Schmitt Industries, Inc.
Annual Report 2008

Plain-text annual report

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549 FORM 10-K (Mark One) xxANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended: May 31, 2008or ¨¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934For the transition period from to Commission File Number: 000-23996 SCHMITT INDUSTRIES, INC.(Exact name of registrant as specified in its charter) Oregon 93-1151989(State or other jurisdiction ofincorporation or organization) (IRS EmployerIdentification Number)2765 N.W. Nicolai StreetPortland, Oregon 97210(Address of principal executive offices) (Zip Code)(503) 227-7908(Registrant’s telephone number, including area code)Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registeredCommon Stock—no par value The NASDAQ Stock Market LLC Securities 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 ¨ No xIndicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the ExchangeAct. Yes ¨ 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 ¨Indicate 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, to thebest of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to thisForm 10-K. xIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one): Large accelerated filer ¨ Accelerated filer ¨Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company xIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No xThe aggregate market value of the voting stock held by non-affiliates of the registrant as of November 30, 2007, the last business day of the registrant'smost recently completed second fiscal quarter, was approximately $13,488,000 based upon the closing price of $6.68 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 August 1, 2008, the registrant had 2,870,160 outstanding shares of Common Stock.Documents Incorporated by ReferencePortions of the registrant’s definitive Proxy Statement for its 2008 Annual Meeting of Shareholders are incorporated by reference into Part III hereof. PART I Item 1.BusinessForward-Looking StatementsThis Annual Report on Form 10-K (the “Report”), including ”Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in Item 7 contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding futureevents and the future results of Schmitt Industries, Inc. and its consolidated subsidiaries (the “Company”) that are based on management’s currentexpectations, estimates, projections and assumptions about the Company’s business. Words such as “expects,” “anticipates,” “intends,” “plans,”“believes,” “sees,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. Thesestatements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actualoutcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements due to numerous factors, including, butnot limited to, those discussed in the “Risk Factors” section in Item 1A, “Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in Item 7 and elsewhere in this Report as well as those discussed from time to time in the Company’s other Securities and Exchange Commissionfilings and reports. In addition, such statements could be affected by general industry and market conditions. Such forward-looking statements speak onlyas of the date of this Report or, in the case of any document incorporated by reference, the date of that document, and we do not undertake any obligationto update any forward-looking statement to reflect events or circumstances after the date of this Report. If we update or correct one or more forward-looking statements, investors and others should not conclude that we will make additional updates or corrections with respect to other forward-lookingstatements.IntroductionSchmitt Industries, Inc. (the Company), an Oregon corporation, designs, manufactures and markets computer-controlled balancing equipment (theBalancer Segment) primarily to the machine tool industry. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), an Oregoncorporation, the Company designs, manufactures and markets precision laser-based measurement products for the disk drive, silicon wafer and opticsindustries; laser-based dimensional sizing and distance measurement products for a variety of industrial applications; and ultrasonic measurement productsthat provide remote sensing and reporting via satellite the capacity and volumes of large chemical storage tanks, such as liquid propane tanks (theMeasurement Segment). The Company also sells and markets its products in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL), locatedin the United Kingdom. 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 line is the Schmitt Dynamic Balance System (the SBS System), consisting of a computer control unit, sensor,spindle-mounting adapter, and balance head. It is designed as an inexpensive yet highly accurate permanent installation on grinding machines. The SBSproducts can detect and correct for vibration as small as 0.02 microns. The Company acquired its original balancing equipment technology pursuant to aseries of agreements from 1987 through 1991, substantially enhancing and advancing the patented technology since that time. Since inception the targetedcustomer base has been operators of grinding machines for a variety of industries such as automotive, aerospace and machine tooling, where operatingtolerances on manufactured parts are exceedingly precise.The SBS System is fully automated, eliminating the need to pre-balance such devices as grinding wheels. This reduces machine setup time and ensuresa smoother and more efficient operation. Operating on a principle of mass compensation for wheel imbalance, the balance head contains two movableeccentric weights, each 2driven by electric motors through a precision gear train. These weights are repositioned to offset any imbalance in a grinding wheel or 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. The controller then drivesthe balance head weights in a direction that reduces the amplitude of the vibration signal. The balance cycle is complete when the weights are positioned toachieve 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 tobalance a wheel while on a machine, virtual elimination of wheel vibration, automatic monitoring of balancing, display in both English and metric systems,instrument grade 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 andtapered types), 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. Within theCompany’s customer base for the 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. SBSSystems are distributed to a variety of markets throughout the world through original equipment manufacturers (OEMs), who incorporate the SBSSystem into their products.