. Item 6. Selected Financial Data In thousands, except per share informationYear Ended 5/31/02 5/31/01 5/3100 5/31/99 5/31/98Sales $6,875 $7,580 $8,854 $7,958 $10,626Net (Loss) Income $(1,599)$(2,367)$561 $(259)$1,250Net (Loss) Income Per Share, Basic $(.21)$(.30)$0.07 $(0.03)$0.18Weighted Average. No. Shares, Basic 7,465 7,905 8,104 7,592 7,091Net (Loss) Income Per Share, Diluted $(.21)$(.30)$0.07 $(0.03)$0.17Weighted Average No. Shares, Diluted 7,465 7,905 8,607 7,592 7,456Stockholders' Equity $7,251 $8,930 $10,128 $10,587 $8,688Total Assets $8,161 $10,291 $10,953 $11,282 $9,619Long-term debt (including current portion) $280 $353 $— $— $—15 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following information contains certain forward-looking statements that anticipate future trends or events. These statements are based oncertain assumptions that may prove to be erroneous and are subject to certain risks including but not limited to the uncertainties of the Company'snew product introductions, the risks of increased competition and technological change in the Company's industries and other factors detailed inthe Company's SEC filings. Accordingly, actual results may differ, possibly materially, from the predictions contained herein.RESULTS OF OPERATIONSCritical Accounting Policies Revenue Recognition—The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, thesales price is fixed or determinable and collectibility is probable. For sales to all customers, including manufacturer representatives, distributors ortheir third-party customers, these criteria are met at the time product is shipped. When other significant obligations remain after products aredelivered, revenue is recognized only after such obligations are fulfilled. Accounts Receivable—The Company maintains credit limits for all customers that are developed based upon several factors, included butnot limited to payment history, published credit reports and use of credit references. On a monthly basis, Management performs various analysesto evaluate accounts receivable balances to ensure recorded amounts reflect estimated net realizable value. This review includes accountsreceivable agings, other operating trends and relevant business conditions, including general economic factors, as they relate to each of theCompany's domestic and international customers. If this analyses leads Management to the conclusion that potential significant accounts areuncollectable, a reserve will be provided. The Company has had no significant bad debt write-offs since its inception in 1986. As of May 31, 2002,Management does not believe any significant accounts were uncollectable and therefore no reserve was considered necessary. Inventories—These assets are stated at the lower of cost or market on an average cost basis. Each fiscal quarter, Management utilizesvarious analyses based on sales forecasts, historical sales and inventory levels to ensure the current carrying value of inventory accuratelyreflects current and expected requirements within a reasonable timeframe. As a result of this analysis at May 31, 2002, Management believes theinventory levels are sufficient based upon the expected requirements in fiscal 2003 and beyond.. Based upon the same analysis in fiscal 2001,Management determined $1,646,517 of inventories were in excess of expected requirements and therefore these amounts were written off. Long term Investment—the long-term investment in Air Packaging Technologies, Inc. (AIRP). This investment is classified as "Available-for-sale securities" under Statement of Financial Accounting Standards No. 115 (SFAS no. 115). As required under that statement, all unrealizedgains and losses (net of taxes) are included in Accumulated Other Comprehensive Loss and reported as a separate component in OtherComprehensive Loss in Stockholders' Equity until realized or until unrealized losses are deemed to be other than temporary. Management reviewsthe investment each quarter in order to evaluate if any unrealized loss is temporary or a permanent impairment in value. If conditions lead to theconclusion the loss appears to be "other than temporary", the investment is written down to the estimated fair market value with the loss includedin earnings. As of May 31, 2002 management believed the decline in value from historic cost was "other than temporary" and therefore this assetwas written down to the fair market value at that date. Further write-downs will be recorded if and when management determines that continuedlosses are "other than temporary." Long-term Deferred Tax Asset—The Company applies the asset and liability method in recording income taxes, under which deferred incometax assets and liabilities are determined based on the16 differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws.Additionally, deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of thedeferred tax asset will not be realized. As of May 31, 2002, Management believed the Company would generate sufficient future income to utilizethe net deferred tax asset. Intangible Assets—There is a periodic review of intangible and other long-lived assets for impairment. This review consists of the analysis ofevents or changes in circumstances that would indicate the carrying amount of the asset may not be recoverable. Recoverability is determined bycomparing the forecasted future net cash flows from the operations to which the assets relate, based on management's best estimates using theappropriate assumptions and projections at the time, to the carrying amount of the assets. If the carrying value is determined to be in excess offuture operating cash flows, the asset is considered impaired and a loss is recognized equal to the amount by which the carrying amount exceedsthe estimated fair value of the assets. As of May 31, 2002, Management did not believe an impairment, as defined above, exists.Discussion of operating results: Sales in Fiscal 2002 decreased to $6,874,659 from $7,580,154 and $8,854,256 in Fiscal 2001 and 2000 respectively. Worldwide sales ofSchmitt Balancing products in Fiscal 2002 decreased to $5,275,556 from $6,030,030 and $7,244,969 in Fiscal 2001 and 2000 respectively.Measurement sales increased to $1,599,103 from $1,550,124 in Fiscal 2001 but decreased slightly from $1,609,287 in Fiscal 2000. The net (loss)for Fiscal 2002 of $(1,598,619) compares to a net loss of $(2,366,953) in Fiscal 2001 and net income for Fiscal 2000 of $561,459. The loss inFiscal 2002 was primarily attributable to a $1,516,000 non-operating charge for a write-down of the Company's long-term investment in AirPackaging Technologies, Inc. The loss in Fiscal 2001 was primarily attributable to a write-off of excess inventory in the subsidiary that designsand assembles laser light scatter products. Also contributing to the losses in Fiscal 2002 and 2001 were decreasing sales, primarily in theBalancer segment with the general economic slowdown in North America and Europe believed to be the biggest cause. Domestic and foreign revenues in the past several months have been affected by the slowdown in the global economy, resulting in reduceddemand for both Balancer and Measurement devices. The Balancer segment sales focus on end-users, rebuilders and original equipmentmanufacturers throughout the world. Sales staff, representatives and distributors throughout these geographic areas spend a large amount of timewith the targeted customers. Over the past several months they have found many of the customers in the automotive, bearing and aircraftindustries have referred to the state of the economy and its impact on the machine tool industry as reasons for their reduced ordering activity. Theprimary target markets for Measurement products have historically been disk drive and silicon wafer manufacturers. Management