Schmitt Industries, Inc.
Annual Report 2006

Plain-text annual report

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 10-K(Mark One)x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the Fiscal year ended: May 31, 2006oro TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to Commission File Number: 000-23996SCHMITT INDUSTRIES, INC.(Exact name of registrant as specified in its charter)Oregon93-1151989(State or other jurisdiction of(IRS Employer Identification Number)incorporation or organization) 2765 N.W. Nicolai StreetPortland, Oregon 97210(Address of principal executive offices) (Zip Code)(503) 227-7908(Registrant’s telephone number, including area code)Securities registered pursuant to Section 12(b) of the Act:Title of each className of each exchange on which registeredCommon Stock - no par valueThe NASDAQ Stock Market LLCSecurities registered pursuant to Section 12(g) of the Act: NoneIndicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o NoxIndicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yeso No xIndicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.Yes x No oIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. xIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (check one):Large accelerated filer oAccelerated filer oNon-accelerated filer x Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x The aggregate market value of the voting stock held by non-affiliates of the registrant as of November 30, 2005, the last business day of the registrant’smost recently completed second fiscal quarter, was approximately $11,129,085 based upon the closing price of $5.70 reported for such date on the NASDAQCapital Market. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 10% of the outstanding shares of CommonStock and shares held by officers and directors of the registrant, have been excluded because such persons may be deemed to be affiliates. This determinationis not necessarily conclusive for other purposes. As of July 31, 2006, the registrant had 2,640,045 outstanding shares of Common Stock.Documents Incorporated by ReferencePortions of the registrant’s definitive Proxy Statement for its 2006 Annual Meeting of Shareholders are incorporated by reference into Part III hereof. PART IItem 1. BusinessIntroductionSchmitt Industries, Inc. (the Company), an Oregon corporation, designs, assembles and markets computer-controlled balancing equipment (the BalancerSegment) primarily to the machine tool industry. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), an Oregon corporation,the Company designs, manufactures and markets precision laser measurement systems (the Measurement Segment). The Company also sells and markets itsproducts in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom. Effective May 30, 2005, the Companyliquidated and dissolved its German subsidiary, Schmitt Europa, GmbH. The Company’s executive offices are located at 2765 N.W. Nicolai Street, Portland,Oregon 97210, and its telephone number is (503) 227-7908.Balancer SegmentThe Company’s principal product is the Schmitt Dynamic Balance System (the SBS System), consisting of a computer control unit, sensor, spindle-mountingadapter, and balance head. It is designed as an inexpensive highly accurate permanent installation on grinding machines. The Company acquired itsoriginal balancing equipment technology pursuant to a series of agreements from 1987 through 1991, substantially enhancing and advancing the patentedtechnology since that time. Since inception the targeted customer base has been operators of grinding machines.The SBS System is fully automated, eliminating the need to pre-balance such devices as grinding wheels. This reduces machine setup time and ensures asmoother and more efficient operation. Operating on a principle of mass compensation for wheel imbalance, the balance head contains two movableeccentric weights, each driven by electric motors through a precision gear train. These weights are repositioned to offset any imbalance in a grinding wheelor other application. Imbalance or vibration is picked up by the sensor that feeds a signal to a controller that filters the signal by revolutions per minute. Thecontroller then drives the balance head weights in a direction that reduces the amplitude of the vibration signal. The balance cycle is complete when theweights 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 awheel while on a machine, virtual elimination of wheel vibration, automatic monitoring of balancing, display in both English and metric systems, instrumentgrade calibration, short balance process, measurement of both displacement and/or velocity and minimal user maintenance.Benefits to the system user include improved quality of finished parts, ease of product adaptation, minimal downtime, complete and ready installation,elimination of static balancing, longer life of the grinding wheel, diamond dressings and spindle bearings, the ability to balance within 0.02 microns and itsadaptability to all types of machines.Precision grinding is necessary in major manufacturing areas including the automotive industry (camshafts, crankshafts, valves), bearings (roller and taperedtypes), ceramics (precision shaping), electric motors (shafts), pumps (shafts and turbines), aircraft (engine parts), and general manufacturing. Precisiongrinding has an established worldwide presence in all industrialized countries and is expanding as a method of material removal and processing. Therefore,the Company believes there may be an increase in market growth and demand for products such as the SBS system. Within the Company’s customer base forthe SBS System, there are three major market segments:Machine Tool Builders - These companies design and manufacture a variety of cylindrical, surface and specialty application grinding machines. SBS Systems are distributed to a variety of world markets through OEM (original equipment manufacturer) accounts, where a special pricing (20%discount) is offered to the machine builder incorporating the SBS System into its machine.2Examples of some well-known worldwide machine tool builders who have offered and/or installed the SBS System include ANCA (Australia), CapcoMachinery (U.S.), Ecotech/SMTW (China/U.S.), Erwin Junker (U.S.), Gleason Works (U.S.), Landis Grinding (U.S.), Kellenberger (U.S.), KoyoMachinery (US, Japan), 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), Toyoda Machine (Japan), USACH Technologies, Tschudin(U.S.) and Weldon Machine Tool (U.S.). The Company currently sells its products directly to major machine builders in the U.S, Western Europeand Asia.Machine Tool Rebuilders — These customers, found in most, if not all, industrialized nations, develop their business by offering to completelyupdate and refurbish older grinding machines. These rebuilders typically tear the old machine apart and install new components, such as the SBSSystem. 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, fieldrepresentatives, referrals and new machine suppliers. The Company’s business is conducted worldwide with some better known customersincluding: Black & Decker, Briggs and Stratton, Caterpillar Inc., Daewoo International Corp., Eaton Corporation, Emerson Power Transmission, FordMotor Company, General Electric Corp., General Motors, Getrag Automotive, Ingersoll Rand, Komatsu, Lawrence Berkeley, Sumitomo HeavyIndustries, NSK Bearing, NTN Bearing, Oakridge National Lab, Purdue University, SKF Bearing Industries, Texas Instruments, The TimkenCompany, TRW Automotive Components and Universal Bearing.In Fiscal 2006, 2005 and 2004, net sales of the Company’s balancing products totaled $7,818,669, $7,430,287 and $5,924,854, respectively. Net sales ofbalancing products accounted for 68%, 70% and 74% of the Company’s total sales in Fiscal 2006, 2005 and 2004, respectively. See Note 10 toConsolidated Financial Statements.Competition:Management believes the SBS System is one of only a few fully automatic balancing systems marketed in the world. Most competitive products requirespecial setup and training or calibration to the specific machine. The Company believes the SBS System is currently the only balancing product that fits allmachines with wheel sizes from 6 to 48 inches in diameter and a spindle rpm of 500 through 12,500.Competitive products come from European companies located in Switzerland, Germany, Spain and Italy. These competitors produce electromechanical andwater balancers similar to the SBS Systems. The Company considers these companies, with their established European base, to be the major competitors. TheCompany believes that these balancers have electronic deficiencies, rendering them less effective in solving essential balancing requirements. The Companyalso believes that they cannot achieve consistent balance levels at low speed (500 rpm) or at high speed (7,500 rpm) as the SBS system can. In addition, theCompany also believes these balancers have inferior brush and cable assemblies that cause down time and high maintenance. Finally, none of thesecompanies can currently compete effectively with the Company in providing mounting adapters for all grinding machines.Water balancers are an older European design still on the market that can be supplied by Schmitt when specifically requested by users. They requireexpensive plumbing and water chambers to be machined into the wheel hub while the SBS System does not. They are currently priced about 1.25 times thelevel of the SBS System. To install these systems, the grinding machines must be disassembled and parts remachined or replaced within the spindleassembly. This can take two days, far longer than required to install the SBS system. The water system is “tuned” or “calibrated” to the machine by a factoryservice technician while the SBS system can be installed by the operator. Water systems work at mid- and high-speeds but cannot balance in low rpmenvironments while SBS 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. Based on published price lists, competitors’ electromechanical systems are priced at $8,000 to$10,000 worldwide while water balancers generally are priced at $9,000 to $11,000 worldwide. Management believes customers perceive the value of anautomatic3balancer to be approximately $8,000, a sales price that has been constant for several years. Company pricing is geared to obtaining a dominant marketposition and meeting competitive supplier prices. The market strategy is to establish the SBS System as the foremost product with the best quality, reliabilityand performance and superior economic value.Measurement SegmentThe Company manufactures and markets a line of laser-based, precision measurement systems and operates a precision laser light scatter measurementlaboratory. Light scatter technology involves using lasers, optics and detectors to direct a beam of light on a material sample and record itsreflection/transmission. Analysis of information can determine material characteristics such as surface roughness, defects and dimensional sizing withoutintroducing contaminants and causing changes to the tested material. The principal products are laser-based measurement products and technologyapplicable to both industrial and military markets. The Company has used patents, patent applications, trademarks and other proprietary technology to focusmarketing efforts on industrial markets including electronics, computer disk and silicon wafer manufacturers.There are four product lines: laser-based light-scatter measurement, dimensional sizing, research and other laser alignment products and a light-scattermeasurement laboratory.Laser-based light-scatter measurement products:These products use a patented laser light scatter technology to perform rapid, accurate, repeatable and non-destructive, non-contact surface measurement teststhat quantify surface micro-roughness. Products are sold to manufacturers of disk drives and silicon wafers, both industries with fabrication processes thatrequire precise and reliable measurements.Computer hard disks require exact manufacturing control and a narrow tolerance band for acceptable roughness, with surface roughness outside that narrowband resulting in a reduction in data density or storage capacity. The Company’s technology simultaneously measures disk surface roughness in twodirections, radially, when the read/write head is moving to another disk sector, and circumferentially, when the read/write head is processing information onthe disk. The two separate roughness levels are required for proper head operation. The Company believes the precise measurement methods provided by itsproducts are not possible through any other cost effective measurement means. The following two products meet the challenges of disk drive manufacturers:· The TMS-2000-RC (Texture Measurement System) product is an accurate non-contact texture measurement system. The product (used onaluminum substrates) is currently used worldwide by most major disk drive manufacturers, providing fast, accurate and repeatable microroughnessmeasurements while quadrupling production throughput when compared to other testing devices. Surface roughness can be measured to levelsbelow 0.5 Angstroms (the point of a needle is one million Angstroms in diameter).