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.), Landis Grinding (U.S.), Koyo Machinery (US, Japan), Micron Machinery Limited(Japan/U.S.), USACH Technologies, Tschudin (U.S.) and Weldon Machine Tool (U.S.). The Company currently sells its products directly to majormachine builders in the U.S, Europe and Asia.Machine Tool Rebuilders—These customers, found in most, if not all, industrialized nations, develop their business by offering to completely updateand refurbish older grinding machines. These rebuilders typically tear the old machine apart and install new components, such as the SBS System. TheCompany currently sells its products directly to major machine rebuilders in the U.S. and 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 customers including:Black & Decker, Briggs and Stratton, Caterpillar, Eaton, Emerson Power Transmission, Ford Motor Company, General Electric, General Motors,Ingersoll Rand, Komatsu, Sumitomo Heavy Industries, SKF Bearing Industries, Timken, TRW Automotive Components and Universal Bearing.For the years ended May 31, 2008, May 31, 2007 and May 31, 2006 (Fiscal 2008, 2007 and 2006), net sales of the Company’s balancing productstotaled $8.4 million, $7.9 million, and $7.8 million, respectively. Net sales of balancing products accounted for 74%, 67% and 68% of the Company’s totalsales in Fiscal 2008, 2007 and 2006, respectively. See Note 6 to Consolidated Financial Statements. 3CompetitionManagement believes the SBS System is one of only a few fully automatic balancing systems marketed in the world. Most competitive productsrequire special setup and training or calibration to the specific machine. The Company believes the SBS System is currently the only balancing product thatfits all machines with wheel sizes from 6 to 48 inches in diameter and a spindlespeed of 500 through 12,500 rpm.Competitive products come from European companies located in Switzerland, Germany, Spain and Italy. These competitors produce electromechanicaland water balancers similar to the SBS System. The Company considers these companies, with their established European base, to be the major competitors.The Company believes that these balancers have electronic deficiencies, rendering them less effective in solving essential balancing requirements. TheCompany also 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. Inaddition, the Company also believes these balancers have inferior brush and cable assemblies that cause down time and high maintenance. Finally, theCompany does not believe these companies can currently compete effectively with the SBS System in providing mounting adapters for all grindingmachines.Water balancers are an older European design still on the market that can be supplied by the Company when specifically requested by users. Theyrequire expensive plumbing and water chambers to be machined into the wheel hub while the SBS System does not. These water balancers are currentlypriced about 1.25 times the level of the SBS System. To install these systems, the grinding machines must be disassembled and parts remachined or replacedwithin the spindle assembly. This can take two days, far longer than required to install the SBS system. The water system is “tuned” or “calibrated” to themachine by a factory service technician while the SBS system can be installed by the operator. Water systems work at mid- and high-speeds but cannotbalance in low rpm environments while SBS products work in both environments. Water systems require periodic monitoring while the SBS systems requirelittle or no operator monitoring.Company pricing is geared to obtaining a dominant market position and meeting competitive supplier prices. The market strategy is to establish theSBS System as the foremost product with the best quality, reliability and performance and superior economic value.Measurement SegmentThe Company manufactures and markets a line of laser-based precision test and measurement products and ultrasonic products for measuring thecapacity and volume of large chemical storage tanks such as liquid propane and operates a precision laser light scatter measurement laboratory. Light scattertechnology involves the use of lasers, optics and detectors to direct a beam of light on a material sample and record its reflection/transmission. Analysis ofinformation can determine material characteristics such as surface roughness, defects and dimensional sizing without introducing contaminants and causingchanges to the tested material. The principal products are laser-based measurement products and technology applicable to both industrial and militarymarkets. The Company has used patents, patent applications, trademarks and other proprietary technology to focus marketing efforts on industrial marketsincluding electronics, computer disk and silicon wafer manufacturers.There are five product lines: laser-based light-scatter measurement, dimensional sizing, capacity and volume of liquid storage tanks, research and otherlaser alignment products and a light-scatter measurement laboratory.Surface Measurement ProductsThese products use a patented laser light scatter technology to perform rapid, accurate, repeatable, non-destructive and non-contact surfacemeasurement tests that quantify surface micro-roughness. The technology is extremely precise, measuring surface roughness at the molecular (Angstrom)level. Products are sold to manufacturers of disk drives, silicon wafers and optical products, industries with fabrication processes that require precise andreliable measurements. 4Computer hard disks require exact manufacturing control and a narrow tolerance band for acceptable roughness, with surface roughness outside thatnarrow band 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 repeatablemicroroughness measurements while quadrupling production throughput when compared to other testing devices. Surface roughness can bemeasured to levels below 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 requirethe technology and products to measure surface roughness of these ceramic/glass substrates to the same exact levels as those that measurealuminum. The Deep Ultra-violet light (DUV) technology and product uses the patented light scatter technology to measure the surfaceroughness of glass substrates 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 precisionto increase performance and capacity and these products help achieve those goals. Silicon wafers are carefully cut and polished to provide the base uponwhich a computer or memory chip is produced. Therefore, chip manufacturing is extremely dependent on the beginning surface roughness of the wafer. Sinceall silicon 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 industry to quantify and control their manufacturing process. The system provides measurements to a few hundredths of an Angstrom, a levelunachievable by competing devices.Dimensional Sizing ProductsThese laser-based distance measurement products, utilizing both triangulation and time-of-flight methods of measurement, are used in a wide range ofindustrial applications including steel casting, glass and paper production, medical imaging, crane control and micron-level part and surface inspection.Presently, there are seven AccuRange (AR) product lines: the AR1000, AR3000 and AR4000 distance measurement sensors, the AR4000 Line Scanner andthe AR700, 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-two 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. Additionally, there are two other optical distance measurement devices, with lower resolution than the AR4000,that accurately measure up to 100 feet for the AR1000 and up to 300 feet for the AR3000. 