and sales staffmonitor industry publications and public financial information in order to judge the potential demand for Measurement products by these targetedindustries. As in the prior fiscal year, this information has discussed at length declining demand for and sales of the products of those twoindustries and has generally defined industries that are in a severe recession. Also, frequent discussions with customers have confirmed theinformation presented in the public information and their inability to purchase Measurement products due to their lack of a capital budget. Historically, the Company has enjoyed low cost of sales percentages, with those on its Balancing products less than 50% and those on itsMeasurement products less than 40%. Fiscal 2002 consolidated cost of sales as a percentage of sales totaled 41% compared to those in Fiscal2001 and 2000 of 68% and 44% respectively. Fiscal 2002 cost of sales decreased significantly from Fiscal 2001 as the latter fiscal year includedlarge write-downs of inventory in the Measurement segment and the write-off of obsolete inventories in the German subsidiary. Cost of sales in theBalancer segment decreased to 46% from 51% in Fiscal 2001 and 47% in Fiscal 2000. The cost of sales percentage in Fiscal 2001 includes a17 write-off of obsolete inventory in the German subsidiary of $110,250 which, when excluded from cost of sales, would decrease the percentage to49%. Cost of sales for Measurement products decreased to 25% from 136% and 30% in Fiscal 2001 and 2000 respectively. Fiscal 2001 includesan inventory writedown of $1,536,267 and, when the inventory write-down is excluded, the cost of sales percentage for Fiscal 2001 is 37%. Thevariation from the percentage in the prior years is due to the sales mix. Management expects the trends in sales and profits during Fiscal 2003 forthe Balancer segment to improve slightly while those of the Measurement segment will approximate results for Fiscal 2002. However, noassurances can be made that the Company will be profitable or will generate increased sales in future time periods. General, administrative and sales expenses as a percentage of net sales were 56% in Fiscal 2002 compared to 57% in Fiscal 2001 and 43%in fiscal 2000. In terms of dollars, these expenses were $3,856,354, $4,297,130 and $3,809,976 in Fiscal 2002, 2001 and 2000 respectively. Thedecrease in expenses in fiscal 2002 occurred as a result of management actions initiated in the second fiscal quarter of that year. The increase inexpenses in fiscal 2001 compared to fiscal 2000, despite decreasing sales, resulted from the acquisition of Acuity Research effective June 1,2001. When the Acuity expenses are excluded, these expenses in 2001 would have been $3,707,754, lower than those reported in fiscal 2000. Infuture fiscal periods, Management believes the Company's costs will not increase at the same rate that sales are anticipated to increase, althoughthere can be no such assurance. Research and development expenses as a percentage of net sales were 3.2% in fiscal 2002 compared to 4.3% in both fiscal 2001 and 2000.In terms of dollars, these expenses were $217,444, $327,474 and $380,601 in fiscal 2002, 2001 and 2000 respectively. The Company's futureoperating results depend, to a considerable extent, on its ability to maintain a competitive advantage in both the products and services it provides.For this reason, Management believes future investments in research and development are critical to ensure the flow of innovative, productive,high-quality products and support services. Accordingly, Management expects to continue to place a high priority on research and developmentprojects in the future. The Company realized a net loss of $1,598,619 ($0.21 per share) compared to a net loss of $(2,366,953) ($0.30 per share) in Fiscal 2001 andnet income of $561,459 in Fiscal 2000 ($0.07 per diluted share). Of the net loss in Fiscal 2002, $1,516,000 ($0.20 per fully diluted share) related tothe write-down to fair market value of the long-term investment in Air Packaging Technologies, Inc. Of the net loss in Fiscal 2001, $1,646,517($0.21 per fully diluted share) related to the write-off of excess inventories in the Measurement segment and obsolete inventories of the Germansubsidiary and $116,275 ($0.01 per diluted share) related to the expenses incurred in relation to the restructure of the German subsidiary. Net sales outside the United States accounted for approximately 40% of the Company's revenues in Fiscal 2002, 37% in Fiscal 2001 and34% in Fiscal 2000. Some foreign customers purchase in their own country's currencies, thereby imposing on the Company a currency risk. AllU.S. sales (60% of total sales in Fiscal 2002) were in U.S. dollars and the remaining Fiscal 2002 sales were in currencies other than U.S. dollars.To date, currency fluctuations have had minimal impact on revenue realization. However, significant variations in the value of the U.S. dollar,relative to currencies of countries in which the Company has significant competitors, can impact future sales. The Company does not engage incurrency hedging. In addition, the longer payment cycles of international sales can have a negative impact on liquidity. The Company believesinternational sales will continue to grow in future periods. A substantial portion of the Company's revenues is derived from sales to end users through selling agents and directly to builders of machinetools. The Company is dependent on the sales activities of its selling agents, and there can be no assurance these agents will continue to besuccessful in their efforts to market the Company's products. The Company enjoys substantial repeat business from a18 broad base of customers, but there is no assurance these customers will continue to buy the Company's products. For Fiscal years 2002, 2001 and 2000, sales to a single customer did not exceed 10% of total revenues. The Company operates in highly competitive industries characterized by increasingly rapid technological changes. The Company'scompetitive advantage and future success are therefore dependent on its ability to develop new products, qualify these new products with itscustomers, successfully introduce these products to the marketplace on a timely basis, commence production to meet customer demands anddevelop new markets in the industries for its products and services. The successful introduction of new technology and products is increasinglycomplex. 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 be adversely impacted.LIQUIDITY AND CAPITAL RESOURCES The Company's ratio of current assets to current liabilities increased to 5.7 to 1 at May 31, 2001 compared to 4.8 to 1 at May 31, 2001. As ofMay 31, 2002 the Company had $447,679 in cash compared to $291,083 at May 31, 2001. During the year ended May 31, 2002, cash provided from operating activities amounted to $252,463 with the changes described as follows:•The net loss for the year ended May 31, 2002 of $(1,598,619) plus three noncash items, the write-down of the long-term investmentof $1,516,000, depreciation and amortization of $245,138 and a $122,975 decrease in the long-term deferred tax asset. •Accounts receivable provided cash as the balance decreased $92,121 to a May 31, 2002 balance of $1,135,036 compared to$1,227,157 at May 31, 2001. At May 31, 2002, no significant accounts receivable were considered a doubtful collection. TheCompany generally experiences a payment cycle of 30-90 days on invoices. Management believes its credit and collection policiesare effective and appropriate for the marketplace and the Company has had no significant bad debt write-offs since its inception in1986. There can be no assurance that the Company's collection procedures will continue to be successful, particularly