· The TMS-2000-DUV-RC product measures the surface microroughness of ceramic/glass rather than aluminum substrates. Manufacturers require thetechnology and products to measure surface roughness of these ceramic/glass substrates to the same exact levels as those that measure aluminum. The Deep Ultra-violet light (DUV) technology and product uses the patented light scatter technology to measure the surface roughness of glasssubstrates to levels less than 0.5 Angstroms.Customers include Hitachi/IBM, Seagate Substrates, Western Digital and Komag, Inc.The Company offers two products devoted to the silicon wafer industry, the TMS-2000W-RC and TMS-3000W-RC. Both products provide fast, accurate,repeatable measurements for manufacturers of silicon wafers, computer chips and memory devices. This industry demands manufacturing precision toincrease performance and capacity and these products help achieve those goals. Silicon wafers are carefully cut and polished to provide the base upon whicha computer or memory chip is produced. Therefore, chip manufacturing is extremely dependent on the beginning surface roughness of the wafer. Since allsilicon wafers exhibit a microscopic level of surface roughness, stemming from chemical deposition, grinding, polishing, etching, or any number of otherproduction techniques, some method of measuring these surface characteristics is required. The wafer measurement products provide a way for customers inthis industry4to quantify and control their manufacturing process. The system provides measurements to a few hundredths of an Angstrom, a level unachievable bycompeting devices.Dimensional sizing products:These products are used in a wide range of industrial applications including steel casting, paper production, medical imaging, crane control and micron-levelpart and surface inspection. Presently, there are four AccuRange (AR) product lines: the AR4000 distance measurement sensor, the AR4000 Line Scannerand the AR600 and AR200 series of triangulating laser displacement sensors.The AR4000 optical distance measurement sensor is used for most diffuse reflective surfaces, but is ideally suited to level and position measurement,machine vision, autonomous vehicle navigation and 3D imaging applications. It operates by emitting a collimated laser beam that is reflected from the targetsurface and collected by a sensor. The sensor is suitable for a wide variety of distance measurement applications that demand high accuracy and fast responsetimes. Notable features include the operating range for most surfaces (zero to fifty feet), fast response time (50 kHz maximum sample rate), compact andlightweight power design and has a tightly collimated output beam for small spot size. There are three output beam configurations available: visible infrared,eye safe infrared and reflective tape targets.The AR4000 Line Scanner is used with the AR4000 to scan and collect distance data over a full circle. The scanner consists of a balanced, rotating mirrorand motor with position encoder and mounting hardware for use with the AR4000. The scanner deflects the beam 90 degrees, sweeping it through a fullcircle as it rotates. The product can scan at rates of up to 2600 lines per minute, sweeps the laser beam through a full 360 degrees and is both compact andlightweight.The AR600 series is a family of triangulating laser displacement sensors with excellent accuracy and sensitivity. The sensor projects a beam of visible laserlight that creates a spot on the target surface. Reflected light from the surface is viewed from an angle by a line scan camera and the target’s distance iscomputed from the image pixel data. The line includes 11 models measuring displacements from 1/8” to 50” and accuracy’s down to .00015” (4 microns). They can operate on all types of surfaces at speeds up to 1250 samples/second. The product is extremely sensitive and can detect glass and liquid surfacesand also detect multiple surfaces of transparent materials, allowing great flexibility in specialized applications.The AR200 line is the most compact series of triangulating laser displacement sensors. Four models cover metric measurement ranges from six to fiftymillimeters. All models boast a 1/500 accuracy rating for measurements within twelve microns. The AR200 sensor is the only sensor of its kind to featurepushbutton selection of output signals. All models are standard with analog, limit switch and serial outputs. The AR200 sensors, much like the longer-rangeAR600 sensors, project a beam of visible laser light that creates a spot on the target surface. Reflected light from the surface is viewed from an angle by a linescan camera and the target’s distance is computed from the image pixel data. The AR200-6M, -12M, -25M and -50M have ranges in millimeters that matchtheir model number. The AR200 displacement sensor cannot be overloaded and measures accurately even when a mirror reflects the entire light beam back tothe detector.Research and other measurement products:The Company’s CASI Scatterometers are sold to companies and institutions involved in research efforts. The CASI Scatterometer uses visiable, ultraviolet orinfrared laser light 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, diffusematerials, semiconductor wafers, magnetic storage media and precision-machined surfaces, as well as surfaces affecting the cosmetic appearance of consumerproducts. 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 separate charging unit. To performa measurement, the operator places the measurement head on the objective area and presses a button. Each measurement takes less than five seconds withresults displayed and stored in system memory. The μScan can store 700 measurements in 255 files and provides the capability to program pass/fail criteria. Software is available for control, analysis and file5conversion. From a single measurement, a user can determine RMS surface roughness, reflectance and scatter light levels (BRDF) on flat or curved surfacesunder any lighting conditions.Light-scatter measurement laboratory:The Company provides a highly advanced measurement services laboratory, using CASI Scatterometers, to a wide variety of industrial and commercialbusinesses that require precise measurements only advanced laser light scatter technology can provide. The true value of the laboratory is not only itsextremely precise measurement capability but also the test item is not altered, touched or destroyed. Thus, the laboratory is widely used by manufacturers ofcritical optical components in aerospace and defense systems, including such companies as Aerojet, AT&T Bell Labs, Eastman Kodak, General Electric, IBM,NASA and other industrial companies, universities and government agencies.In Fiscal 2006, 2005 and 2004, net sales of Measurement products totaled $3,684,691, $3,160,942 and $1,999,912 respectively and accounted for 32%, 30%and 25% of the Company’s total sales in Fiscal 2006, 2005 and 2004 respectively. See Note 10 to Consolidated Financial Statements.Sales by Geographic AreaIn Fiscal 2006, 2005 and 2004, the Company recorded net sales of its products in the United States, its country of domicile, of $5,709,044, $5,610,274 and$4,320,421, respectively. Sales in the last three Fiscal years by geographic areas are:North AmericaEuropeAsiaOthersFiscal 2006$5,878,538$1,764,347$2,919,556$940,919Fiscal 2005$5,872,740$2,076,089$2,122,384$520,016Fiscal 2004$4,520,940$1,777,250$1,365,840$260,736Business and Marketing StrategyThe Company designs, assembles and markets all of its products with operations divided into a number of different areas.Balancer Segment Products:The Vice President of Operations directs production of Balancer segment products including production, assembly, and purchasing, engineering andtechnical services. Product marketing for all Balancer segment products is managed by the President/CEO. Two marketing managers are responsible fordomestic sales , one marketing manager is responsible for sales in Europe and another is responsible for sales in mainland China, Taiwan and Korea. TheCompany also has one person who performs field service/sales. Finally, research and development efforts are supervised directly by the President/CEO andthe Vice President of Operations.The Company markets and sells the Balancer segment products in a variety of ways. First are the channels provided by independent manufacturer’srepresentatives 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 20% discount.Second, OEMs include the Balancer segment products on the machine tools they produce. Users thus purchase the Balancer segment products concurrentlywith the machine tools. Conversely, end users of grinding machines that have purchased the SBS system directly from the Company, and after enjoying thebenefits of the products, often request that SBS products be included with the new equipment they order from OEMs. The SBS Systems are often installed bymachine builders prior to displaying their own machine tools at various trade shows, becoming endorsements that prove beneficial to the Company’s salesefforts.Third, worldwide trade shows have proven to be an excellent source of business. Company representatives, usually one or more of the marketing managersand/or the President/CEO, attend these events along with local Company representatives. These individuals operate a display booth featuring an SBS Systemdemonstration stand and product and technical literature. Representatives from all facets of the Company’s target markets attend these trade shows.6In North America and Asia, products are shipped directly to customers from the Company’s distribution center in Portland, Oregon. Where the Company hasdistributors, the product is shipped to the distributor, who in turn pays the Company directly and then delivers and installs the product for the end user. European distribution to customers is handled by shipping the product directly from the Company’s Portland headquarters to the European subsidiary in theUnited Kingdom, who in turn sells and distributes the products.Measurement Segment Products:The Vice President of Operations directs production of all Measurement segment products including production, assembly, and purchasing, engineering andtechnical services.Similar to the Balancer segment, the Measurement segment uses a variety of methods to market and sell its products. First, a Marketing Manager, under thedirection of the President/CEO, directs the overall worldwide marketing efforts for surface measurement products. Second, both a marketing and a salesmanager, again under the direction of the President/CEO, direct the overall worldwide marketing and sales efforts for dimensional sizing products. Third, theCompany has an exclusive distribution agreement with a company in Asia for the promotion and sale of surface measurement products in China, Taiwan,Malaysia, Singapore, Thailand and the Philippines. In addition, there are distribution agreements with one company in Japan and two in Korea. Fourth, tradeshows represent a significant amount of marketing/sales effort. The President/CEO attends these events along with various Company representatives. Theseindividuals operate a display booth featuring demonstrations of Measurement segment products along with product and technical literature. Representativesfrom all facets of the 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 can lead to orders for the Company’s laser based light scatter measurement products.All Measurement segment products are assembled in the Portland, Oregon facility and shipped worldwide directly to customers.The Balancer and Measurement segment customer bases each consist of over 250 companies.BacklogThe Company does not generally track backlog. Normally, orders are shipped within a few days after receipt unless the customer requests otherwise.ManufacturingThere are no unique sources of supply or raw materials in any product lines. Essential electronic components, available in large quantities from varioussuppliers, are assembled into the Balancing and Measurement electronic control units under the Company’s quality and assembly standards. Company-owned software and firmware are coupled with the electronic components to provide the basis of the Company’s various electronic control units. Management believes several supply sources exist for all electronic components and assembly work incorporated into its electronic control systems. Theprimary outside supplier of electronic assemblies is Silicon Forest Electronics of Vancouver, Washington, a custom supplier of assembled electronic productsfor several Pacific Northwest companies. In the event of supply problems, the Company believes that two or three alternatives could be developed withinthirty days to supplement or replace Silicon Forest Electronics.Mechanical parts for the Company’s products are produced by high quality CNC machine shops. The Company is not dependent on any one supplier ofmechanical components. Principal suppliers of components for the Company’s products include MacKay Manufacturing of Spokane, Washington; OEMManufacturing of Corvallis, Oregon; Davis Tool of Portland, 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 isheld on Company property to assure adequate flow of parts to meet customer order requirements. Inventory is monitored by a computer control systemdesigned to assure timely re-ordering of components.7In-house personnel assemble various products and test all finished components before placing them in the finished goods inventory. Finished goodsinventory is maintained via computer to assure timely shipment and service to customers. All customer shipments are from the finished goods inventory.The Company’s Quality Control Program first received full ISO 9001 certification in 1996. On November 4, 2005, the Company received its certification tothe newer ISO 9001:2000 requirements.Proprietary TechnologyThe Company’s success depends in part on its proprietary technology, which the Company attempts to protect through patents, copyrights, trademarks, tradesecrets and other measures. The Company has U.S. patents covering both Balancer and Measurement products, processes and methods that the Companybelieves provide it with a competitive advantage. The Company has a policy of seeking patents where appropriate on inventions concerning new productsand improvements 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 applied or thatcurrent defenses as to issued patents will, in fact, be considered substantial in the future. There can be no assurance as to the degree and range of protectionany patent will afford and whether patents will be issued or the extent to which the Company may inadvertently infringe upon patents granted to others.