5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, rotatingmirror and motor with position encoder and mounting hardware for use with the AR4000. The scanner deflects the beam 90 degrees, sweeping it through afull circle 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 visiblelaser light 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 AR700 is a new series of triangulation laser displacement sensors that the Company is developing and testing to supplement the existing line ofAR600 sensors. The AR700 will provide performance advances over the AR600 in accuracy, repeatability, and sample speed. The first product offering ofthis new family of sensors was released in Fiscal 2007 and include measurement ranges from displacements of 1/8” up to 4” and accuracy down to .00006”(1.5 microns). The AR700 is smaller than the AR600 and features increased speeds of up to 5000 samples/second while maintaining the flexibility to measureextremely sensitive surfaces.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.Ultrasonic Measurement ProductsThe Company’s primary product for this new market is called Xact™. The Xact product utilizes ultrasonic technology to detect and measure thecapacity and volume of large chemical storage tanks, such as liquid propane tanks. Each sensor, which is affixed to the exterior of the underside of each tank,produces a small electrical pulse, or a “ping,” through the tank’s steel shell, which is reflected off the bottom surface of the liquid stored in the tank in theform of an echo that is detected and calculated to measure, based on tank size, shape and the characteristics of the liquid, the volume of liquid the tankcontains. This information is then remotely transmitted via a satellite transceiver that is affixed to the top of the tank to a secure website on the internet,processed using proprietary software and displayed on that website. Each tank can be remotely monitored simultaneously anywhere in the world. The userhas the ability to individually set the time the volume of each tank is to be measured simply by adjusting the settings for each tank as provided on thewebsite. Initial sales of the Xact product are expected to occur during the first half of Fiscal 2009.Research and Other Measurement ProductsThe Company’s CASI Scatterometers are sold to companies and institutions involved in research efforts. The CASI Scatterometer uses visible,ultraviolet or infrared laser light as a nondestructive probe to measure surface quality, optical performance, smoothness, appearance, defects andcontamination on a wide variety of materials. These products are scientific measurement instruments providing customers with molecular-level precision inroughness measurement of optical surfaces, diffuse materials, semiconductor wafers, magnetic storage media and precision-machined surfaces, as well assurfaces affecting the cosmetic appearance of consumer products. 6The µScan System is a portable device consisting of a hand-held control unit, an interchangeable measurement head and a separate charging unit. Toperform a measurement, the operator places the measurement head on the objective area and presses a button. Each measurement takes less than five secondswith results displayed and stored in system memory. The µScan can store 700 measurements in 255 files and provides the capability to program pass/failcriteria. Software is available for control, analysis and file conversion. From a single measurement, a user can determine RMS surface roughness, reflectanceand scatter light levels (BRDF) on flat or curved surfaces under any lighting conditions.Light-Scatter Measurement LaboratoryThe 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 value of the laboratory is not only its extremelyprecise measurement capability but also the test item is not altered, touched or destroyed. Thus, the laboratory is widely used by manufacturers of criticaloptical components in aerospace and defense systems and other industrial companies, universities and government agencies.In Fiscal 2008, 2007 and 2006, net sales of Measurement products totaled $3.0 million, $4.0 million and $3.7 million, respectively, and accounted for26%, 33% and 32% of the Company’s total sales in Fiscal 2008, 2007 and 2006, respectively. See Note 6 to Consolidated Financial Statements.CompetitionManagement believes its surface measurement products are one of only a few systems that provide fast, accurate, repeatable microroughnessmeasurements for computer hard disk manufacturers and the silicon wafer industry. The Company believes its surface measurement products are currently theonly systems that can provide measurements to a few hundredths of an angstrom (Å-a unit of measure equal to 1 hundred-millionth of a centimeter) withreproducibility +/- 0.2Å or 1% and repeatability of +/-0.1Å. The differences between our surface measurement products and other optical techniques (whichinclude profilometers, scanning tunneling microscopes, atomic force microscopes or interferometers) are that scanning tunneling microscopes, atomic forcemicroscopes and optical profilometers require the intervention of a skilled operator and perform measurements relatively slowly, whereas our surfacemeasurement product is much simpler and, consequently, can make measurements more rapidly while still maintaining excellent repeatability and accuracy.Stylus profilometers are simpler devices which require less skilled operators. However, measurements must be conducted under vibration isolationconditions, and large areas require numerous scans; thus, stylus profilometers are generally destructive to soft materials such as most coated optics.The market for dimensional sizing products is extremely competitive, characterized by rapidly changing technology. The Company believes theprincipal elements of competition include quality of ongoing technical support and maintenance coupled with responsiveness to customer needs, as well asprice, product quality, reliability and performance. The differences between the Company’s sensors and competitive products include pushbutton selection ofoutput signals in certain models and sensors that can be programmed using serial commands through a PC computer. The AR200 displacement sensor cannotbe overloaded and measures accurately even when a mirror reflects the entire light beam back to the detector.Competitive surface measurement products and dimensional sizing products come from established multinational competitors, some of which aresignificantly larger and have greater financial, engineering, manufacturing and marketing resources. Company pricing is geared to obtaining a dominantmarket position and meeting competitive supplier prices. The market strategy is to establish measurement products as products with the best quality,reliability and performance and superior economic value. 