with currenteconomic conditions. •Inventories decreased $350,916 from the balances at May 31, 2001 with inventories in the Balancer segment decreasing by$401,343 and those in the Measurement segment increasing by $50,427. The Company maintains levels of inventory sufficient tosatisfy normal customer demands plus an increasing short-term delivery requirement for a majority of its Balancer products.Management believes its ability to provide prompt delivery gives it a competitive advantage for certain sales. •Prepaid expenses decreased by $24,690 due to amortization of several items including prepaid trade show costs, professional feesand various business and life insurance costs. •Trade accounts payable decreased by $179,079 with the reduction due to the continued decline in purchasing activities of the UScompanies. The purchasing activities of those companies, particularly for inventory items, were lower in the weeks proceedingMay 31, 2002 than in the weeks preceding May 31, 2001. •Other accrued liabilities (including commission, payroll items and other accrued expenses) decreased by $198,594, with the largestdecrease in accrued payroll and related liabilities ($48,323) and the liability related to the restructure of operations in Germany($106,764).19 During the year ended May 31, 2002, net cash used in investing activities was $71,081, consisting of net additions to property andequipment. Net cash used in financing activities amounted to $135,993, which consists of $33,877 in long-term borrowings, less $106,015 inrepayments of long-term debt and the purchase of shares of the Company's common stock for $63,855. The following summarizes contractual obligations at May 31, 2002 and the effect on future liquidity and cash flows:Years EndingMay 31, Long-Term Debt Capital LeaseObligations Operating Leases TotalContractualObligations2003 $252,600 $12,244 $93,926 $358,7702004 — 11,344 39,180 50,5242005 — 4,274 39,180 43,4542006 — — 6,276 6,2762007 — — 3,138 3,138Thereafter — — — — Total $252,600 $27,862 $181,700 $462,162 The acquisition of SMS in Fiscal 1995 resulted in a tax loss of approximately $5.5 million, which is available to offset domestic earningsthrough the year 2009. As of May 31, 2002, approximately $2.1 million of these losses remain. Specific business challenges faced by the Company over the past few years have had a negative impact on operations and liquidity.Management has responded to these challenges by reducing operating expenses, developing new products and penetrating new markets for theCompany's products. As a result of these efforts, Management believes its cash flows from operations, available credit resources and its cashposition will provide adequate funds on both a short-term and long-term basis to cover currently foreseeable debt payments, lease commitmentsand 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-relatedcontingencies during Fiscal 2003. However, in the event the Company fails to achieve its operating and financials goals in for fiscal 2003,management may be required to take certain actions to finance operations in that time period. These actions could include, but are not limited to,implementation of additional cost cutting measures, increased borrowings from existing credit facilities or entering into additional borrowingarrangements that are collateralized by assets. Item 7A. Qualitative and Quantitative Disclosures about Market Risk Interest Rate Risk The Company did not have any derivative financial instruments as of May 31, 2002. However, the Company is exposed to interest rate risk.The Company employs established policies and procedures to manage its exposure to changes in the market risk of its marketable securities. The Company's interest income and expense are most sensitive to changes in the general level of U.S. and European interest rates.Therefore, changes in U.S. and European interest rates affect the interest earned on the Company's cash equivalents and marketable securities aswell as interest paid on debt. The Company has lines of credit and other debt whose interest rates are based on various published prime rates that may fluctuate over timebased on economic changes in the environment. The Company is subject to interest rate risk and could be subject to increased interest paymentsif20 market interest rates fluctuate. The Company does not expect any change in the interest rates to have a material adverse effect on the Company'sresults from operations.Foreign Currency Risk The Company operates subsidiaries in the United Kingdom and Germany. The Company's business and financial condition is, therefore,sensitive to currency exchange rates or any other restrictions imposed on their currencies. To date, the foreign currency exchange rates have notsignificantly impacted the Company's profitability.21 Item 8. Financial Statements and Supplementary Data SCHMITT INDUSTRIES, INC.CONSOLIDATED BALANCE SHEETSMAY 31, 2002 AND 2001 ASSETS 2002 2001 Current Assets Cash $447,679 $291,083 Accounts receivable 1,135,036 1,227,157  Inventories 3,208,122 3,559,038 Prepaid expenses 161,880 186,570 Income taxes receivable 156,636 33,661 5,109,353 5,297,509 Property and Equipment Land 299,000 299,000 Buildings and improvements 1,206,346 1,216,140 Furniture, fixtures and equipment 947,866 948,901 Vehicles 139,091 155,010 2,592,303 2,619,051 Less accumulated depreciation and amortization 1,174,560 1,081,854 1,417,743 1,537,197 Other Assets Long-term investment 619,000 2,408,000 Long-term deferred tax asset 636,006 613,871 Other assets 379,328 433,931 1,634,334 3,455,802 TOTAL ASSETS $8,161,430 $10,290,508 LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Line of credit $200,000 $200,000 Accounts payable 239,008 418,087 Accrued commissions 157,325 129,154 Other accrued liabilities 33,978 260,743 Current portion of long-term debt 264,845 100,000 895,156 1,107,984 Long-term Debt 15,617 252,600 Commitments and Contingencies (Note 8) Stockholders' Equity Common stock, no par value, 20,000,000 shares authorized, 7,405,274 and 7,505,774 sharesissued and outstanding at May 31, 2002 and 2001, respectively 7,343,621 7,407,476 Accumulated other comprehensive loss (192,747) (175,954) Retained earnings 99,783 1,698,402 7,250,657 8,929,924 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $8,161,430 $10,290,508 The accompanying notes are an integral part of these consolidated statements22 SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF OPERATIONSFOR THE YEARS ENDED MAY 31, 2002, 2001 AND 2000 2002 2001 2000 Net Sales $6,874,659 $7,580,154 $8,854,256  Cost of Sales Operations, exclusive of inventory write-downs 2,844,937 3,529,991 3,895,345 Inventory write-downs — 1,646,517 — Total cost of sales 2,844,937 5,176,508 3,895,345 Gross profit 4,029,722 2,403,646 4,958,911 Operating expenses: General, administrative, and sales 3,856,354 4,297,130 3,809,976 Research and development 217,444 327,474 380,601 Restructure expenses — 116,275 — Total operating expenses 4,073,798 4,740,879 4,190,577 Operating (loss) income (44,076) (2,337,233) 768,334 Other income and expense: Interest expense (53,468) (15,016) (628) Interest income 4,665 36,513 30,462 Loss on write-down of long-term investment (1,516,000) — — Gain (loss) on foreign currency exchange (15,470) (63,855) (61,377) Rental income 22,800 18,407 22,800 Miscellaneous (expense) income 2,930 (5,769) 4,072 Other income and expense (1,554,543) (29,720) (4,671) (Loss) income before provision for income taxes (1,598,619) (2,366,953) 763,663 Provision for income taxes — — 202,204 Net (loss) income $(1,598,619)$(2,366,953)$561,459 Net (loss) income per common share, basic $(0.21)$(0.30)$0.07 Weighted average number of common shares, basic 7,465,357 7,904,793 8,103,563 Net (loss) income per common share, diluted $(0.21)$(0.30)$0.07 