“SBS” and “SMS” are registered trademarks and are affixed to all products and literature created in the Company’s balancer and measurement product lines,respectively.The Company manufactures its Balancer segment products under copyright protection in the U.S. for electronic board designs. Encapsulation of the finishedproduct 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 others will notindependently develop substantially equivalent proprietary information and techniques or otherwise gain access to the Company’s trade secrets or disclosesuch technology or that the Company 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 andcontinuing technology advancement, manufacturing capabilities, affordable high-quality products, new product introduction and direct marketing efforts todevelop and maintain its competitive position.Product DevelopmentThe Company maintains an ongoing research and development program to expand the product lines and capabilities of both product segments. The goal ofthis program is to expand the product base in historic markets and to enter new market areas so as to reduce reliance on historic market segments. In the pastfew fiscal years, the Company has developed the following new balancing and laser measurement products:The SB-4500 controller is a multi-function unit providing the versatility to control several activities including all balancer products. It controls balancing inapplications with speeds ranging from 300 to 30,000 rpm compared to a range of 500 to 12,500 rpm with the prior Schmitt product. Vibrations are measuredto 0.02 microns or 0.75 millionths of an inch. It also allows customers to balance their grinding machines faster, reducing costly down time and increasingfactory throughput. This computer controller allows the future addition of new products.The Acoustical Emissions Monitoring System (AEMS) is controlled by the SB-4500 controller and monitors the customers’ dressing and grinding processesby direct measurement of machine-generated acoustic signals. By monitoring the high frequency sound signal generated by contact between the wheel andwork piece, the system automatically determines when wheel contact is made. Users can eliminate the “gap” time from their grinding process and alsoautomatically detect the beginning of a wheel “crash” and immediately signal the grinding machine to stop before real damage occurs. The benefits of theAEMS product to the customer include time savings from quick and easy setups, improved dressing and grinding processes, and elimination of expensivepart and machine damage.8 The disk drive industry presented the Company with the challenge of developing the technology and products to measure the surface roughness of glasssubstrates. Existing laser-based light-scatter technology was modified to produce the required light scatter information to provide the necessarymeasurements. The engineering staff developed the DUV (Deep Ultra-violet light) technology to measure surface microroughness of glass substrates to thesame precise levels as existing products and at levels required by the industry. This technology compliments existing products and provides the Companythe ability to supply solutions for all media used by the disk drive industry. During Fiscal 2006, 2005 and 2004, the Company’s research and development expense totaled $81,815, $42,395 and $30,370, respectively. The Fiscal 2006levels are higher than in prior years as the Company devoted much of its 2005 and 2004 internal labor efforts (most R&D costs are internal labor costs) toexpanding production levels and the transition of engineering and production of dimensional sizing products from Menlo Park, CA to Portland, OR. Management expects amounts expended for R&D in Fiscal 2007 to increase over the levels experienced in Fiscal 2006.EmployeesAs of July 19, 2006, the Company employed 38 individuals worldwide on a full-time basis. There were no regular part-time employees. None of theCompany’s employees is covered by a collective bargaining agreement.Item 1A. Risk FactorsBusiness RisksThis report includes “forward-looking statements” as that term is defined in Section 21E of the Securities Exchange Act of 1934. Forward-looking statementscan be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,”“plans,” “estimates,” “anticipates,” or “hopes,” or the negative of those terms or other comparable terminology, or by discussions of strategy, plans orintentions. For example, this section contains numerous forward-looking statements. All forward-looking statements in this report are made based onmanagement’s current expectations and estimates, which involve risks and uncertainties, including those described in the following paragraphs. Amongthese 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.· Production time and the overall cost of products could increase if any of the primary suppliers are lost or if any primary supplier increased theprices 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.· The Company maintains a significant investment in inventories in anticipation of future sales.· 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.Such risks and uncertainties could cause actual results to be materially different from those in the forward-looking statements. Readers are cautioned not toplace undue reliance on the forward-looking statements in this report. We assume no obligation to update such information.Demand for Company products may change:Over the past eight fiscal quarters, the Company has experienced increased demand for its Balancer products in North America. These increases are attributedprimarily to an improving economy in North America. The conditions and circumstances could change in future periods and as a result demand for theCompany’s products could decline. Management is responding to these risks in two 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. The Company will therefore continue to devote part of its futureR&D efforts toward developing products that will both broaden the scope of Balancing products offered to the9current customer base. Second, there are uses for the Company’s Balancer products in industries other than those in the Company’s historic customer base. Management is devoting a significant portion of its time to identify these markets and educate those markets on the value of those products within theiroperations.The laser light-scatter products of the Measurement segment have relied heavily upon sales to disk drive and silicon wafer manufacturers. Conditions inthose markets adversely affected sales beginning in Fiscal 1999 and those poor conditions continued into Fiscal 2004 and consequently, demand for drivesfell over these periods. As the operations of those companies suffered, they in turn reduced capital spending resulting in minimal demand for and sporadicsales of the Company’s laser light-scatter products. Industry forecasts are for improving conditions, and the Company experienced increasing sales in Fiscal2005 and 2006 to those industries. However, the long-term impact on demand for the Company’s surface Measurement products cannot be predicted withany certainty.The semiconductor industry has also faced a down cycle over the past few fiscal years. Beginning in Fiscal 2002, the semiconductor industry experiencedbacklog cancellations, resulting in slower revenue growth and these conditions continued into Fiscal 2004. 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. The Companyexperienced increasing sales in Fiscal 2006 to those industries. However, the long-term impact on demand for the Company’s wafer products cannot bepredicted with any certainty.Management will continue to market these products to these historic markets as it appears no other technology has been introduced that would make the laserlight-scatter products technologically obsolete. There is the belief that once market conditions improve in the disk drive and silicon wafer markets, demandfor the Company’s products and technology will increase although most likely not to historic levels. Also, management believes there are other uses for theCompany’s laser light scatter technology and continues to evaluate 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 couldresult in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design, develop, manufacture,assemble, test, market and support new products and enhancements on a timely and cost-effective basis. New product opportunities may not be identifiedand developed and brought to market in a timely and cost-effective manner. Products or technologies developed by other companies may render products ortechnologies obsolete or noncompetitive, or a fundamental shift in technologies in the product markets could have a material adverse effect on theCompany’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 paying other companies for infringing on theirintellectual property rights. The Company relies on patent, trade secret, trademark and copyright law to protect such technologies. There is no assurance anyof the Company’s U.S. patents will not be invalidated, circumvented, challenged or licensed to other 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 prices of rawmaterials:Manufacturing operations depend upon obtaining adequate supplies of raw materials on a timely basis. The results of operations could be adversely affectedif adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increased significantly.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 beyond management’s control. As aresult of quarterly operating fluctuations, it is important to realize quarter-to-quarter comparisons of operating results are not necessarily meaningful andshould not be relied upon as indicators of future performance.10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. However, should future sales decline significantly and rapidly, thereis no guarantee management could take actions that would further reduce operating expenses in either a timely manner or without seriously impacting theoperations of the Company.The Company maintains a significant investment in inventories in anticipation of future sales:The Company believes it maintains a competitive advantage by shipping product to its customers more rapidly than its competitors. As a result, theCompany has a significant investment in inventories. These inventories are recorded using the lower-of-cost or market method, which requires managementto make certain estimates. Management evaluates the recorded inventory values based on customer demand, market trends and expected future sales andchanges these estimates accordingly. A significant shortfall of sales may result in carrying higher levels of inventories of finished goods and raw materialsthereby increasing the risk of inventory obsolescence and corresponding inventory write-downs. As a result, the Company may not carry adequate reserves tooffset such write-downs.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 competition exists for suchpersonnel and there is no assurance key technical and sales personnel can be retained nor assurances there will be the ability to attract, assimilate and retainother highly qualified technical and sales personnel as required. There is also no guarantee key employees will not leave and subsequently compete againstthe Company. The inability to retain key personnel could adversely impact the business, financial condition 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 account for a significantportion 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 economicinstability; general economic conditions; and fluctuations in foreign currencies. No assurances can be given these factors will not have a material adverseeffect on future international sales and operations and, consequently, on business, financial condition and results of operations.Item 1B. Unresolved Staff CommentsNot applicable.Item 2. PropertiesThe Company’s design and assembly facilities and executive offices are located in Portland, Oregon in three company-owned buildings with totalapproximate square footage of 40,500 square feet. SEL occupies a 1,893-square foot facility in Coventry, England pursuant to a three-year lease beginningJune 1, 2005 with a basic monthly rent of £1,875 (approximately $3,512 as of May 31, 2006).Item 3. Legal ProceedingsThere are no material legal proceedings currently pending against the Company.Item 4. Submission of Matters to a Vote of Security HoldersNo matters were submitted to a vote of the security holders of the Company during the fourth quarter ended May 31, 2006. 11PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesThe Company’s Common Stock is traded on the NASDAQ Capital 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 Capital Market for the periodsindicated.Year Ended May 31, 2006HighLowFirst Quarter$11.95$7.69Second Quarter$9.10$5.40Third Quarter$7.47$5.47Fourth Quarter$8.39$5.78 Year Ended May 31, 2005HighLowFirst Quarter$8.16$2.20Second Quarter$9.54$5.65Third Quarter$9.71$5.82Fourth Quarter$9.70$6.23 As of July 31, 2006, there were 2,640,045 shares of Common Stock outstanding held by approximately 175 holders of record. The number of holders doesnot include individual participants in security position listings; the Company believes that there are more than 2,000 individual holders of shares ofCommon 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 the Company’sbusiness. Future dividends will be dependent upon the Company’s financial condition, results of operations, current and anticipated cash requirements,acquisition plans and plans for expansion and any other factors that the Company’s Board of Directors deems relevant. The Company has no presentintention of paying dividends on its Common Stock in the foreseeable future.The following table summarized information about equity awards under the Company’s equity compensation plans at May 31, 2006:Plan CategoryNumber ofSecurities to be issued upon exercise ofoutstanding optionsWeighted-averageexercise price of outstanding optionsNumber of Securitiesremaining availablefor future issuanceunder equitycompensation plans(excluding securities in column a)abcEquity compensation plans approved by security holders216,496$2.52352,178Equity compensation plans not approved by security holders———216,496$2.52352,178 12Item 6. Selected Financial DataIn thousands, except per share informationYear Ended5/31/065/31/055/31/045/31/035/31/02 Sales$11,503$10,591$7,925$7,420$6,875Net Income (Loss)$1,350$1,608$517$(1,487)$(1,599)Net Income (Loss) Per Share, Basic$.52$.64$.21$(.60)$(.64Weighted Average No. Shares, Basic2,6062,5282,4392,4682,488Net Income (Loss) Per Share, Diluted$.49$.59$.20$(.60)$(.64)Weighted Average No. Shares, Diluted2,7462,7092,5242,4682,488Stockholders’ Equity$9,814$7,979$6,114$5,665$7,251Total Assets$10,927$9,075$7,100$6,272$8,161Long-term Debt (including current portion)$22$53$67$24$280 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following information contains certain forward-looking statements that anticipate future trends or events. These statements are based on certainassumptions that may prove to be erroneous and are subject to certain risks including but not limited to the uncertainties of the Company’s new productintroductions, the risks of increased competition and technological change in the Company’s industries and other factors detailed in the Company’s SECfilings. Accordingly, actual results may differ, possibly materially, from the predictions contained herein.RESULTS OF OPERATIONSOverviewBalancer segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers of grinding machines with the targetgeographic markets in North America, Asia and Europe. Combined Balancer sales increased 5.2% for the year ended May 31, 2006 compared to the yearended May 31, 2005. Beginning in March 2004, improving economic conditions in North America resulted in increased sales in that geographic market. Sales people, representatives and distributors throughout these geographic areas spend a large amount of time with targeted customers. Many customers inthe automotive, bearing and aircraft industries refer to improved economic conditions and its impact on the machine tool industry in North America as thereason for their increased orders, although the growth rate has slowed in the last three quarters. While those customers are optimistic regarding short termdemand for Balancer products, they remain uncertain as to the strength and duration of current business conditions in North America for their products whichincorporate the Balancer segment product line. North American Balancer sales decreased 0.7% in the year ended May 31, 2006 compared to the year endedMay 31, 2005. Market demand in Asia for the Balancer segment products remains strong with that region showing a 49.5% increase for the year ended May31, 2006 compared to the year ended May 31, 2005. The European market remains soft as total Balancer sales into that geographic market declined 25.7%during the year ended May 31, 2006 compared to the year ended May 31, 2005. Sales in all Other markets increased to $845,198 in the year ended May 31,2006 compared to the $426,656 for the year ended May 31, 2005, a 98.1% increase. The large percentage increase was predominately a result of increases inthe Japan and South American markets. As with the North American market, the duration of the strong demand in Asia, Japan and South American marketscannot be forecasted with any certainty.The Measurement segment product line consists of both laser light-scatter and dimensional sizing products. Combined Measurement sales increased 16.6%for the year ended May 31, 2006 compared to the year ended May 31, 2005. As noted below sales can be very cyclical in the Measurement segment. Thebusiness operations and prospects for these two product lines are summarized as follows:Laser light-scatter products— The primary target markets for Measurement products have been disk drive and silicon wafer manufacturers and companies andorganizations involved in research efforts. Certain13segments of these targeted industries have seen consolidation into very large international manufacturers. Sales totaled $1,948,386 for the year ended May31, 2006 compared to the $1,396,806 for the year ended May 31, 2005. Management and the sales staff monitor industry publications and public financialinformation in order to judge the potential demand for products by the targeted industries. Over the past year, this information has indicated improvingdemand for and sales of the products of those industries. Sales to customers in these industries can be very cyclical and therefore the impact of this recoveryon sales to the Company’s laser light-scatter products is unknown at this time.Laser light-scatter products from research organizations — The Company continues to receive inquiries for these products and provide quotes to interestedparties. However, in the current fiscal year, no sales of these products were realized.Dimensional sizing products — These products are marketed and sold into a wide array of industries. Sales totaled $1,736,305 for the year ended May 31,2006 compared to the $1,764,136 for the year ended May 31, 2005. In Fiscal 2004, management built a sales distribution network covering all fifty states. As a result of this action, the Company experienced increasing interest and sales in these products. During the quarter ended August 31, 2003, managementconsolidated the operations related to these products (which had been located in Menlo Park, California) into the Measurement segment operations inPortland, Oregon. The relocation was completed as of August 31, 2003. Since relocation to Portland, sales of these products have increased from the$1,023,278 reported in Fiscal 2004.Critical Accounting PoliciesRevenue Recognition — The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixedor determinable and collectibility is probable. For sales to all customers, including manufacturer representatives, distributors or their third-party customers,these criteria are met at the time product is shipped. When other significant obligations remain after products are delivered, revenue is recognized only aftersuch obligations are fulfilled.Cash Equivalents and Short Term Investments — The Company generally invests excess cash in money market funds and investment grade highly liquidsecurities. The Company considers securities that are highly liquid, readily convertible into cash and have original maturities of less than three months whenpurchased to be cash equivalents. At May 31, 2006, short-term investments are classified as available-for-sale. The carrying amounts of cash equivalents andshort term investments are stated at cost, which approximate fair market value because of their short maturities. There were no related unrealized holdinggains or losses at May 31, 2006.Accounts Receivable — The Company maintains credit limits for all customers that are developed based upon several factors, including but not limited topayment history, published credit reports and use of credit references. On a monthly basis, management performs various analyses to evaluate accountsreceivable balances to ensure recorded amounts reflect estimated net realizable value. This review includes accounts receivable agings, other operatingtrends and relevant business conditions, including general economic factors, as they relate to the Company’s domestic and international customers. If theseanalyses lead management to the conclusion that potential significant accounts are uncollectible, a reserve is provided.Inventories — These assets are stated at the lower of cost or market on an average cost basis. Each fiscal quarter, management utilizes various analyses basedon sales forecasts, historical sales and inventory levels to ensure the current carrying value of inventory accurately reflects current and expected requirementswithin a reasonable timeframe.Deferred Tax Assets— The Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilitiesare determined, based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted taxrates 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. In Fiscal 2005 and at November 30, 2005, management concluded future operations would produce sufficient earningsso that a portion of this asset could be used in future periods to reduce federal and state tax liabilities. Management continues to review the level of thevaluation allowance on a quarterly basis. There can be no assurance that the Company’s future operations will produce sufficient earnings so that thedeferred tax asset can be fully utilized.14Intangible Assets — There is a periodic review of intangible and other long-lived assets for impairment. This review consists of the analysis of events orchanges in circumstances that would indicate the carrying amount of the asset may not be recoverable. Recoverability is determined by comparing theforecasted future net cash flows from the operations to which the assets relate, based on management’s best estimates using the appropriate assumptions andprojections at the time, to the carrying amount of the assets. If the carrying value is determined to be in excess of future operating cash flows, the asset isconsidered impaired and a loss is recognized equal to the amount by which the carrying amount exceeds the estimated fair value of the assets. As of May 31,2006, management does not believe impairment, as defined above, exists.Recently issued accounting pronouncements:The Financial Accounting Standards Board (FASB) issued SFAS No. 151, “Inventory Costs - an Amendment to ARB No. 43, Chapter 4” in November 2004. This Statement requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) costs be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacityof the production facilities. The Company does not expect this pronouncement to have a material impact on the financial statements.The FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3”. ThisStatement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim FinancialStatements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntarychanges in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. TheCompany does not expect this pronouncement to have a material impact on the financial statements.The FASB revised SFAS No. 123R, “Share-Based Payment” in December 2004. Under the revised standard, the Company will be required to recognizecompensation cost, related to its stock options, beginning in the first fiscal quarter of the year beginning June 1, 2006. The cost of services received fromemployees in exchange for awards of share-based compensation generally shall be measured based on the grant-date fair value of the equity instrumentsissued. The Company expects the effect of this pronouncement to approximate the pro forma amounts disclosed in Note 2 of the Notes to ConsolidatedFinancial Statements.The FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) in June 2006. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in our financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. The provisions of FIN48 are effective for our fiscal year beginning June 1, 2007. We are currently evaluating the impact of the provisions of FIN 48.Discussion of operating results: Year ended May 31, 2006 Consolidated BalancerMeasurement Dollars % Dollars%Dollars% Sales$11,503,360100.0%$7,818,669100.0%$3,684,691100.0%Cost of sales5,029,71443.7%3,772,69248.3%1,257,02234.1%Gross profit6,473,64656.3%$4,045,97751.7%$2,427,66965.9%Operating expenses4,740,05041.2%Operating income$1,733,59615.1% 15 Year ended May 31, 2005 Consolidated BalancerMeasurement Dollars % Dollars%Dollars% Sales$10,591,229100.0%$7,430,287100.0%$3,160,942100.0%Cost of sales4,460,76942.1%3,473,85846.8%986,91131.2%Gross profit6,130,46057.9%$3,956,42953.2%$2,174,03168.8%Operating expenses4,914,00046.4%Operating income$1,216,46011.5% Year Ended May 31, 2004 Consolidated BalancerMeasurement Dollars % Dollars%Dollars% Sales$7,924,766100.0%$5,924,854100.0%$1,999,912100.0%Cost of sales3,405,76143.0%2,727,40546.0%678,35633.9%Gross profit4,519,00557.0%$3,197,44954.0%$1,321,55666.1%Operating expenses4,081,73951.5%Operating income$437,2665.5% Worldwide sales of Balancer products increased 5.2% in the year ended May 31, 2006 compared to the year ended May 31, 2005 as sales to the Asianmarkets increased by 49.5% offset by a decline in the North American market of 0.7%. Sales in all Other markets increased to $845,198 in the year endedMay 31, 2006 compared to the $426,656 for the year ended May 31, 2005, a 98.1% increase. These increases were offset by decreases in the Europeanmarket of 25.7%. Unit sales prices of Balancer products are relatively stable and therefore any increases or decreases in the dollar amount of sales betweenfiscal periods can generally be attributed to an increase or decrease in the number of units sold. The Balancer product sales increase in Asia and Othermarkets is attributed to expansion of the sales efforts in China and other market regions. The decreased units sold in Europe are attributed to strong Europeancompetition and weaker economic conditions in certain European markets. The large percentage increase in Other markets was predominately a result ofincreases in the Japan and South American markets.Measurement product sales increased 16.6% in the year ended May 31, 2006 compared to the year ended May 31, 2005 as sales of the Company’s surfacemeasurement products increased by 39.5% offset by slight decrease in dimensional sizing products of 1.6%. The sales of surface measurement products in theyear ended May 31, 2006 compared to the year ended May 31, 2005 increased as they included more unit sales than in the same fiscal period in the prioryear.Cost of sales for both the Balancer and Measurement segments increased (as a percentage of sales) in the year ended May 31, 2006 compared to the yearended May 31, 2005 primarily due to the product sales mix as production labor and overhead costs were relatively stable. Margins were also negativelyimpacted as a result of higher sales in foreign markets as a large portion of those sales are made through distributors who receive pricing net of commissionsand other sales costs.The decrease in operating expenses between Fiscal 2006 and 2005 occurred primarily due to the reduction of operating expenses in the Company’s foreignoperations resulting from the liquidation and dissolution of its the German subsidiary, Schmitt Europa, GmbH, effective May 30, 2005. The costs in theforeign operations decreased due to the reduction in sales and administration staff that occurred due to the consolidation of Schmitt Europa, GmbHoperations into Schmitt Europe Ltd. The increase in operating expenses between Fiscal 2005 and 2004 occurred primarily due to the higher levels of sales.Sales by Schmitt Europe Ltd. totaled $1,810,377 for the year ended May 31, 2006 compared to sales of $2,119,103 in the year ended May 31, 2005. Approximately 10.5% of the decrease was due to lower unit sales volumes with the remainder due to the changes in foreign exchange rates between the twofiscal periods. The lower sales volumes were realized as a result of the soft sales in European markets, which were partially offset by increases in othermarkets primarily located in Asia and South America.16Net sales outside North America accounted for approximately 49% of the Company’s revenues in Fiscal 2006, 45% in Fiscal 2005 and 43% in Fiscal 2004. Some foreign customers purchase in their own country’s currencies, thereby imposing on the Company a currency risk. Of total sales in Fiscal 2006, 2005and 2004, approximately 15%, 20% and 23%, respectively, were denominated in currencies other than U.S. dollars. To date, currency fluctuations have hadminimal impact on sales. However, significant variations in the value of the U.S. dollar, relative to currencies of countries in which the Company hassignificant competitors, can impact future sales. The Company does not engage in currency hedging. In addition, the longer payment cycles of internationalsales can have a negative impact on liquidity. The Company believes international sales will continue to grow in future periods.The net income for Fiscal 2006 of $1,350,129 ($0.49 per fully diluted share) compared to net income of $1,608,140 ($0.59 per fully diluted share) and netincome of $516,585 ($0.20 per fully diluted share) in Fiscal 2005 and 2004, respectively. Net income in Fiscal 2006 included a $280,223 reduction in thedeferred tax asset valuation allowance which reduced the Fiscal 2006 income tax provision. Net income in Fiscal 2005 included two significant items; aforeign exchange loss of $174,274 which was incurred due to the closure of the German subsidiary (Schmitt Europa, GmbH); and $640,000 income taxbenefit due to the reduction in the deferred tax asset valuation allowance. Management believes the effective tax rate in future periods will reflect a normalcombined state and federal rate.A substantial portion of the Company’s revenues are derived from sales to end users through selling agents. The Company is dependent on the sales activitiesof its selling agents, and there can be no assurance these agents will continue to be successful in their efforts to market the Company’s products. TheCompany enjoys substantial repeat business from a broad base of customers, but there is no assurance these customers will continue to buy the Company’sproducts.In Fiscal years 2006, 2005 or 2004, sales to any single customer did not exceed 10% of total revenues.The Company operates in highly competitive industries characterized by increasingly rapid technological changes. The Company’s competitive advantageand future success are therefore dependent on its ability to develop new products, qualify these new products with its customers, successfully introduce theseproducts to the marketplace on a timely basis, commence production to meet customer demands and develop new markets in the industries for its productsand services. The successful introduction of new technology and products is increasingly complex. If the Company is unable, for whatever reason, todevelop and introduce new products in a timely manner in response to changing market conditions or customer requirements, its results of operations couldbe adversely impacted.LIQUIDITY AND CAPITAL RESOURCESThe Company’s ratio of current assets to current liabilities increased to 8.1 to 1 at May 31, 2006 compared to 6.5 to 1 at May 31, 2005. Cash, cashequivalents and available for sale short term investments totaled $3,538,012 as of May 31, 2006 compared to $1,176,959 at May 31, 2005. As of May 31,2006 the Company had $1,552,072 in cash and cash equivalents compared to $1,176,959 at May 31, 2005. As of May 31, 2006 the Company had$1,985,940 in short term investments compared to $-0- at May 31, 2005. Short term investments consisted of highly liquid A1-P1 rated commercial papersecurities maturing through September 2006.During the year ended May 31, 2006, cash provided by operating activities amounted to $2,358,936 with the changes described as follows:• Net income for the year ended May 31, 2006 of $1,350,129 plus one non-cash item: depreciation and amortization of $210,606; less the non-cashincrease in deferred tax assets of $28,460 net of a $335,238 tax benefit related to stock options.• Accounts receivable generated cash as the balance decreased by $126,053 to a May 31, 2006 balance of $1,983,090 compared to $2,109,143 atMay 31, 2005, a 6% decrease. The Company generally experiences a payment cycle of 30-90 days on invoices, depending on the geographic market. Management believes its credit and collection policies are effective and appropriate for the marketplace. There can be no assurance that the Company’scollection procedures will continue to be successful, particularly with current economic conditions.17• Inventories decreased $291,723 to a May 31, 2006 balance of $3,241,590 compared to $3,533,313 at May 31, 2005, a 8.3% decrease. TheCompany maintains levels of inventory sufficient to satisfy normal customer demands plus an increasing short-term delivery requirement for a majority of itsBalancer products. Management believes its ability to provide prompt delivery gives it a competitive advantage for certain sales.• Prepaid expenses decreased by $26,666 to $77,626 from a balance of $104,292 at May 31, 2005 with the decrease due to prepaid fees, trade showcosts and various business and insurance costs.• Trade accounts payable used cash as the balance decreased by $93,716 to $403,490 from a balance of $497,206 at May 31, 2005 primarily due tonormal fluctuations in timing of payment of outstanding payable balances.• Other accrued liabilities (including customer deposits, commissions, payroll items and other accrued expenses) increased by $106,607 to a balanceof $626,785 from $520,178 at May 31, 2005.During the year ended May 31, 2006, net cash used in investing activities was $2,102,808, consisting of net additions to property and equipment of$116,868 and net purchases of short term investments of $1,985,940. Net cash provided by financing activities amounted to $84,382 which consisted ofrepayments of long-term obligations of $31,258 net of common stock issued on exercised stock options of $115,640.The following summarizes contractual obligations at May 31, 2006 and the effect on future liquidity and cash flows:Years endingMay 31,Capital Lease and PurchaseContractOperating LeasesTotalContractualObligations2007$15,204$63,026$78,23020086,40863,02669,4342009—8,5508,550Thereafter—521521Total$21,612$135,123$156,735 Management has historically responded to business challenges that had a negative impact on operations and liquidity by reducing operating expenses,developing new products and attempting to penetrate new markets for the Company’s products. As a result of these efforts, results of operations and cashflow from operations have improved. Management believes its cash flows from operations, its available credit resources and its cash position will provideadequate funds on both a short-term and long-term basis to cover currently foreseeable debt payments, lease commitments and payments under existing andanticipated supplier agreements. Management believes that such cash flow (without the raising of external funds) is sufficient to finance current operations,projected capital expenditures, anticipated long-term sales agreements and other expansion-related contingencies during Fiscal 2007. However, in the eventthe Company fails to achieve its operating and financial goals for Fiscal 2007, management may be required to take certain actions to finance operations inthat time period. These actions could include, but are not limited to, implementation of cost cutting measures and/or entering into additional borrowingarrangements collateralized by assets.Item 7A. Quantitative and Qualitative Disclosures about Market RiskInterest Rate RiskThe Company did not have any derivative financial instruments as of May 31, 2006. However, the Company could be exposed to interest rate risk at anytime in the future and, therefore, employs established policies and procedures to manage its exposure to changes in the market risk of its marketablesecurities.The Company’s interest income and expense are most sensitive to changes in the general level of U.S. and European interest rates. In this regard, changes inU.S. and European interest rates affect the interest earned on the Company’s interest bearing cash equivalents and short term investments. The Company hasa variable rate line of credit facility with a bank but there is no outstanding balance as of May 31, 2006. Also, there is no other long-term obligation whoseinterest rates are based on variable rates that may fluctuate over time based on economic changes in the environment. Therefore, at this time, the Company isnot subject to interest rate risk on outstanding interest bearing obligations if market interest rates fluctuate and does not expect any change in the interestrates to have a material effect on the Company’s results from operations.18Foreign Currency RiskThe Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to account for a significantportion of future revenue. The Company operates a subsidiary in the United Kingdom and acquires certain materials and services from vendors transacted inforeign currencies. Therefore, the Company’s business and financial condition is sensitive to currency exchange rates or any other restrictions imposed ontheir currencies. For the years ended May 31, 2006, 2005 and 2004, results of operations included gains (losses) on foreign currency translation of $(9,757),$(184,106) and $40,608, respectively. The foreign exchange loss in Fiscal 2005 was directly attributable to the closure, liquidation and pending dissolutionof the Company’s German subsidiary, Schmitt Europa, GmbH. In the fourth quarter of Fiscal 2005, management chose to terminate the only two employeesin that country, eliminating the need for a separate German company. As there will be no future activity in that subsidiary, the accumulated foreign exchangeloss, included in other comprehensive income on the balance sheet in prior periods, was recognized in the fourth quarter of Fiscal 2005. The foreignexchange gains or losses in Fiscal 2006 and 2004 are primarily attributable to Company’s United Kingdom subsidiary, Schmitt Europe, Ltd. 19Item 8. Financial Statements and Supplementary DataSCHMITT INDUSTRIES, INC.CONSOLIDATED BALANCE