7Sales by Geographic AreaIn Fiscal 2008, 2007 and 2006, the Company recorded net sales of its products in the United States, its country of domicile, of $6.0 million, $5.9million and $5.7 million, respectively. Net sales in the last three fiscal years by geographic areas are: North America Europe Asia OthersFiscal 2008 $6,305,626 $1,842,008 $2,811,167 $462,456Fiscal 2007 $6,055,129 $2,098,677 $2,702,531 $1,025,739Fiscal 2006 $5,878,538 $1,764,347 $2,919,556 $940,919Business and Marketing StrategyThe Company designs, manufactures and markets all of its products with operations divided into a number of different areas.Balancer Segment ProductsThe Vice President of Operations directs production of Balancer segment products including production, manufacturing and purchasing, engineeringand technical 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.Second, OEMs include the Balancer segment products on the machine tools they produce. Users thus purchase the Balancer segment productsconcurrently with the machine tools. Conversely, end users of grinding machines that have purchased the SBS system directly from the Company, and afterenjoying the benefits of the products, often request that SBS products be included with the new equipment they order from OEMs. The SBS Systems are ofteninstalled by machine builders prior to displaying their own machine tools at various trade shows, becoming endorsements that prove beneficial to theCompany’s sales efforts.Third, worldwide trade shows have proven to be an excellent source of business. Company representatives, usually one or more of the marketingmanagers and/or the President/CEO, attend these events along with local Company representatives. These individuals operate a display booth featuring anSBS System demonstration stand and product and technical literature. Representatives from all facets of the Company’s target markets attend these tradeshows.In North America and Asia, products are shipped directly to customers from the Company’s distribution center in Portland, Oregon. Where theCompany has distributors, the product is shipped to the distributor, who in turn pays the Company directly and then delivers and installs the product for theend user. European distribution to customers is handled by shipping the product directly from the Company’s Portland headquarters to the Europeansubsidiary in the United Kingdom, who in turn sells and distributes the products. 8Measurement Segment ProductsThe Vice President of Operations directs production of all Measurement segment products including production, manufacturing and purchasing,engineering and technical services.Similar to the Balancer segment, the Measurement segment uses a variety of methods to market and sell its products. First, a Marketing Manager, underthe direction 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. Trade showsalso represent a significant amount of marketing/sales effort. Company representatives operate a display booth featuring demonstrations of Measurementsegment products along with product and technical literature. Representatives from all facets of the market to which the Company directs its sales effortsattend these trade shows. Finally, one of the best marketing channels is the testing laboratory. Once customers see the capabilities of the technology, it canlead 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 andMeasurement 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 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; DavisTool 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-suppliedparts is held 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. In-house personnel assemble various products and test all finished components before placing them inthe finished goods inventory. Finished goods inventory is maintained via computer to assure timely shipment and service to customers. All customershipments 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 itscertification to the newer ISO 9001:2000 requirements. 9Proprietary TechnologyThe Company's success depends in part on its proprietary technology, which the Company protects 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”, “SMS” and “Xact” are trademarks and are affixed to all products and literature created in the Company's balancer, measurement and Xactproduct lines, respectively.The Company manufactures its Balancer segment products under copyright protection in the U.S. for electronic board designs. Encapsulation of thefinished product further protects the Company's technologies including software.The Company also relies upon trade secret protection for its confidential and proprietary information. There can be no assurance that 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. Thegoal of this 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. Inthe past fiscal year, the Company has developed and tested the AR700, a new series of triangulation laser displacement sensors intended to supplement theexisting line of AR600 sensors. The AR700 will provide performance advanced over the AR600 in accuracy, repeatability, and sample speed. The firstproduct offering of this new family of sensors was released in Fiscal 2008 and included measurement ranges from displacements of 1/8” up to 4” and accuracydown to .00006” (1.5 microns). The AR700 is smaller than the AR600 and features increased speeds of up to 5000 samples/second while maintaining theflexibility to measure extremely sensitive surfaces.During Fiscal 2008, 2007 and 2006, the Company’s research and development expense totaled $628,000, $88,000 and $82,000, respectively. TheFiscal 2008 increase in product development costs relates primarily to the acquisition of the Xact product technology and further development of thattechnology. We expect to start selling these new Xact products during the first half of Fiscal 2009.EmployeesAs of August 1, 2008, the Company employed 40 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. 10Item 1A.RISK FACTORSThe following are important factors that could cause actual results or events to differ materially from those contained in any forward-lookingstatements made by or on behalf of the Company (see the forward-looking statements disclaimer at the beginning of Part 1, Item 1 in this Report). In addition,the risks and uncertainties described below are not the only ones that the Company faces. Unforeseen risks could arise and problems or issues that theCompany now views as minor could become more significant. If the Company were unable to adequately respond to any risks, the Company’s business,financial condition or results of operations could be materially adversely affected. In addition, the Company cannot be certain that nay actions taken toreduce known risks and uncertainties will be effective.Demand for Company products may changeDuring Fiscal 2008, the Company experienced increased demand for its Balancer products in North America, its largest market, attributed primarily toan improving economy in North America. However, during Fiscal 2007 Balancer sales in North America declined 8.3% when compared to Fiscal 2006. Theconditions and circumstances could change in future periods, and as a result demand for the Company’s products could decline. Management is respondingto these risks in two ways. First, it appears there is still a significant portion of the marketplace that is not using the automatic balancing products of theCompany or any of its competitors. The Company will therefore continue to devote part of its future R&D efforts toward developing products that will bothbroaden the scope of Balancing products offered to the current customer base. Second, there are uses for the Company’s Balancer products in industries otherthan those in the Company’s historic customer base. Management is devoting time to identify these markets and educate those markets on the value of thoseproducts within their operations.The laser light-scatter products of the Measurement segment have relied heavily upon sales to disk drive and