Weighted average number of common shares, diluted 7,465,357 7,904,793 8,606,835 The accompanying notes are an integral part of these consolidated financial statements23 SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITYFOR THE YEARS ENDED MAY 31, 2002, 2001 AND 2000  Shares Amount AccumulatedOtherComprehensive(Loss) RetainedEarnings Total TotalComprehensive(Loss) Balance, May 31, 1999 8,184,889 $7,284,445 $(201,781)$3,503,896 $10,586,560 $ Stock options exercised 10,000 30,000 — — 30,000 Common shares retired (192,500) (282,975) — — (282,975) Note cancelled in return forstock 282,975 — — 282,975 Common shares repurchased (22,000) (55,046) — — (55,046) Net income — — — 561,459 561,459 561,459 Other comprehensive loss — — (994,902) — (994,902) (994,902) Balance, May 31, 2000 7,980,389 7,259,399 (1,196,683) 4,065,355 10,128,071 Comprehensive loss, yearended May 31, 2000 (433,443) Common shares issued topurchase Acuity Research 275,000 747,725 — — 747,725 Common shares retired (293,250) (586,500) — — (586,500) Note cancelled in return forstock 586,500 — — 586,500 Common shares repurchased (456,365) (599,648) (599,648) Net (loss) — — — (2,366,953) (2,366,953) (2,366,953)Other comprehensive income — — 1,020,729 — 1,020,729 1,020,729 Balance, May 31, 2001 7,505,774 7,407,476 (175,954) 1,698,402 8,929,924 Comprehensive loss, yearended May 31, 2001 (1,346,224) Common shares repurchased (100,500) (63,855) (63,855) Net (loss) — — (1,598,619) (1,598,619) (1,598,619)Other comprehensive loss — — (16,793) (16,793) (16,793) Balance, May 31, 2002 7,405,274 $7,343,621 $(192,747)$99,783 $7,250,657 Comprehensive loss, yearended May 31, 2002 $(1,615,412) The accompanying notes are an integral part of these consolidated financial statements24 SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED MAY 31, 2002, 2001 AND 2000 2002 2001 2000 Cash Flows Relating to Operating Activities Net (loss) income $(1,598,619)$(2,366,953)$561,459 Adjustments to reconcile net (loss) income to net cash provided by (usedin) operating activities Write-down of long-term investment 1,516,000 — — Write-down of excess inventory quantities — 1,646,517 — Depreciation and amortization 245,138 269,631 267,580 Deferred taxes 122,865 — 139,757 (Increase) decrease in: Accounts receivable 92,121 215,525 46,189 Inventories 350,916 (495,524) (191,780) Prepaid expenses 24,690 (115,202) 10,432 Income taxes receivable (122,975) (8,743) 271,046 Increase (decrease) in: Accounts payable (179,079) (59,226) 79,309  Accrued commissions and other accrued liabilities (198,594) 36,847 62,302 Income taxes payable — — (12,819) Net cash provided by (used in) operating activities 252,463 (877,128) 1,233,475 Cash Flows Relating to Investing Activities Purchase of property and equipment (110,458) (147,616) (190,086) Disposal of property and equipment 39,377 17,067 47,145 Cash acquired in purchase of wholly-owned subsidiary — 113,604 Net cash used in investing activities (71,081) (16,945) (142,941) Cash Flows Relating to Financing Activities Proceeds from line of credit borrowings — 200,000 Proceeds of long-term borrowings 33,877 — — Repayment of long-term debt (106,015) (119,400) — Common stock repurchased (63,855) (127,648) (55,049) Exercise of stock options — — 30,000 Net cash used in financing activities (135,993) (47,048) (25,049) Effect of foreign exchange translation on cash 111,207 (32,271) (69,898) Decrease (increase) in cash 156,596 (973,392) 995,587 Cash, beginning of year 291,083 1,264,475 268,888 Cash, end of year $447,679 $291,083 $1,264,475 Supplemental Disclosure of Cash Flow Information Cash paid during the period for interest $58,771 $15,016 $628 Cash paid during the period for income taxes $110 $20,132 $16,110 Supplemental Schedule of NoncashInvesting and Financing Activities Increase (decrease) in market value of long-term investment $(273,000)$1,596,000 $(1,323,000)Increase (decrease) in long-term deferred tax asset $145,000 $(543,000)$398,000 Common stock issued for purchase of wholly-owned subsidiary $— $747,725 $— Wholly-owned subsidiary — net tangible assets acquired $— $(325,901)$— Wholly owned subsidiary — intangible assets acquired $— $(421,824)$— Long-term debt incurred to repurchase stock $— $472,000 $— The accompanying notes are an integral part of these consolidated statements25 SCHMITT INDUSTRIES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2002, 2001 AND 2000 NOTE 1ORGANIZATION AND NATURE OF OPERATIONS Schmitt Industries, Inc. (the Company) designs, assembles, markets and distributes electronic and mechanical components for machine toolproducts and laser measurement systems worldwide.NOTE 2SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPrinciples of Consolidation These consolidated financial statements include those of the Company and its wholly owned subsidiaries: Schmitt MeasurementSystems, Inc. (SMS), Schmitt Europe, Ltd. (SEL), Schmitt Europa GmbH (SEG) and Acuity Research Incorporated (ARI). All significantintercompany accounts and transactions have been eliminated in the preparation of the consolidated financial statements.Foreign Currency Translation Financial statements for the Company's subsidiaries outside the United States are translated into U.S. dollars at year-end exchange rates forassets and liabilities and weighted average exchange rates for income and expenses. The resulting translation adjustments are included as aseparate component of stockholders' equity titled "Accumulated Other Comprehensive Loss."Revenue Recognition The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed ordeterminable and collectibility is probable. For sales to all customers, including manufacturer representatives, distributors or their third-partycustomers, these criteria are met at the time product is shipped. When other significant obligations remain after products are delivered, revenue isrecognized only after such obligations are fulfilled.Research and Development Costs Research and development costs are charged to expense when incurred.Stock-Based Compensation Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (FAS 123) encourages, but does notrequire, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen tocontinue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,"Accounting for Stock Issued to Employees" (APB 25). Accordingly, compensation cost for stock options is measured as the excess, if any, ofthe quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock.Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carryingamounts of existing assets and liabilities and their respective tax bases.26 Earnings Per Share Basic earnings per share are computed using the weighted average number of shares outstanding. Diluted earnings per share are computedusing the weighted average number of shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchasecommon stock. Incremental shares of 503,272 in 2000 were used in the calculation of diluted earnings per share. In Fiscal 2002 and 2001, 380,142and 384,442 incremental shares were excluded from the diluted loss per share calculation, as their effect was anti-dilutive.Cash and Cash Equivalents The Company considers short-term investments that are highly liquid, readily convertible into cash and have original maturities of less thanthree months to be cash equivalents.Inventory Inventory is valued at the lower of cost or market with cost determined on the average cost basis. As of May 31, 2002 and 2001, inventoriesconsisted of raw materials ($1,870,507 and $1,962,312, respectively), work-in-process ($1,151 and $16,838, respectively), and finished goods($1,336,464 and $1,579,888, respectively).Property and Equipment Property and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three toseven years for furniture fixtures, and equipment; three years for