SHEETSMay 31, 2006May 31, 2005 ASSETSCurrent assetsCash and cash equivalents$1,552,072$1,176,959Short-term investments1,985,940—Accounts receivable, net of allowance of $52,186 and $41,366at May 31, 2006 and May 31, 2005, respectively1,983,0902,109,143Inventories3,241,5903,533,313Prepaid expenses77,626104,292Deferred tax asset116,08092,3198,956,3987,016,026Property and equipmentLand299,000299,000Buildings and improvements1,275,9221,214,348Furniture, fixtures and equipment1,180,6481,120,946Vehicles96,84996,8492,852,4192,731,143Less accumulated depreciation and amortization(1,643,047)(1,462,637)1,209,3721,268,506Other assetsLong-term deferred tax asset552,380547,681Other assets208,405243,009760,785790,690 Total assets$10,926,555$9,075,222 LIABILITIES & STOCKHOLDERS’ EQUITYCurrent liabilitiesAccounts payable$403,490$497,206Accrued commissions250,835275,745Accrued payroll liabilities138,801102,883Other accrued liabilities237,149141,550Income taxes payable60,23726,147Current portion of long-term obligations15,20432,1141,105,7161,075,645 Long-term obligations6,40820,756 Stockholders’ equityCommon stock, no par value, 20,000,000 shares authorized, 2,625,045 and 2,559,687 shares issued andoutstanding at May 31, 2006 and May 31, 2005, respectively7,946,9767,496,098Accumulated other comprehensive loss(220,051)(254,654)Retained earnings2,087,506737,3779,814,4317,978,821TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY$10,926,555$9,075,222 The accompanying notes are an integral part of these consolidated financial statements20 SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF OPERATIONSFOR THE YEARS ENDED MAY 31, 2006, 2005 AND 2004 2006 20052004 Net sales$11,503,360$10,591,229$7,924,766Cost of sales5,029,7144,460,7693,405,761Gross profit6,473,6466,130,4604,519,005 Operating expenses:General, administration and sales4,658,2354,871,6054,051,369Research and development81,81542,39530,370Total operating expenses4,740,0504,914,0004,081,739 Operating income1,733,5961,216,460437,266 Other income (expense)Gain (loss) on foreign currency exchange(9,757(184,106)40,608Miscellaneous income (expense)59,833(30,21445,511Loss on write-down of long-term investment——(6,800Total other income (expense)50,076(214,32079,319 Income before income taxes1,783,6721,002,140516,585 Provision (benefit) for income taxes433,543(606,000)— Net income$1,350,129$1,608,140$516,585 Net income per common share, basic$0.52$0.64$0.21 Weighted average number of common shares, basic2,606,0392,527,6652,438,895 Net income per common share, diluted$0.49$0.59$0.20 Weighted average number of common shares, diluted2,746,4022,708,7972,524,050 The accompanying notes are an integral part of these consolidated financial statements21 SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED MAY 31, 2006, 2005 AND 2004 2006 20052004Cash flows relating to operating activitiesNet income$1,350,129$1,608,140$516,585Adjustments to reconcile net income to net cashprovided by operating activities:Depreciation and amortization210,606214,933188,314Deferred taxes(28,460)(640,000)—Tax benefit related to stock options335,238——Write-down of long-term investment——6,800(Increase) decrease in:Accounts receivable126,053(293,726)(491,217)Inventories291,723(618,220)(189,162)Prepaid expenses26,66620,05642,844Income taxes receivable—35,894(3,235)Increase(decrease) in:Accounts payable(93,716)(68,340)210,217Accrued liabilities and customer deposits106,607166,131127,014Income taxes payable34,09026,147—Net cash provided by operating activities2,358,936451,015408,160Cash flows relating to investing activitiesPurchase of short-term investments(1,985,940)——Maturities of short-term investments———Purchase of property and equipment(116,868)(93,060)(108,796)Disposals of property and equipment——(1,686)Net cash used in investing activities(2,102,808)(93,060)(110,482)Cash flows relating to financing activitiesAdditions to long-term obligations———Repayments on long-term obligations(31,258)(42,064)(35,678)Common stock issued on exercise of stock options115,640135,27967,835Common stock repurchased——(40,000)Net cash provided by financing activities84,38293,215(7,843) Effect of foreign exchange translation on cash34,603121,595(95,886) Increase in cash and cash equivalents375,113572,765193,949 Cash and cash equivalents, beginning of period1,176,959604,194410,245 Cash and cash equivalents, end of period$1,552,072$1,176,959$604,194 Supplemental Disclosure of Cash Flow InformationCash paid during the period for interest$872$1,083$4,330Cash paid during the period for income taxes$139,065$7,853$4,035 Supplemental Schedule of Noncash Investing and Financing Activities Fixed assets financed$—$27,861$78,447 The accompanying notes are an integral part of these consolidated financial statements22 Schmitt Industries, Inc.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYFOR THE YEARS ENDED MAY 31, 2006, 2005 AND 2004 Common StockAccumulatedothercomprehensive Retained TotalcomprehensiveSharesAmountloss earnings Total income (loss) Balance, May 31, 20032,457,932$7,332,984$(280,363)$(1,387,348)$5,665,273 Common stock repurchased(40,000)(40,000)——(40,000)Stock options exercised56,52967,835——67,835Net income———516,585516,585$516,585Other comprehensive (loss)——(95,886)—(95,886)(95,886)Balance, May 31, 20042,474,4617,360,819(376,249)(870,763)6,113,807 Comprehensive income, year endedMay 31, 2004$420,699 Stock options exercised85,226135,279——135,279Net income———1,608,1401,608,140$1,608,140Other comprehensive income——121,595—121,595121,595Balance, May 31, 20052,559,6877,496,098(254,654)737,3777,978,821 Comprehensive income, year endedMay 31, 2005$1,729,735 Stock options exercised and relatedtax benefit of $335,23865,358450,878——450,878Net income———1,350,1291,350,129$1,350,129Other comprehensive income——34,603—34,60334,603Balance, May 31, 20062,625,045$7,946,976$(220,051)$2,087,506$9,814,431 Comprehensive income, year endedMay 31, 2006$1,384,732 The accompanying notes are an integral part of these consolidated statements 23Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2006, 2005 AND 2004NOTE 1ORGANIZATION AND NATURE OF OPERATIONSSchmitt Industries, Inc. (the Company) designs, assembles, markets and distributes electronic and mechanical components for machine tool products and lasermeasurement systems worldwide.NOTE 2SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPrinciples of ConsolidationThese consolidated financial statements include those of the Company and its wholly owned subsidiaries: Schmitt Measurement Systems, Inc. (SMS),Schmitt Europe, Ltd. (SEL) and Schmitt Europa GmbH (SEG). Effective May 31, 2005 SEG has been liquidated. All significant intercompany accounts andtransactions have been eliminated in the preparation of the consolidated financial statements.Revenue RecognitionThe Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable andcollectibility is probable. For sales to all customers, including manufacturer representatives, distributors or their third-party customers, these criteria are metat the time product is shipped. When other significant obligations remain after products are delivered, revenue is recognized only after such obligations arefulfilled.Cash Equivalents and Short Term InvestmentsThe Company generally invests excess cash in money market funds and investment grade highly liquid securities. The Company considers securities that arehighly liquid, readily convertible into cash and have original maturities of less than three months when purchased to be cash equivalents. At May 31, 2006,short-term investments are classified as available-for-sale. The carrying amounts of cash equivalents and short term investments are stated at cost, whichapproximate fair market value because of their short maturities. There were no related unrealized holding gains or losses at May 31, 2006.Accounts ReceivableThe Company maintains credit limits for all customers based upon several factors, included but not limited to payment history, published credit reports anduse of credit references. On a monthly basis, management performs various analyses to evaluate accounts receivable balances to ensure recorded amountsreflect estimated net realizable value. This review includes accounts receivable agings, other operating trends and relevant business conditions, includinggeneral economic factors, as they relate to each of the Company’s domestic and international customers. If these analyses lead management to the conclusionthat potential significant accounts are uncollectible, a reserve is provided.InventoryInventory is valued at the lower of cost or market with cost determined on the average cost basis. As of May 31, 2006 and 2005, inventories consisted of rawmaterials ($1,578,767 and $1,830,748, respectively), work-in-process ($368,592 and $127,001, respectively), and finished goods ($1,294,231 and$1,575,564, respectively).Property and EquipmentProperty and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three to seven years forfurniture fixtures, and equipment; three years for vehicles; and twenty-five years for buildings and improvements.24Foreign Currency TranslationFinancial statements for the Company’s subsidiaries outside the United States are translated into U.S. dollars at year-end exchange rates for assets andliabilities and weighted average exchange rates for income and expenses. The resulting translation adjustments are included as a separate component ofstockholders’ equity titled “Accumulated Other Comprehensive Loss.”AdvertisingAdvertising costs included in general, administrative and selling, are expensed when the advertising first takes place. Advertising expense was $82,322,$87,853 and $86,648 for the fiscal years ended May 31, 2006, 2005 and 2004, respectively.Research and Development CostsResearch and development costs, which are predominately internal labor costs, are charged to expense when incurred.Stock-Based CompensationThe Company has elected to follow the accounting provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued toEmployees”, for stock-based compensation and to furnish the pro forma disclosures required under Statement of Financial Accounting Standards (SFAS) No.148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” No stock-based employee compensation cost is reflected in net incomebecause all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant.The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No.123 to stock-based compensation:200620052004 Net income, as reported$1,350,129$1,608,140$516,585Add: Stock-based employee compensation expense included in reported net income, net of tax———Deduct: Total stock-based employee compensation expense determined under fair value basedmethod for all awards, net of tax(120,411)(230,865)(28,937)Pro forma net income$1,229,718$1,377,275$487,648 Earnings per share — basicAs reported$0.52$0.64$0.21Pro forma$0.47$0.54$0.20Earnings per share — dilutedAs reported$0.49$0.59$0.20Pro forma$0.45$0.51$0.19 The effects of applying SFAS No. 123 in this pro forma disclosure are not necessarily indicative of future amounts.25 Deferred Tax AssetsThe Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities are determined, basedon the 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 the deferred taxasset will not be realized. In Fiscal 2005 and at November 30, 2005, management concluded future operations would produce sufficient earnings so that aportion of this asset could be used in future periods to reduce federal and state tax liabilities. Management continues to review the level of the valuationallowance on a quarterly basis. There can be no assurance that the Company’s future operations will produce sufficient earnings so that the deferred tax assetcan be fully utilized.Intangible AssetsThere is a periodic review of intangible and other long-lived assets for impairment. This review consists of the analysis of events or changes in circumstancesthat would indicate the carrying amount of the asset may not be recoverable. Recoverability is determined by comparing the forecasted future net cash flowsfrom the operations to which the assets relate, based on management’s best estimates using the appropriate assumptions and projections at the time, to thecarrying amount of the assets. If the carrying value is determined to be in excess of future operating cash flows, the asset is considered impaired and a loss isrecognized equal to the amount by which the carrying amount exceeds the estimated fair value of the assets. As of May 31, 2006, management does notbelieve impairment, as defined above, exists.Earnings Per ShareBasic earnings per share is computed using the weighted average number of common shares outstanding. Diluted earnings per share is computed using theweighted average number of common shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase commonstock.Concentration of Credit RiskFinancial instruments that potentially expose the Company to concentration of credit risk are trade accounts receivable. Credit terms generally include adiscount of 1-1/2% if the invoice is paid within ten days, with the net amount payable in 30 days.Financial InstrumentsBased on borrowing rates currently available to the Company for bank loans with similar terms and maturities, the fair value of the Company’s long-term debtapproximates the carrying value. Furthermore, the carrying value of all other financial instruments potentially subject to valuation risk (principallyconsisting of cash and cash equivalents, short term investments, accounts