silicon wafer manufacturers. Sales duringFiscal 2008 and 2007 have decreased 50.4% and 13.6%, respectively. Previous information had indicated continued improving demand for and sales of diskdrive products. Recently, however, certain disk drive manufacturers have scaled back their outlook for the current calendar year, blaming a price war overhigh-capacity desktop computer drives, which now store as much as about one trillion bytes of data. With respect to handheld applications, disk drivemanufacturers believe disk drive products with smaller than 1.8 inch form factors have to a large extent been replaced by competing storage technologies,such as solid state or flash memory. The long-term impact on demand for the Company’s surface Measurement products cannot be predicted with anycertainty.Management will continue to market these products to these historic markets as it appears no other technology has been introduced that would makethe laser light-scatter products technologically obsolete. There is the belief that once market conditions improve in the disk drive and silicon wafer markets,demand for the Company’s products and technology will increase although most likely not to historic levels. Also, management believes there are other usesfor the Company’s laser light scatter technology and continues to evaluate R&D efforts to develop new products and introduce them to the marketplace.The acquisition of Xtero Datacom Inc. technology and the introduction of the Xact™ product may not become commercially viable and satisfy expecteddemandOn February 20, 2008, the Company completed the acquisition of Xtero Datacom Inc. (Xtero) and Xtero’s patented and patent pending technology forremote satellite sensing of large chemical storage tanks. Management believes the Xtero product called Xact has reached technological feasibility. Althoughour acquisition of Xtero with related research and development costs has negatively impacted current operating results, the transactions should allow us toenter new measurement markets and is expected to add sales and profits to the Company in future years. However, the introduction of the Xact product maynot be successful, anticipated market demand for the product may not materialize and additional product or market opportunities may not be identified and 11developed and brought to market in a timely and cost-effective manner, each of which could continue to negatively impact future operating results and resultin large and immediate write-offs of recorded intangible asset balances.New products may not be developed to satisfy changes in consumer demandsThe failure to develop new technologies, or react to changes in existing technologies, could materially delay development of new products, whichcould result in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design, develop, manufacture,assemble, test, market and support new products and enhancements on a timely and cost-effective basis. New product opportunities may not be identified anddeveloped 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 growthFailure 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.Competition is intense and the Company’s failure to compete effectively would adversely affect its businessCompetition in the markets for the Company’s products is intense. The speed with which companies can identify new applications for the Company’svarious technologies, develop products to meet those needs and supply commercial quantities at low prices to those new markets are important competitivefactors. The principal competitive factor in the Company’s markets are product features, performance, reliability and price. Many of the Company’scompetitors have greater financial, technical, research and development and marketing resources. No assurance can be given that the Company will be able tocompete effectively in the future, and the failure to do so would have a material adverse effect on the Company’s business, financial condition and results ofoperations.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 rawmaterialsManufacturing operations depend upon obtaining adequate supplies of raw materials on a timely basis. The results of operations could be adverselyaffected if 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 performanceQuarterly 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 a result 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.The Company may not be able to reduce operating costs quickly enough if sales declineOperating expenses are generally fixed in nature and largely based on anticipated sales. However, should future sales decline significantly and rapidly,there is no guarantee management could take actions that would further reduce operating expenses in either a timely manner or without seriously impactingthe operations of the Company. 12The Company maintains a significant investment in inventories in anticipation of future salesThe 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 personnelFuture 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.Changes in securities laws and regulations have increased and will continue to increase Company expensesChanges in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules promulgated bythe Securities and Exchange Commission, have increased and will continue to increase Company expenses as the Company devotes resources to ensurecompliance with all applicable laws and regulations. In particular, the Company will incur significant additional administrative expense and a diversion ofmanagement’s time in Fiscal 2008 to implement Section 404 of the Sarbanes-Oxley Act which requires management to report on, and the Company’sindependent registered public accounting firm to ultimately attest to, our internal control over financial reporting. The Company may also incur additionalfees necessary for them to provide their attestation. In addition, the NASDAQ Capital Market, on which the Company’s common stock is listed, has alsoadopted comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased the scope, complexity andcost of corporate governance, reporting and disclosure practices. The Company may be required to hire additional personnel and use outside legal,accounting and advisory services to address these laws, rules and regulations. The Company also expects these developments to make it more difficult andmore expensive for the Company to obtain director and officer liability insurance in the future, and the Company may be required to accept reduce coverageor incur substantially higher costs to obtain coverage. Further, Company board members, Chief Executive Officer and Chief Financial Officer could face anincreased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualifiedboard members and executive officers, which would adversely affect the Company.The Company faces risks from international sales and currency fluctuationsThe Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to account for asignificant portion of future revenue. International sales are subject to a number of risks, including: the imposition of governmental controls; traderestrictions; difficulty in collecting receivables; changes in tariffs and taxes; difficulties in staffing and managing international operations; political andeconomic instability; general economic conditions; and fluctuations in foreign currencies. No assurances can be given these factors will not have a materialadverse effect on future international sales and operations and, consequently, on business, financial condition and results of operations. 