vehicles; and twenty-five years for buildings and improvements.Concentration of Credit Risk Financial instruments that potentially expose the Company to concentration of credit risk are trade accounts receivable. Credit termsgenerally include a discount of 11/2% if the invoice is paid within ten days, with the net amount payable in 30 days. No allowance for doubtfulaccounts is considered necessary.Financial Instruments The carrying amounts of financial instruments approximate their fair values at May 31, 2002.Use of Estimates The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actualresults could differ from those estimates.New Accounting Pronouncements On July 20, 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations. SFAS No. 141establishes new standards for accounting and reporting requirements for business combinations and requires the purchase method of accountingbe used for all business combinations initiated after June 30, 2001. Use of the pooling-of-interest method is now prohibited. The Company adoptedthis statement during the first quarter of Fiscal 2002. The adoption of SFAS No. 141 did not have a material impact on the Company's consolidatedfinancial statements.27 On July 20, 2001, the FASB issued FASB Statement No. 142 (FAS 142) Goodwill and Other Intangible Assets. FAS 142 changes theaccounting for goodwill and certain other intangible assets from an amortization method to an impairment-only approach. Upon adoption ofFAS 142, goodwill and certain other intangible assets will be tested at the reporting unit annually and whenever events or circumstances occurindicating that goodwill and certain other intangible assets might be impaired. Amortization of goodwill and certain other intangible assets, includinggoodwill recorded in past business combinations, will cease. The adoption date for the Company will be June 1, 2002. The Company hasdetermined the impact of FAS 142 will not have an material impact on the Company's results of operations and financial position as of the adoptiondate. During Fiscal 2002, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which requires the recognition, as anAsset Retirement Obligation (ARO), of a liability for dismantlement and restoration costs associated with the retirement of tangible long-livedassets in the period in which the liability is incurred. SFAS No. 143 must be applied for fiscal years beginning after June 15, 2002. The Companyis currently evaluating the impact of SFAS 143 and expects there to be no material financial statement effect relating to its adoption. During 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedesSFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 144 retains thefundamental provisions of SFAS No. 121 for the measurement and recognition of the impairment of long-lived assets to be held and used, as wellas the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 resolves significant implementation issues related to SFASNo. 121, broadens the component of an entity to be included in the presentation for discontinued operations, and measures long-lived assets heldfor sale at the lower of their carrying amount or fair value (less cost to sell), while ceasing depreciation. SFAS 144 must be applied for fiscal yearsbeginning after December 15, 2001. The Company is evaluating the impact of SFAS No. 144 and expects there to be no material financialstatement effect relating to its adoption.NOTE 3LONG-TERM INVESTMENTS The Company owns 1,375,716 shares or approximately 11% of the outstanding shares of Air Packaging Technologies, Inc. That company isengaged in the design, manufacture, marketing and sales of "Air Box" patented packaging systems used in the retail, industrial protective andpromotional packaging markets worldwide. This investment is classified as "Available-for-sale securities" under Statement of Financial AccountingStandards No. 115 (SFAS No. 115). As required under that statement, all unrealized gains and losses are reported in Accumulated OtherComprehensive Loss and included as a separate component in Other Comprehensive Loss in Stockholders' Equity until realized or until unrealizedlosses are deemed to be "other than temporary". At May 31, 2002 Management determined the decline in value of the investment from acquisition cost was "other than temporary", and, asrequired under SFAS No. 115, the long-term investment was written down by $1,516,000 to its fair market value as of May 31, 2002. Fair marketvalue was the closing price of the stock on the over-the-counter market at May 31, 2002. As required under SFAS No. 115, the new cost basisshall not be changed for subsequent recoveries in fair value. Future temporary gains and losses will be reported as required under SFAS No. 115.NOTE 4LINE OF CREDIT The Company has a $500,000 short-term line of credit agreement with a commercial bank, secured by U.S. accounts receivable andinventories. The line is guaranteed by the Company's wholly owned28 subsidiary, Schmitt Measurement Systems, Inc. Interest is payable at the bank's prime rate plus 1.50% and expires on February 1, 2003. As ofboth May 31, 2002 and 2001 $200,000 was outstanding on this line of credit. There are certain covenants related to the earnings of the Companyand the current ratio. As of May 31, 2002 the Company was in compliance with the current ratio requirement but was in violation of the net incomerequirement. As of May 31, 2002, the bank has waived its default rights with respect to this violation.NOTE 5INCOME TAXES The provision (benefit) for income taxes was as follows Years ended May 31, 2002 2001 2000 Current $— $— $62,447 Deferred (533,183) (718,431) 249,757 Increase (decrease) in valuation allowance 533,183 718,431 (110,000) Total provision (benefit) for income taxes $— $— $202,204 Deferred tax assets (liabilities) are comprised of the following components: 2002 2001 Depreciation $19,679 $3,311 Net operating loss carryforwards 1,319,512 1,527,545 Deferred taxes related to the (increase) decline in fair marketvalue of long-term investment 582,144 (145,000)Other asset capitalization 9,324 10,489 Other deferred assets 81,192 60,188 Gross deferred tax assets 2,011,851 1,456,533 Deferred tax asset valuation allowance (1,375,845) (842,662) Net deferred tax asset $636,006 $613,871 Through the acquisition of Schmitt Measurement Systems, Inc., the Company acquired approximately $5.5 million of U.S. federal netoperating loss carryforwards. As of May 31, 2002, approximately $2.1 million of these net-operating losses remain and will expire in the years 2007through 2009. The deferred tax asset valuation allowance in fiscal years 2002 and 2001 has been established based on management'sdetermination of the portion of the deferred tax asset that will more likely than not be utilized. The provision for income taxes differs from the amount of income taxes determined by applying the U.S. statutory federal tax rate to pre-tax(loss) income due to the following: Years Ended May 31, 2001 2001 2000 Statutory federal tax rate 34.0%34.0%34.0%State taxes, net of federal benefit — — 4.4 Change in deferred tax valuation allowance (29.8)(30.3)(13.2)Permanent and other differences (4.2)(3.7)1.3 Effective tax rate —%—%26.5% 29NOTE 6EMPLOYEE BENEFIT PLANS The Company adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan & Trust effective June 1, 1996. Employees must meet certainage and service requirements to be eligible. Participants may contribute up to 15% of their eligible compensation that is partially matched by theCompany. The Company may further make either a profit sharing contribution or a discretionary contribution. Contributions made by the Companyto this Plan during the years ended May 31, 2002, 2001 and 2000 were $47,881 $128,543 and $88,759 respectively.NOTE 7LONG-TERM DEBT During Fiscal 