receivable and accounts payable) also approximate fair value because of their short-term maturities.Use of EstimatesThe preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.Recently issued accounting pronouncements:The Financial Accounting Standards Board (FASB) issued SFAS No. 151, “Inventory Costs - an Amendment to ARB No. 43, Chapter 4” in November 2004. This Statement requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) costs be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacityof the production facilities. The Company does not expect this pronouncement to have a material impact on the financial statements.26 The FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3”. ThisStatement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim FinancialStatements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntarychanges in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. TheCompany does not expect this pronouncement to have a material impact on the financial statements.The FASB issued SFAS No. 123R, “Share-Based Payment” in December 2004. Under the revised standard, the Company will be required to recognizecompensation cost, related to its stock options, beginning in the first fiscal quarter of the year beginning June 1, 2006. The cost of services received fromemployees in exchange for awards of share-based compensation generally shall be measured based on the grant-date fair value of the equity instrumentsissued. The Company will use the modified prospective transition method and will continue to value stock-based compensation utilizing the Black-Scholesvaluation model. The Company has evaluated the provisions of SFAS No. 123R and expects its adoption will have a material impact on the Company’sconsolidated results of operations and earnings per share, as the stock-based compensation expense will be charged directly against the Company’s reportedearnings. The amount of expense that will be recognized is largely dependent on several variables, including the level of share-based payments that will begranted during the fiscal year in addition to the assumptions used in the valuation model. The Company estimates that a total of approximately $90,000 willbe recorded as additional compensation expense over the period beginning with the quarter ending August 31, 2006 through the fiscal year ending May 31,2009, for all options which are outstanding as of May 31, 2006, but which were not yet vested. The adoption of SFAS No. 123R will not have any effect onthe Company’s cash flows or liquidity as stock-based compensation is a non-cash expense. See Stock-Based Compensation in Note 2 and Note 11.The FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) in June 2006. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in our financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. The provisions of FIN48 are effective for our fiscal year beginning June 1, 2007. We are currently evaluating the impact of the provisions of FIN 48.ReclassificationsCertain reclassifications have been made to the 2005 and 2004 amounts to conform to 2006 presentations.NOTE 3ACCOUNTS RECEIVABLEChanges in the Company’s allowance for doubtful accounts are as follows:20062005 Beginning balance$41,366$32,550Bad debt expense39,51340,527Accounts written off(28,693)(31,711)Ending balance$52,186$41,366 27NOTE 4INVENTORIESChanges in the Company’s allowance for slow moving inventories are as follows:20062005 Beginning balance$163,414$172,696Items added to allowance18,77794,664Items used in production(9,246)(103,946)Ending balance$172,945$163,414 NOTE 5LINE OF CREDITThe Company has a $1.0 million bank line of credit agreement secured by U.S. accounts receivable, inventories and general intangibles. Interest is payableat the bank’s prime rate, 8% as of May 31, 2006, and the agreement expires on September 1, 2007. There were no outstanding balances on the line of credit atMay 31, 2006.NOTE 6INCOME TAXESThe provision (benefit) for income taxes was as follows:Years ended May 31,200620052004Current$109,100$34,000$—Deferred604,666420,167226,827Decrease in valuation allowance(280,223)(1,060,167)(226,827)Total (benefit from) provision for income taxes$433,543$(606,000)$— Deferred tax assets (liabilities) are comprised of the following components:20062005Depreciation$62,869$65,749Net operating loss carryforwards197,958637,258Deferred taxes related to the decline in fairmarket value of long-term investment694,696694,696Other deferred items, net500,569330,175Gross deferred tax assets1,456,0921,727,878Deferred tax asset valuation allowance(787,632)(1,087,878)Net deferred tax asset$668,460$640,000 The Net deferred tax asset is classified as follows:20062005Current deferred tax asset$116,080$92,319Long-term deferred tax asset552,380547,681Net deferred tax asset$668,460$640,000 The Company’s U.S. federal and state net operating loss carryforwards expire through Fiscal 2025. 28The Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities are determined, basedon the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws. Deferredtax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. The Company has recorded a substantial deferred tax asset related to the expected realization of net operating loss carryforwards for federal income taxpurposes and other temporary differences between book and tax bases of assets and liabilities. Due to the uncertainty of utilization of the Company’s netoperating losses and in consideration of other factors, management recorded a valuation allowance on the deferred tax asset at May 31, 2003.In Fiscal 2005, management concluded future operations would produce sufficient earnings so that a portion of the net deferred tax asset could be used infuture periods to reduce federal and state tax liabilities. As a result, the valuation reserve for this asset was reduced as of May 31, 2005 to reflect the amountof the asset management expected to utilize in future fiscal periods. During Fiscal 2006, management concluded future operations would produce sufficientearnings so that additional portions of this asset could be used in future periods to reduce federal and state tax liabilities and the allowance was reduced toreflect the amount of the deferred tax asset management believes can be utilized in Fiscal 2006 and beyond. Management believes the effective tax rate infuture periods will reflect a normal combined state and federal rate.The provision for income taxes differs from the amount of income taxes determined by applying the U.S. statutory federal tax rate to pre-tax (loss) income dueto the following: Years ended May 31, 2006 2005 2004 Statutory federal tax rate34.0%34.0%34.0%State taxes, net of federal benefit4.44.4—Change in deferred tax valuation allowance(15.7)(105.8)(43.9)Permanent and other differences1.66.99.9Effective tax rate24.3%(60.5)%—% NOTE 7EMPLOYEE BENEFIT PLANSThe Company adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan & Trust effective June 1, 1996. Employees must meet certain age and servicerequirements to be eligible. Participants may contribute up to 15% of their eligible compensation which may be partially matched by the Company. TheCompany may further make either a profit sharing contribution or a discretionary contribution. As of June 1, 2005 the Company resumed matchingcontributions in conjunction with employee contributions to the plan and made contributions totaling $45,041 during Fiscal 2006. There were nocontributions made by the Company to this Plan during the years ended May 31, 2005 and 2004.NOTE 8LONG-TERM OBLIGATIONSDuring Fiscal 2005, the Company entered into a purchase contract for $27,861. The agreement calls for monthly principal and interest payments of $810 andcarries interest at 1.9%. During Fiscal 2004, the Company entered into an equipment lease, which was treated as a capital lease, and a purchase contracttotaling $78,477. The agreements call for monthly principal payments of $832 and $2,131 and both carry no interest. One lease expired in Fiscal 2006 andthe second expires in Fiscal 2007. Equipment recorded under the capital lease was $48,477, with related accumulated depreciation of $37,704 at May 31,2006.29As of May 31, 2006, future capital lease and purchase contract payments are:Years ending May 31, 2007$15,2042008$6,4082009$— NOTE 9COMMITMENTS AND CONTINGENCIESIn a transaction related to the acquisition of Schmitt Measurement Systems, Inc., formerly TMA Technologies, Inc. (TMA), the Company established a royaltypool and vested in each shareholder and debt holder of the acquired company an interest in the royalty pool equal to the amount invested or loanedincluding interest payable through March 1995. The royalty pool is funded at 5% of net sales (defined as gross sales less returns, allowances and salescommissions) of the Company’s surface measurement products and future derivative products developed by Schmitt Industries, Inc., which utilize thesetechnologies. As part of the royalty pool agreement, each former shareholder and debt holder released TMA from any claims with regard to the acquisitionexcept their rights to future royalties. Royalty expense applicable to the years ended May 31, 2006, 2005 and 2004 amounted to $87,567, $79,268 and$41,430, respectively.The Company has entered into various non-cancelable leases for facilities used to support operations in the United Kingdom. Rent expense for the yearsended May 31, 2006, 2005 and 2004 amounted to $39,960, $41,806 and $67,133, respectively.Lease commitments under these leases for each of the years ending May 31 are as follows:Years ending May 31, 2007$63,0262008$63,0262009$8,550Thereafter$521 NOTE 10SEGMENTS OF BUSINESSThe Company operates principally in two segments of business: the design and assembly of dynamic balancing systems and components (Balancer) for themachine tool industry, and the design and assembly of laser measurement systems (Measurement). The Company also operates in two principal geographicmarkets, United States and Europe.Segment InformationYears ended May 31, 200620052004 BalancerMeasurementBalancerMeasurementBalancerMeasurement Gross sales$8,429,409$3,765,191$8,276,258$3,188,941$6,644,781$2,017,494Intercompany sales(610,740)(80,500)(845,971)(27,999)(719,927)(17,582)Net sales$7,818,669$3,684,691$7,430,287$3,160,942$5,924,854$1,999,912 Income (loss) from operations$674,446$1,059,150$274,710$941,750$2,674$434,592 Intercompany rent$(30,000)$30,000$(30,000)$30,000$(30,000)$30,000 Depreciation expense$139,905$36,097$137,184$43,146$111,282$35,764 Amortization expense$—$34,604$—$34,603$6,665$34,603 Capital expenditures$54,903$61,965$103,658$17,263$169,295$17,948 30Geographic InformationGeographic SalesYears ended May 31, 200620052004 North American SalesUnited States$5,709,044$5,610,274$4,320,421Intercompany———5,709,0445,610,2744,320,421Canada and Mexico169,494262,466200,519 North America total5,878,5385,872,7404,520,940 European SalesGermany313,655552,438469,342Intercompany(10,293)——Germany total303,362552,438469,342 United Kingdom1,081,9811,276,9681,136,035Intercompany(677,415)(873,970)(737,509)United Kingdom total404,566402,998398,526Other European Sales1,056,4191,120,653909,382 Total Europe1,764,3472,076,0891,777,250 Asia2,919,5562,122,3841,365,840Others940,919520,016260,736$11,503,360$10,591,229$7,924,766 Years ended May 31, 200620052004 United StatesEuropeUnited StatesEuropeUnited StatesEurope Income (loss) from operations$1,730,712$2,884$1,547,349$(330,889)$623,887$(186,621) Depreciation expense$164,394$11,608$172,903$7,427$137,606$9,440 Amortization expense$34,604$—$34,603$—$41,268$— Capital expenditures$112,101$4,767$120,921$—$182,094$5,149 Long-term AssetsMay 31, 2006May 31, 2005 Segment:Balancer$1,483,166$1,563,468Measurement$486,991$495,728 Geographic:United States$1,949,390$2,031,587Europe$20,767$27,609Note — Europe is defined as the European subsidiary, Schmitt Europe, Ltd.NOTE 11STOCK OPTIONSThe Board of Directors adopted a Stock Option Plan in December 1995, which plan was amended in August 1996 and October 2004 and restated in August1998. An option granted under the Amended and Restated Stock Option Plan (the Plan) might be either an incentive stock option (ISO), or a nonstatutorystock option (NSO). ISOs may be granted only to employees and members of the Board of Directors of the Company and are subject to certain limitations, inaddition to restrictions applicable to all stock options under the Plan. Options not meeting these limitations will be treated as NSOs. The purchase price ofISOs is fair market value on the date of grant; the purchase price of NSOs may vary from fair market value. Vesting is at the discretion of the compensationcommittee of the Board of Directors, but is either 50% at grant date and 16.7% on each anniversary thereafter or 50% at grant date and 25% on eachanniversary thereafter. The Company initially reserved 400,000 shares for issuance under the Plan and in October 2004 the shareholders approved another400,000 shares for issuance under the Plan. All outstanding options will expire no later than 2015.31The following summarizes the options outstanding as of May 31, 2006:SharesWeightedAverageExercisePrice Options outstanding, May 31, 2003243,989$1.20Options granted——Options exercised(56,529)1.20Options forfeited/cancelled(16,944)1.20 Options outstanding May 31, 2004170,516$1.20Options granted165,5002.30Options exercised(85,226)1.59Options forfeited/cancelled—— Options outstanding May 31, 2005250,790$1.79Options granted34,0006.47Options