13Item 1B.Unresolved Staff CommentsNone. 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 755-square foot facility in Coventry, England pursuant to a two year lease beginningMay 7, 2007 with a basic monthly rent of £1,360 (approximately $2,690 as of May 31, 2008). 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, 2008. 14PART II Item 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 theperiods indicated. Year Ended May 31, 2008 High LowFirst Quarter $11.69 $7.50Second Quarter $7.80 $6.01Third Quarter $7.01 $5.52Fourth Quarter $6.38 $5.30Year Ended May 31, 2007 High LowFirst Quarter $7.99 $6.58Second Quarter $7.86 $6.27Third Quarter $7.98 $7.04Fourth Quarter $8.20 $7.20As of August 1, 2008, there were 2,870,160 shares of Common Stock outstanding held by approximately 175 holders of record. The number of holdersdoes not include individual participants in security position listings; the Company believes that there are more than 1,750 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 theCompany’s business. Future dividends will be dependent upon the Company’s financial condition, results of operations, current and anticipated cashrequirements, acquisition plans and plans for expansion and any other factors that the Company’s Board of Directors deems relevant. The Company has nopresent intention of paying dividends on its Common Stock in the foreseeable future.This table shows information about equity awards under the Company’s equity compensation plans at May 31, 2008: Plan Category Number of Securitiesto be issued uponexercise ofoutstanding options Weighted-averageexerciseprice ofoutstandingoptions Number of Securitiesremaining availablefor future issuanceunder equitycompensation plans(excluding securitiesin column a) a b cEquity compensation plans approved by security holders 188,484 $2.89 269,000Equity compensation plans not approved by security holders — — — 188,484 $2.89 269,000Issuer Purchases of Equity SecuritiesNone. 15Item 6.Selected Financial DataIn thousands, except per share informationYear Ended 5/31/08 5/31/07 5/31/06 5/31/05 5/31/04Sales $11,421 $11,882 $11,503 $10,591 $7,925Net Income (Loss) $1,103 $1,285 $1,350 $1,608 $517Net Income (Loss) Per Share, Basic $.40 $.49 $.52 $.64 $.21Weighted Average No. Shares, Basic 2,725 2,649 2,606 2,528 2,439Net Income (Loss) Per Share, Diluted $.39 $.47 $.49 $.59 $.20Weighted Average No. Shares, Diluted 2,834 2,763 2,746 2,709 2,524Stockholders’ Equity $13,756 $11,365 $9,814 $7,979 $6,114Total Assets $15,727 $12,471 $10,927 $9,075 $7,100Long-term Debt (including current portion) $— $— $22 $53 $67 16Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsRESULTS OF OPERATIONSOverviewSchmitt Industries, Inc designs, manufactures and markets computer controlled balancing equipment (the Balancer segment) to the worldwide machinetool industry and, through its wholly owned subsidiary, Schmitt Measurement Systems, Inc., precision laser-based test and measurement products andultrasonic measurement systems (the Measurement segment) for a variety of industrial applications worldwide. The Company sells and markets its products inEurope through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL) located in the United Kingdom. The Company is organized into two operatingsegments: the Balancer segment and the Measurement segment.For the year ended May 31, 2008 (Fiscal 2008), total sales decreased $461,000 or 3.9% to $11.4 million from $11.9 million in the year May 31, 2007(Fiscal 2007). Balancer segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers of grinding machines withthe target geographic markets in North America, Asia and Europe. Balancer sales increased $490,000 or 6.2% to $8.4 million in Fiscal 2008 compared to $7.9million in Fiscal 2007. The Measurement segment product line consists of both laser light-scatter and dimensional sizing products. Total Measurement salesdecreased $951,000 or 24.0% to $3.0 million in Fiscal 2008 compared to $4.0 million in Fiscal 2007. The decrease is primarily due to the lower volumes ofshipments of surface measurement products to disk drive and silicon wafer manufacturers.During the third quarter of Fiscal 2008, the Company completed its acquisition of Xtero Datacom, Inc. (Xtero). The Company acquired Xtero’s businessincluding its patented technologies that utilize ultrasonic measurement systems to remotely measure and report via satellite to a secure website the capacityand volumes of large chemical storage tanks anywhere in the world. This acquisition resulted in higher research and development costs of $540,000 duringFiscal 2008. These higher expenses negatively impacted operating results during Fiscal 2008.Net income was $1.1 million or $0.39 per fully diluted share for the year ended May 31, 2008 as compared to $1.3 million or $0.47 per fully dilutedshare for the year ended May 31, 2007. Earnings per share were also negatively impacted due to the issuance of 200,000 shares used in connection with theacquisition of Xtero.Xtero AcquisitionOn February 20, 2008, the Company, through its newly formed wholly owned subsidiary, Schmitt Industries (Canada) Limited, a British Columbiacorporation (SICL), acquired all of the issued and outstanding common shares of Xtero Datacom Inc., a British Columbia corporation (Xtero) that specializesin technologies that utilize ultrasonic measurement systems to remotely and report via satellite to a secure website the capacity and volumes of largechemical storage tanks anywhere in the world. As consideration for the Xtero shares, the Company issued 199,977 shares of Company common stock to theXtero shareholders. In addition, Xtero shareholders will be eligible to receive additional shares of SICL stock that are exchangeable for shares of Schmittcommon stock on a one-for-one basis based on 50% of the after-tax net earnings derived from Xtero products during a five-year earn-out period ending onMay 31, 2013. The issuance of the 199,977 shares was not registered, and was made with reliance upon Section 3(a) (10) of the Securities Act of 1933 (theAct), which exempts judicially approved share exchanges from the Act’s registration requirements. On January 29, 2008, the Supreme Court of BritishColumbia granted a final order approving the transaction. Based upon the closing price of the Company’s common stock of $5.90 on February 20, 2008 asreported on the NASDAQ Capital Market, the aggregate value of the Company’s 199,977 shares issued to the Xtero shareholders was approximately$1,179,865. The aggregate purchase price for the acquisition was $1,797,367, which includes the value of shares issued, advances of $500,000 to Xtero priorto February 20, 2008 based on a convertible promissory note and other transaction costs. The fair value of the purchased technology of $2.7 million is beingamortized over the expected remaining useful life of 15 years. 