2001, the Company purchased 400,000 shares of its common stock from a private investor for $472,000. Under the terms ofthe stock purchase agreement, the Company paid $94,400 in cash at closing with the remainder due under a note agreement. The agreement callsfor quarterly principal payments of $25,000, plus interest at 9.00%, with the remaining balance due on December 31, 2002. During Fiscal 2002, the Company entered into two equipment lease agreements for $33,877. The agreements call for monthly principal andinterest payments of $534 and $580 with one requiring no interest payments and the other interest of 13.8%. The leases both expire in Fiscal2004. As of May 31, 2002, future debt principal and capital lease payments are:Year EndingMay 31, 2003 $264,8442004 $11,3442005 $4,274NOTE 8COMMITMENTS AND CONTINGENCIES In a transaction related to the acquisition of Schmitt Measurement Systems, Inc., formerly TMA Technologies, Inc. (TMA), the Companyestablished a royalty pool and vested in each shareholder and debt holder of the acquired company an interest in the royalty pool equal to theamount invested or loaned including interest payable through March 1995. The royalty pool will be funded at 5% of net sales (defined as grosssales less returns, allowances and sales commissions) of Schmitt Measurement Systems, Inc.'s products and future derivative productsdeveloped by Schmitt Industries, Inc., which utilize these technologies. As part of the royalty pool agreement, each former shareholder and debtholder released TMA from any claims with regard to the acquisition except their rights to future royalties. Royalty expense applicable to the yearsended May 31, 2002, 2001 and 2000 amounted to $27,763, $36,964 and $78,977, respectively. The Company has entered into various non-cancelable leases for facilities used to support operations in the United Kingdom, Germany andCalifornia. Rent expense for the years ended May 31, 2002, 2001 and 2000 amounted to $136,374, $136,388 and $77,466 respectively.30 Lease commitmentsYear EndingMay 31, 2003 $93,9262004 $39,1802005 $39,1802006 $6,2762007 $3,138Thereafter $— Specific business challenges faced by the Company over the past few years have had a negative impact on operations and liquidity.Management has responded to these challenges by reducing operating expenses, developing new products and penetrating new markets for theCompany's products. As a result of these efforts, Management believes its cash flows from operations, available credit resources and its cashposition will provide adequate funds on both a short-term and long-term basis to cover currently foreseeable debt payments, lease commitmentsand 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-relatedcontingencies during Fiscal 2003. However, in the event the Company fails to achieve its operating and financials goals in for fiscal 2003,management may be required to take certain actions to finance operations in that time period. These actions could include, but are not limited to,implementation of additional cost cutting measures, increased borrowings from existing credit facilities or entering into additional borrowingarrangements that are collateralized by assets.NOTE 9SEGMENTS OF BUSINESS The Company operates principally in two segments of business: the design and assembly of dynamic balancing systems and components(Balancing) for the machine tool industry, and the design and assembly of laser measurement systems (Measurement). The Company alsooperates in two principal geographic markets, United States and Europe.Segment Information Year Ended May 31, 2002 2001 2000 MechanicalComponents MeasurementSystems MechanicalComponents MeasurementSystems MechanicalComponents MeasurementSystemsGross sales $6,197,649 $1,605,288 $7,112,415 $1,644,309 $8,173,275 $1,625,717Intercompany sales $922,093 $6,185 $1,082,385 $94,185 $928,306 $16,430 Net sales $5,275,556 $1,599,103 $6,030,030 $1,550,124 $7,244,969 $1,609,287 Income (loss) from operations $(270,416)$226,340 $(353,064)$(1,984,169)$119,015 $649,319 Intercompany rent $— $30,000 $— $30,000 $— $30,000 Depreciation expense $136,864 $53,671 $147,719 $67,352 $176,367 $71,213 Amortization expense $20,000 $34,603 $20,000 $34,560 $20,000 $— Capital expenses $80,491 $29,967 $98,014 $49,602 $173,071 $17,015 31Geographic Information Year Ended May 31,Geographic Sales 2002 2001 2000North American Sales United States $4,230,818 $5,181,886 $6,130,386 Intercompany $72,319 $396,660 $307,445 $4,158,499 $4,785,226 $5,822,941 Canada $151,732 $242,115 $144,992 Mexico $27,686 $14,489 $95,351 North America total $4,337,917 $5,041,830 $6,063,284 European Sales Germany $897,670 $1,317,399 $1,765,220 Intercompany $206,824 $320,354 $360,967 Germany total $690,846 $997,045 $1,404,253 United Kingdom $1,065,416 $1,278,375 $1,046,482 Intercompany $649,135 $459,556 $276,324 United Kingdom total $416,281 $818,819 $770,158 Other European Sales $520,076 $134,531 $63,674 Total Europe $1,627,203 $1,950,395 $2,238,085 Asia $887,093 $542,485 $448,178Others $22,446 $45,444 $104,709 $6,874,659 $7,580,154 $8,854,256 Year Ended May 31, 2002 2001 2000 UnitedStates Europe UnitedStates Europe UnitedStates Europe Income (loss) from operations $113,812 $(157,888)$(2,032,282)$(304,951)$823,904 $(55,570) Depreciation expense $177,851 $12,684 $174,593 $40,478 $194,204 $53,376 Amortization expense $54,603 $— $54,560 $— $20,000 $— Capital expenses $107,388 $3,070 $133,153 $14,463 $137,443 $52,643 Long-term Assets May 31, 2002 May 31, 2001Segment: Mechanical $2,314,838 $4,074,588 Measurement $860,104 $918,411Geographic: United States $3,144,770 $4,940,040 Europe $30,172 $52,959Note—Europe is defined as the two European subsidiaries, Schmitt Europe, Ltd. and Schmitt Europa, GmbH32NOTE 10STOCK OPTIONS The Board of Directors adopted a Stock Option Plan in December- 1995, which plan was amended in August 1996 and restated inAugust 1998. An option granted under the Amended and Restated Stock Option Plan might be either an incentive stock option (ISO), or anonstatutory stock option (NSO). ISOs may be granted only to employees and members of the Board of Directors of the Company and are subjectto certain limitations, in addition to restrictions applicable to all stock options under the Plan. Options not meeting these limitations will be treatedas NSOs. The purchase of ISOs is fair market value on the date of grant; the purchase price of NSOs may vary from fair market value. Vesting isat the discretion of the option committee of the Board of Directors but generally 50% at grant date and 16.7% on each anniversary thereafter. TheCompany has 800,000 shares reserved for issuance under the stock option plan. All outstanding options all expire in 2012. The following summarizes the options outstanding as of May 31, 2002: Shares WeightedAverageExercisePriceOptions outstanding, May 31, 1999 451,750 $3.02Options granted 179,000 $2.77Options exercised (10,000) 3.00Options forfeited/cancelled (37,500)$3.00 Options outstanding, May 31, 2000 583,250 $2.94Options granted 645,000 $1.36Options repurchased (329,250)$3.00Options forfeited/cancelled (222,000)$2.82 Options outstanding May 31, 2001 677,000 $1.44Options granted 862,000 $0.48Options forfeited/cancelled (807,000)$1.36 Options outstanding May 31, 2002 732,000 $0.40 Options vested at May 31, 2002 366,000 $0.40 The Company has adopted the disclosure only provisions of SFAS 123. Accordingly, no compensation cost has been recognized for thestock option plans. Adjustments are made for options forfeited prior to vesting. For the years ended May 31, 2002, 2001 and 2000, total value ofoptions granted was computed to be $110,532, $621,850 and $473,460, respectively, which would be amortized on the straight-line basis over thevesting period of the options. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grantdate for the awards in 2002, 2001 and 2000, consistent with the provisions of SFAS 123, the Company's pro forma net (loss) income for the yearsended May 31, 2002, 2001 and 2000, would be $(1,709,151), $(2,758,930) and $261,255, respectively. Pro forma basic (loss) earnings per sharefor the years ended May 31, 2002, 2001 and 2000 would be $(.23) $(.35) and $.03 respectively. Pro forma diluted (loss) earnings per share for theyears ended May 31, 2002, 2001 and 2000 would be $(.23), $(.35) and $.03, respectively. Pursuant to SFAS 123, the fair value of each option granted is estimated on the date of the grant using the Black-Scholes option and pricingmodel. The weighted average assumptions used for Fiscal 2002, 2001 and 2000 were a risk-free interest rate of 4.00% for 2002, 5.00% for 2001and 7.50% for33 2000, an expected dividend yield of 0% for all years, an expected life of four years for Fiscal 2002 and eight years for Fiscal 2001 and 2000, and avolatility of 121%, 80% and 132%, respectively. The effects of applying SFAS No. 123 in the proforma disclosure are not indicative of future amounts. Prior to 1995, the Company granted stock options to officers and employees of the Company. Stock options for up to 10% of the outstandingshares were eligible for grant provided the stock options for any one individual did not exceed 5% of the issued and outstanding shares of commonstock. The purchase price of the optioned shares was equal to not less than the average closing price of the Company's common stock for the tentrading days immediately preceding the grant date of the stock options. The maximum term of each stock option did not exceed five years and alloptions were vested and exercisable upon grant. Prior to the fiscal year ended May 31, 1999 the officers/employees who exercised options under this program issued notes to the Companyfor the exercise price. During the years ended May 31, 2001 and 2000, the Company and each of the officers/employees mutually agreed toterminate the notes. The notes were secured by outstanding common stock of the Company that had been issued upon exercise of the options. Inreturn for cancellation of the note, the officers/employees surrendered the shares that secured the notes, with those shares subsequentlycancelled.NOTE 11COMPREHENSIVE OTHER LOSS Years ended May 31, 2002 2001 2000 Significant components of net (loss) income: Write-down of long-term investment to fair market value $(1,516,000)$— $— Inventory write-downs — (1,646,517) — Restructure costs — (116,275) — Operations exclusive of inventory write-downs and restructure costs (82,619) (604,161) 561,459 Net (loss) income (1,598,619) (2,366,953) 561,459 Other comprehensive (loss) income: Increase (decrease) in fair market value of long- term Investment, net oftaxes (128,000) 1,053,000 (925,000)Foreign currency translation adjustment 111,207 (32,271) (69,902) Total comprehensive loss $(1,615,412)$(1,346,224)$(433,443) The long-term investment is considered an "Available-for-sale security". As required under Statement of Financial Accounting StandardsNo. 115, all unrealized gains and losses, net of tax benefits, are reported in Accumulated Other Comprehensive (Loss) Income and included as aseparate component of Other Comprehensive (Loss) Income in Stockholders' Equity until realized or until unrealized losses are deemed to be"other than temporary". The cumulative translation adjustment consists of unrealized gains/losses from translation adjustments on intercompanyforeign currency transactions that are of a long-term investment nature.NOTE 12ACQUISITION OF ACUITY RESEARCH INCORPORATED On June 1, 2000, in a business combination accounted for as a purchase, the Company acquired Acuity Research Incorporated. Acuitydesigns manufactures and markets precision dimensional laser34 measurement sensors. The results of operations of Acuity are included in the accompanying consolidated financial statements since the date ofacquisition. The Company issued 275,000 of its common shares, valued at $747,725, in exchange for all of the outstanding stock of Acuity. Thepurchase price was allocated, based upon management estimates, to the estimated fair value of assets and liabilities acquired, with the allocationas follows:Current assets net of current liabilities $253,732Fair value of equipment acquired 72,169Intangible assets, patented technology acquired 421,824 $747,725 The patents acquired are being amortized over useful lives ranging from eleven to seventeen years.NOTE 13PRO FORMA RESULTS—IMPACT OF PURCHASE OF ACUITY RESEARCH The following pro forma results (unaudited) of operations are provided for illustrative purposes only and do not purport to be indicative of theconsolidated results of operations for future periods or what actually would have been realized had the Company and Acuity Research been aconsolidated entity during the period presented. The pro forma results combine the results of operations as if Acuity had been acquired as of thebeginning of the period presented. The results include the impact of the valuation assigned to the patented technology acquired. Year Ended May 31,2000 (Actual) (Pro forma)(Unaudited)Net sales $8,854,256 $9,526,338Net income $561,459 $571,259Net income per share, basic $.07 $.07Net income per share, diluted $.07 $.07NOTE 14RESTRUCTURING CHARGES During the fourth quarter of fiscal 2001, the Company restructured the operations of SEG and, in association with that action, the Companyincurred $226,525 in restructuring charges. These costs included the provision for a $56,840 liability related to the payroll and benefits of fiveterminated employees. In addition, one-time charges of $110,250 were recognized to write-off inventory related to discontinued product lines and$9,511 in equipment written-off. Finally, a liability of $49,924 was established for certain costs expected to be incurred in association with thechanges in German operations. Of these total costs, $110,250 was included in cost of sales and $116,275 was included in operating expenses.35 During the year ended May 31, 2002 this liability changed as follows: Payroll andBenefits OperatingExpenses Total Balance at May 31, 2001 $56,840 $49,924 $106,764 Payments to terminated employees (56,840) (56,840)Payments of other expenses (49,924) (49,924) Balance at May 31, 2002 $— $— $— The restructure was completed in the third quarter of Fiscal 2002.SUMMARIZED QUARTERLY FINANCIAL DATAIn thousands, except per share information(unaudited)2002 Quarter Ended August31 November30 February28 May31 Sales $1,585 $1,879 $1,453 $1,958 Gross Profit $868 $1,119 $861 $1,182 Net (Loss) income $(252)$71 $(65)$(1,353)Net (Loss) income Per Share, Basic $(.03)$.01 $(.01)$(0.18)Net (Loss) income Per Share, Diluted $(.03)$.01 $.