exercised(63,294)1.83Options forfeited/cancelled(5,000)2.30 Options outstanding May 31, 2006216,496$2.52 The Company continues to measure compensation cost for the Plan using the method of accounting prescribed by APB 25. In electing to continue to followAPB 25 for expense recognition purposes, the Company is required to provide the expanded disclosures required under SFAS No. 148 for stock-basedcompensation granted, including disclosure of pro forma net income and earnings per share, as if the fair value based method of accounting defined in theSFAS No. 123, had been adopted.The Company has computed, for pro forma disclosure purposes, the value of all stock options granted during Fiscal 2006 and 2005 using the Black-Scholesoption pricing model as prescribed by SFAS No. 123 using the following assumptions:20062005Risk-free interest rate4.25-4.45%3.8-4.0%Expected dividend yield0%0%Expected life4.7 years4.0 yearsExpected volatility98%95-102% Using the Black-Scholes methodology, the total value of stock options granted during Fiscal 2006 and 2005 was $143,432 and $270,684 respectively, whichwould be amortized on a pro forma basis over the vesting period of the options. The average fair value of the options granted in Fiscal 2006 and 2005 was$4.84 and $1.64, respectively. No stock options were granted during Fiscal 2004.The following table summarized information about stock options outstanding at May 31, 2006:Outstanding Options Exercisable OptionsExercisePrice NumberofShares WeightedAverageExercisePrice WeightedAverageRemainingContractual Life(yrs) Numberof Shares WeightedAverageExercise Price$1.2086,414$1.205.886,414$1.20 2.3096,0822.308.059,6662.30 5.805,0005.809.41,6675.80 6.5829,0006.589.38,2506.58216,496$2.527.3155,997$1.95 32NOTE 12EARNINGS PER SHAREBasic earnings per share is computed using the weighted average number of shares outstanding. Diluted earnings per share is computed using the weightedaverage number of shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase common stock. The followingtable is a reconciliation of the numerators and denominators of the basic and diluted per share computations for each of the three years in the period endedMay 31, 2006: Income(Numerator)WeightedAverage Shares(Denominator)PerShareAmount Year ended May 31, 2006Basic earnings per shareIncome available to common stockholders$1,350,1292,606,039$0.52Effect of dilutive securities stock options—140,363Diluted earnings per shareIncome available to common stockholders$1,350,1292,746,402$0.49 Year ended May 31, 2005Basic earnings per shareIncome available to common stockholders$1,608,1402,527,665$0.64Effect of dilutive securities stock options—181,132Diluted earnings per shareIncome available to common stockholders$1,608,1402,708,797$0.59 Year ended May 31, 2004Basic earnings per shareIncome available to common stockholders$516,5852,438,895$0.21Effect of dilutive securities stock options—85,155Diluted earnings per shareIncome available to common stockholders$516,5852,524,050$0.20 NOTE 14RELATED PARTY TRANSACTIONSEffective June 1, 2004, the Company entered into a contract to provide consulting services to PulverDryer USA, Inc., (“PulverDryer”) pursuant to whichPulverDryer paid the Company $8,000 a month from June 2004 through October 2004. PulverDryer also buys certain products from the Company at normalprevailing rates. The Company and PulverDryer extended the contract from November 1, 2004 forward at that same monthly fee of $8,000. Product sales toPulverDryer during the fiscal years ended May 31, 2006 and 2005 totaled $152,305 and $88,873, respectively.In connection with the contract, the Board authorized Wayne Case, the Company’s Chief Executive Officer, to provide advisory services to PulverDryer, andpermitted Mr. Case to receive as compensation the total consulting fees paid by PulverDryer from June 2004 through October 2004. Effective November 1,2004, Mr. Case receives 40% of the ongoing consulting fee from PulverDryer, which percentage was determined by the Compensation Committee. Mr. Casealso serves on the board of directors of PulverDryer.33 SUMMARIZED QUARTERLY FINANCIAL DATAIn thousands, except per share information(unaudited)2006 Quarter EndedAugust 31November 30February 28May 31Sales$2,665$2,606$2,707$3,525Gross profit$1,428$1,506$1,414$2,126Net income$243$395$198$514Net income per share, basic$.09$.15$.08$.20Net income per share, diluted$.09$.14$.07$.19Market Price of Common StockHigh$11.95$9.10$7.47$8.39Low$7.69$5.40$5.47$5.78 2005 Quarter EndedAugust 31November 30February 28May 31 Sales$2,432$2,481$2,563$3,115Gross profit$1,358$1,481$1,466$1,825Net income$280$289$253$786(1)Net income per share, basic$.11$.11$.10$.32Net income per share, diluted$.10$.11$.09$.29Market Price of Common StockHigh$8.16$9.54$9.71$9.70Low$2.20$5.65$5.82$6.23(1)—Includes $606,000 income tax benefit.Report of Independent Registered Public Accounting Firm:Board of Directors and ShareholdersSchmitt Industries, Inc.We have audited the accompanying consolidated balance sheets of Schmitt Industries, Inc. and its subsidiaries as of May 31, 2006 and 2005, and the relatedconsolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended May 31, 2006. Thesefinancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based onour audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal controlover financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinionon the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining,on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis forour opinion.In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Schmitt Industries, Inc.and its subsidiaries as of May 31, 2006 and 2005, and the consolidated results of their operations and their consolidated cash flows for each of the three yearsin the period ended May 31, 2006, in conformity with accounting principles generally accepted in the United States of America./s/ GRANT THORNTON LLP Portland, OregonAugust 15, 200634ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosureNone.Item 9A. Controls and Procedures(a) Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, weconducted an evaluation of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d — 15(e) promulgatedunder the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based on their evaluation, our principalexecutive officer and principal financial officer concluded that our disclosure controls and procedures are effective as of the end of the periodcovered by this report.(b) There have been no changes in our internal controls that occurred during the period covered by this report that has materially affected, or isreasonably likely to materially affect, our internal control over financial reporting.Item 9B. Other InformationNone.PART IIICertain information required by Part III is included in the Company’s definitive Proxy Statement for its 2006 Annual Meeting of Shareholders (“ProxyStatement”) and is incorporated herein by reference. The Proxy Statement will be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934not 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 CompensationThe information required by these items is included in the Proxy Statement under the headings “Management,” “Executive Compensation,” “SummaryCompensation Table,” “Options Grants in Fiscal 2006,” “Aggregated Option Expenses in Fiscal 2006 and Fiscal Year-End Option Values,” “Section 16(a)Beneficial Ownership Reporting Compliance” and “Code of Ethics” and is incorporated herein by reference.Item 12. Security Ownership of Certain Beneficial Owners and ManagementThe information required by this item is included in the Proxy Statement under the heading “Security Ownership of Certain Beneficial Owners” and isincorporated herein by reference.Item 13. Certain Relationships and Related TransactionsThe information required by this item is included in the Proxy Statement under the heading “Certain Relationships and Related Transactions” and isincorporated herein by reference.Item 14. Principal Accounting Fees and ServicesThe information required by this item is included in the Proxy Statement under the heading “Independent Public Accountants” and is incorporated herein byreference.35PART IVItem 15. Exhibits and Financial Statement Schedules(a) Financial Statements:(1)Consolidated Balance Sheets as of May 31, 2006and 2005Consolidated Statements of Operations for the yearsended May 31, 2006, 2005 and 2004Consolidated Statements of Cash Flows for theyears ended May 31, 2006, 2005 and 2004Consolidated Statements of Changes inStockholders’ Equity for the years ended May 31,2006, 2005 and 2004Notes to Consolidated Financial Statements for theyears ended May 31, 2006, 2005 and 2004Report of Independent Registered PublicAccounting Firm(2)Financial Statement Schedules: All financialstatement schedules are omitted either because theyare not applicable, not required, or the requiredinformation is included in the financial statementsor notes thereto.(3)Exhibits: Reference is made to the list on page 38of the Exhibits filed with this report. SIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.SCHMITT INDUSTRIES, INC.By: /s/ Wayne A. Case Wayne A. Case Chairman of the Board, President and Chief Executive OfficerDate: August 21, 200636 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrantand in the capacities indicated on August 21, 2006.Signature Title/s/ Wayne A. CaseChairman of the Board, President and ChiefWayne A. CaseExecutive Officer (Principal Executive Officer)/s/ Michael S. McAfeeChief Financial Officer/TreasurerMichael S. McAfee(Principal Financial and Accounting Officer)/s/ Maynard BrownDirectorMaynard Brown/s/ Timothy D.J. HennessyDirectorTimothy D.J. Hennessy/s/ David M. HudsonDirectorDavid M. Hudson/s/ Michael J. EllsworthDirectorMichael J. Ellsworth 37INDEX TO EXHIBITSExhibits Description 3.1Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the Company). Incorporated by reference to Exhibit 3(i) to theCompany’s Annual Report on Form 10-K for the Fiscal year ended May 31, 1999. 3.2Second Restated Bylaws of the Company. Incorporated by reference to Exhibit 3(ii) to the Company’s Annual Report on Form 10-K for theFiscal year ended May 31, 1999. 4.1See exhibits 3.1 and 3.2 for provisions of the Articles of Incorporation and Bylaws defining the rights of security holders. *10.1Schmitt Industries, Inc. Amended & Restated Stock Option Plan. Incorporated by reference to Exhibit 10.1 to the Company’s Annual Reporton Form 10-K for the Fiscal year ended May 31, 1999. 14.1Code of Ethics and Business Conduct. Incorporated by reference to Exhibit 14.1 to the Company’s Annual Report on Form 10-K for theFiscal year ended May 31, 2004. **21.1Subsidiaries of Schmitt Industries, Inc. as of May 31, 2006. **23.1Consent of Independent Registered Public Accounting Firm. **31.1Certification of Principal Executive Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-OxleyAct of 2002. **31.2Certification of Principal Financial Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Actof 2002. **32.1Certification of Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of The Sarbanes-Oxley Act of 2002.*Management contract or compensatory plan.**Filed herewith EXHIBIT 21.1SUBSIDIARIES OF SCHMITT INDUSTRIES, INC.AS OF MAY 31, 2006SubsidiaryState of Incorporation or Country in Which OrganizedSchmitt Measurement Systems, Inc.OregonSchmitt Europe, Ltd.United Kingdom EXHIBIT 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe have issued our report dated August 15, 2006, accompanying the financial statements included in the Annual Report of Schmitt Industries, Inc. on Form10-K for the year ended May 31, 2006. We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-3910)./s/Grant Thornton LLPPortland, OregonAugust 21, 2006EXHIBIT 31.1CERTIFICATION PURSUANT TO18 U.S. C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Wayne A. Case, certify that:1. I have reviewed this annual report on Form 10-K of Schmitt Industries, Inc.;2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared;(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, theregistrant’s internal control over financial reporting; and5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date:August 21, 2006/s/ Wayne A. CaseWayne A. Case, President/CEO/Director EXHIBIT 31.2CERTIFICATION PURSUANT TO18 U.S. C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Michael S. McAfee, certify that:1. I have reviewed this annual report on Form 10-K of Schmitt Industries, Inc.;2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared;(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, theregistrant’s internal control over financial reporting; and5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, tothe registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: August 21, 2006/s/ Michael S. McAfeeMichael S. McAfee, Chief Financial Officer/Treasurer Exhibit 32.1CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002In connection with the Annual Report of Schmitt Industries, Inc. (the “Company”) on Form 10-K for the Fiscal year ended May 31, 2006 as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), we, Wayne A. Case and Michael S. McAfee, Chief Executive Officer and ChiefFinancial Officer, respectively, of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, thatto our knowledge:(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.Wayne A. CaseChief Executive OfficerAugust 21, 2006Michael S. McAfeeChief Financial OfficerAugust 21, 2006

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