17Critical Accounting PoliciesRevenue Recognition—The Company recognizes revenue for sales and billing for freight charges upon delivery of the product to the customer at afixed or determinable price with a reasonable assurance of collection, passage of title to the customer as indicated by shipping terms and fulfillment of allsignificant obligations, pursuant to the guidance provided by Staff Accounting Bulletin No. 104, “Revenue Recognition,” issued by the Securities andExchange Commission in December 2003. For sales to all customers, including manufacturer representatives, distributors or their third-party customers, thesecriteria are met at the time product is shipped. When other significant obligations remain after products are delivered, revenue is recognized only after suchobligations are fulfilled. In addition, judgments are required in evaluating the credit worthiness of our customers. Credit is not extended to customers andrevenue is not recognized until we have determined that collectibility is reasonable assured.Allowance for Doubtful Accounts—Our policy is to maintain allowances for estimated losses resulting from the inability of our customers to makerequired payments. Credit limits for all customers are established based upon several factors, including but not limited to financial condition and stability,payment 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 operating trendsand relevant business conditions, including general economic factors, as they relate to the Company's domestic and international customers. When acustomer’s account balance becomes past due, we initiate dialogue with the customer to determine the cause. If it is determined that the customer will beunable to makes its financial obligation to us, such as in the case of a bankruptcy filing, we record a specific allowance to reduce the related receivable to theamount we expect to recover given all of the information presently available.Inventories—As a designer and manufacturer of high technology systems, we are exposed to a number of economic and industry factors that couldresult in portions of our inventories becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited, technologicalchanges in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of keycomponents from our suppliers. Our policy is to record inventory write-downs when conditions exist that suggest our inventories may be in excess ofanticipated demand for our products and market conditions. We regularly evaluate the ability to realize the value of our inventories based upon acombination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future marketvalues and new product introductions. Purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventoryexposure. When recorded, our write-downs are intended to reduce the carrying value of our inventories to their net realizable value and establish a new costbasis.Deferred Taxes—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. Management continues to review the level of the valuation allowance on a quarterly basis. There can be no assurancethat the Company’s future operations will produce sufficient earnings so that the deferred tax assets can be fully utilized.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 assets 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 31,2008, we have determined that there has been no impairment, as defined above, of our intangible assets. 18Recently issued accounting pronouncementsSee Note 1 of Notes to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.Discussion of Operating Results Year Ended May 31, 2008 2007 2006 Balancer sales $8,414,120 73.7% $7,923,627 66.7% $7,818,669 68.0%Measurement sales 3,007,137 26.3% 3,958,449 33.3% 3,684,691 32.0%Total sales 11,421,257 100.0% 11,882,076 100.0% 11,503,360 100.0%Cost of sales 5,305,144 46.4% 5,254,205 44.2% 5,029,714 43.7%Gross profit 6,116,113 53.6% 6,627,871 55.8% 6,473,646 56.3%Operating expenses: General, administration and sales 4,628,003 40.5% 4,770,996 40.2% 4,658,235 40.5%Research and development 628,150 5.5% 88,425 0.7% 81,815 0.7%Total operating expenses 5,256,153 46.0% 4,859,421 40.9% 4,740,050 41.2%Operating income 859,960 7.5% 1,768,450 14.9% 1,733,596 15.1%Other income 251,282 2.2% 226,375 1.9% 50,076 0.4%Income before income taxes 1,111,242 9.8% 1,994,825 16.8% 1,783,672 15.5%Provision for income taxes 8,138 0.1% 710,000 6.0% 433,543 3.8%Net income $1,103,104 9.7% $1,284,825 10.8% $1,350,129 11.7%Sales—Sales in the Balancer segment increased $490,000, or 6.2%, to $8.4 million for Fiscal 2008 compared to $7.9 million for Fiscal, 2007. Thisincrease is primarily due to increased sales in North America and Asia during the year. North American sales increased $401,000, or 11.2%, in Fiscal 2008compared to the prior year. Market demand in Asia for the Balancer segment products remained strong with that region showing an increase of $327,000, or13.4%, for Fiscal 2008 compared to the prior year. European sales decreased $68,000, or 4.1%, in Fiscal 2008 compared to Fiscal 2007. The increase in NorthAmerican and Asian sales is primarily the result of a recovery from softer balancer sales experienced over the past two years due to weaknesses in theworldwide automotive, bearing and aircraft industries and its impact on the machine tool industry. The European market has continued its recent weaknessdue to the economic conditions in these manufacturing industries and greater competition with other European companies. As with the North Americanmarket, the duration of the stronger demand in Asia and the weaker conditions in the European cannot be forecasted with any certainty.Sales in the Measurement segment decreased $951,000, or 24.0%, to $3.0 million in Fiscal 2008 compared to $4.0 million in Fiscal 2007. The decreaseis primarily due to the lower volumes of shipments of surface measurement products to disk drive and silicon wafer manufacturers. These industries haveundergone significant consolidation as manufacturers merged or exited the markets resulting in a redeployment of equipment rather than making additionalinvestments in capital equipment. Fiscal 2008 sales of laser-based dimensional sizing products increased slightly, $5,000, as compared to Fiscal 2007.Sales of Balancer products increased 1.3% in Fiscal, 2007 compared to Fiscal 2006 as sales to Asia increased by 33.7% which offset a decline of salesto the North American market of 8.3%. European sales grew 10.1% in Fiscal 2007 to $1.6 million compared to Fiscal 2006 sales of $1.5 million. Unit saleprices of Balancer products in North America and Asia 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 19units sold. The Balancer product sales increase in Asia is attributed to continued expansion and penetration of the sales efforts in China. The increased salesin Europe are primarily attributed to changes in foreign exchange rates between the two fiscal periods. The large percentage decrease in Other markets waspredominately a result of lower unit sales in Australia, Japan and South American markets.Measurement product sales increased 7.4% in Fiscal 2007 compared to Fiscal 2006 as sales of the Company’s dimensional sizing products increasedby 18.8%, offset by a decrease in surface measurement products of 2.7%. The sales of surface measurement products in Fiscal 2007 compared to Fiscal 2006decreased as unit sales to customers in the Asia markets declined.Gross margin—Gross margin for Fiscal 2008 decreased to 53.6% as