(01)$(0.18)Market Price of Common Stock High $1.090 $0.920 $0.560 $0.720 Low $0.710 $0.290 $0.350 $0.340 2001 Quarter Ended August31 November30 February28 May31 Sales $1,943 $1,785 $2,131 $1,721 Gross Profit $1,177 $696 $1,194 $(663)Net (Loss) income $29 $(269)$7 $(2,134)Net (Loss) income Per Share, Basic $.00 $(.03)$.00 $(.28)Net (Loss) income Per Share, Diluted $.00 $(.03)$.00 $(.28)Market Price of Common Stock High $3.469 $3.000 $2.375 $1.240 Low $2.125 $2.000 $0.875 $0.625 Report of Independent Accountants:To the Board of Directors and Shareholders ofSchmitt Industries, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes instockholders' equity and of cash flows present fairly, in all material respects, the financial position of Schmitt Industries, Inc. and its subsidiariesat May 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended May 31, 2002 inconformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of theCompany's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our auditsof these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan andperform the audit to obtain reasonable assurance36 about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts 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 our opinion.PricewaterhouseCoopers LLPPortland, OregonJuly 3, 2002 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None37 PART III Certain information required by Part III is included in the Company's definitive Proxy Statement for its 2002 Annual Meeting of Shareholders("Proxy Statement") and is incorporated herein by reference. The Proxy Statement will be filed pursuant to Regulation 14A of the SecuritiesExchange Act of 1934 not later than 120 days after the end of the fiscal year covered by this Report. Items 10 and 11. Directors and Executive Officers of the Registrant and Executive Compensation The information required by these items is included in the Proxy Statement under the headings "Election of Directors, Equity CompensationPlan," "Executive Compensation," "Summary Compensation Table," "Options Grants in Fiscal 2002," "Aggregated Option Expenses in Fiscal 2002and Fiscal Year-End Option Values" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is included in the Proxy Statement under the heading "Principal Shareholders" and is incorporatedherein by reference. Item 13. Certain Relationships and Related Transactions The information required by this item is included in the Proxy Statement under the heading "Certain Transactions" and is incorporated hereinby reference. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (1)Financial Statements: A.Consolidated Balance Sheets as of May 31, 2002 and 2001 B.Consolidated Statements of Operations for the years ended May 31, 2002, 2001 and 2000 C.Consolidated Statements of Changes in Stockholders' Equity for the years ended May 31, 2002, 2001 and 2000 D.Consolidated Statements of Cash Flows for the years ended May 31, 2002, 2001 and 2000 E.Notes to Consolidated Financial Statements F.Report of Independent Accountants(2)Financial Statement Schedules: all financial statement schedules are omitted either because they are not applicable, not required, orthe required information is included in the financial statements or notes thereto. (3)Exhibits: Reference is made to the list on page35 of the Exhibits filed with this report (4)Reports on Form 8-K: None38 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to besigned on its behalf by the undersigned, thereunto duly authorized. SCHMITT INDUSTRIES, INC. By: /s/ Wayne A. CaseWayne A. CaseChairman of the Board, Presidentand Chief Executive Officer Date: August 23, 2002 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf ofthe registrant and in the capacities indicated on August 23, 2002.Signature Title/s/ WAYNE A. CASE Wayne A. Case Chairman of the Board, President and ChiefExecutive Officer(Principal Executive Officer)/s/ ROBERT C. THOMPSON Robert C. Thompson Chief Financial Officer/Treasurer(Principal Financial and Accounting Officer)/s/ MAYNARD BROWN Maynard Brown Director/s/ DAVID M. HUDSON David M. Hudson Director/s/ JOHN A. RUPP John A. Rupp Director39 INDEX TO EXHIBITS Exhibits Description3(i)Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the "Company"). Incorporated by reference to Exhibit 3(i) tothe Company's Annual Report on Form 10-K for the fiscal year ended May 31, 19993(ii)Second Restated Bylaws of the Company Incorporated by reference to Exhibit 3(ii) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1999*10.1 Schmitt Industries, Inc. Amended & Restated Stock Option Plan. Incorporated by reference to Exhibit 10.1 to the Company'sAnnual Report on Form 10-K for the fiscal year ended May 31, 199910.2 Agreement dated December 1, 2000 between Wayne A. Case and Registrant. Incorporated by reference to Exhibit 10.3 to theCompany's Quarterly Report on Form 10-Q for the quarterly period ended February 28, 2001.10.3 Stock Purchase Agreement dated December 31, 2000 between Hortex Anstalt and Registrant and Promissory Note datedDecember 31, 2000 from Registrant to Hortex Anstalt. Incorporated by reference to Exhibit 10.4 to the Company's QuarterlyReport on Form 10-Q for the quarterly period ended February 28, 2001.**21.1 Subsidiaries of Schmitt Industries, Inc.**23.1 Consent of PricewaterhouseCoopers LLP**99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of The Sarbanes-Oxley Act of 2002*Management contract or compensatory plan. **Filed herewith40QuickLinksPART IItem 1. BusinessItem 2. PropertiesItem 3. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security HoldersPART IIItem 5. Market for Registrant's Common Equity and Related Stockholder MattersItem 6. Selected Financial DataItem 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsItem 7A. Qualitative and Quantitative Disclosures about Market RiskItem 8. Financial Statements and Supplementary DataSCHMITT INDUSTRIES, INC. CONSOLIDATED BALANCE SHEETS MAY 31, 2002 AND 2001SCHMITT INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED MAY 31, 2002, 2001 AND 2000SCHMITT INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED MAY31, 2002, 2001 AND 2000SCHMITT INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED MAY 31, 2002, 2001 AND 2000SCHMITT INDUSTRIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED MAY 31, 2002, 2001 AND2000Item 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosurePART IIIItems 10 and 11. Directors and Executive Officers of the Registrant and Executive CompensationItem 12. Security Ownership of Certain Beneficial Owners and ManagementItem 13. Certain Relationships and Related TransactionsPART IVItem 14. Exhibits, Financial Statement Schedules and Reports on Form 8-KSIGNATURESINDEX TO EXHIBITSQuickLinks -- Click here to rapidly navigate through this document EXHIBIT 21.1 SUBSIDIARIES OF SCHMITT INDUSTRIES, INC.AS OF MAY 31, 2002 Subsidiary State of Incorporation or Countryin Which OrganizedSchmitt Measurement Systems, Inc. MontanaSchmitt Europa Systems, GmbH GermanySchmitt Europe, Ltd. United KingdomAcuity Research Incorporated CaliforniaQuickLinksEXHIBIT 21.1SUBSIDIARIES OF SCHMITT INDUSTRIES, INC. AS OF MAY 31, 2002QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-3910) of Schmitt Industries, Inc. ofour report dated July 3, 2002 relating to the financial statements, which appears in this Form 10-K.PricewaterhouseCoopers LLPPortland, OregonAugust 23, 2002QuickLinksEXHIBIT 23.1CONSENT OF INDEPENDENT ACCOUNTANTSQuickLinks -- Click here to rapidly navigate through this document Exhibit 99.1 CERTIFICATION PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Schmitt Industries, Inc. (the "Company") on Form 10-K for the fiscal year ended May 31, 2002 asfiled with the Securities and Exchange Commission on the date hereof (the "Report"), I, Wayne A. Case, Chief Executive Officer of the Company,certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:(1)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2)The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of theCompany.Wayne A. CaseChief Executive OfficerAugust 23, 2002 CERTIFICATION PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Schmitt Industries, Inc. (the "Company") on Form 10-K for the fiscal year ended May 31, 2002 asfiled with the Securities and Exchange Commission on the date hereof (the "Report"), I, Robert C. Thompson, Chief Financial Officer of theCompany, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:(1)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2)The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of theCompany.Robert C. ThompsonChief Financial OfficerAugust 23, 2002QuickLinksExhibit 99.1CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACTOF 2002CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACTOF 2002

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