compared to 55.8% for Fiscal 2007. This decrease is due to changes in the productsales mix shifting towards lower margin products. Gross margin decreased slightly to 55.6% for Fiscal 2007 as compared to 56.3% for Fiscal 2006 primarilydue to the product sales mix. Balancer margins were also negatively impacted as a result of higher sales in foreign markets as a large portion of those sales aremade through distributors who receive pricing net of commissions and other sales costs.Operating expenses—Operating expenses increased $397,000, or 8.2%, to $5.3 million for Fiscal 2008 as compared to $4.9 million for Fiscal 2007.This increase is primarily due to increased research and development expenses of $540,000 related to technologies acquired from Xtero and expensesassociated with the implementation of Section 404 of the Sarbanes-Oxley Act offset by lower personnel costs in general, administrative and sales expenses.Operating expenses increased $119,000, or 2.5%, to $4.9 million in Fiscal 2007 as compared to $4.7 million in Fiscal 2006. This increase in operatingexpenses between Fiscal 2007 and 2006 occurred primarily due to higher sales commissions offset by the continued reduction of operating expenses in theCompany’s foreign operations.Other income—Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was$227,000, $206,000 and $60,000 in Fiscal 2008, 2007 and 2006, respectively. Interest income has increased due to higher investment balances offset bylower interest rates. Foreign currency exchange gain was $25,000 and $21,000 in Fiscal 2008 and 2007, respectively. The foreign currency exchange loss was$10,000 in Fiscal 2006.Income tax provision—The effective tax rate in Fiscal 2008 was 0.7%. The effective tax rate on consolidated net income differs from the federalstatutory tax rate primarily due to export tax incentives claimed during the year related to prior years, domestic manufacturing deduction, lower effective taxrates on net income reported by the Company’s wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom, the net tax benefitsrelated to a gain exclusion provision provided in Canada on the sale of technology from the Canadian subsidiary to a US subsidiary and a reduction in thevaluation allowance offset by certain expenses not deductible for income tax reporting. The effective tax rate was 35.6% for Fiscal 2007. Our effective taxrate on consolidated net income differs from the federal statutory tax rate primarily due to certain expenses not deductible for income tax reporting offset bylower effective tax rates on net income reported by SEL. The effective tax rate of 24.3% in Fiscal 2006 differs from the federal statutory tax rate primarily dueto a reduction in the valuation allowance. Management believes the effective tax rate on consolidated net income in future periods will reflect a normalcombined state and federal rate, net of the effect from expenses not deductible for income tax reporting purposes.Net income—Net income decreased $182,000, or 14.1%, to $1.1 million, or $0.39 per diluted share, for Fiscal 2008 as compared to $1.3 million, or$0.47 per diluted share, for Fiscal 2007. Net income decreased due primarily to lower sales, lower gross profit, higher research and development expensesoffset by a lower tax provision during Fiscal 2008. Net income for Fiscal 2007 of $1.3 million, or $0.47 per diluted share, decreased as compared to netincome of $1.4 million, or $0.49 per diluted share, in Fiscal 2006. Net income in Fiscal 2006 included a $280,223 reduction in the deferred tax assetvaluation allowance which reduced the Fiscal 2006 income tax provision. 20LIQUIDITY AND CAPITAL RESOURCESThe Company’s working capital increased $149,000 to $9.9 million as of May 31, 2008 compared to $9.7 million as of May 31, 2007. Cash, cashequivalents and available for sale short term investments totaled $5.5 million as of both May 31, 2008 and 2007, respectively. As of May 31, 2008 theCompany had $3.0 million in cash and cash equivalents on hand compared to $1.5 million at May 31, 2007. As of May 31, 2007 the Company had$3,964,650 in short term investments compared to $1,985,940 at May 31, 2006. The increase in cash and cash equivalents and the decrease in short-terminvestments are due to the maturity dates of the investments, which impacts the classification of the investments as compared to the prior year. Short-terminvestments consisted of highly liquid A1-P1 rated commercial paper securities and certificates of deposit maturing through October 2008.Cash provided by operating activities was $890,000 in Fiscal 2008 as compared to $2.1 million in Fiscal 2007. The decrease was primarily due todecreases in net income, offset by increases in account receivable, inventories, accounts payable and deferred taxes.At May 31, 2008, we had accounts receivable of $1.6 million as compared to $1.5 million at May 31, 2007. The slight increase in accounts receivableis due to higher sales in the fourth quarter of 2008 as compared to the fourth quarter in the prior year. At May 31, 2008, inventories increased $220,000 to$3.9 million in 2008 as compared to $3.7 million in 2007. The increase in inventories is primarily due to additional raw materials purchased to support thenew products to be built using the Xtero technology acquired and increases in safety stock on certain parts. At May 31, 2008, accounts payable increased$193,000 to $528,000 as compared to $336,000 at May 31, 2007. The increase is primarily due to the increase in inventories and the timing of payments ascompared to the prior year.During the year ended May 31, 2008, net cash provided by investing activities was $595,000, which consisted of net maturities of short-terminvestments of $1.5 million offset by additions to property and equipment of $396,000 and advances and payments on asset acquisition of $484,000. Netcash provided by financing activities amounted to $23,000 which consisted of common stock issued on exercised stock options and the tax benefitassociated with stock-based compensation.The following summarizes contractual obligations at May 31, 2008 and the effect on future liquidity and cash flows: Long termobligations Operatingleases TotalcontractualobligationsYears ending May 31, 2009 $— $38,000 $38,0002010 — 5,000 5,000Thereafter — — — Total $— $43,000 $43,000The Company has a $1.0 million bank line of credit agreement secured by U.S. accounts receivable, inventories and general intangibles. Interest ispayable at the bank’s prime rate, 5.0% as of May 31, 2008, and the agreement expires on March 1, 2009. There were no outstanding balances on the line ofcredit at May 31, 2008 and 2007.We believe that our existing cash and investments combined with the cash we anticipate to generate from operating activities, and our available line ofcredit and financing available from other sources will be sufficient to meet our cash requirements for the foreseeable future. We do not have any significantcommitments nor are we aware of any significant events or conditions that are likely to have a material impact on our liquidity or capital resources. 21Item 7A.Quantitative and Qualitative Disclosures about Market RiskInterest Rate RiskThe Company did not have any derivative financial instruments as of May 31, 2008. However, the Company could be exposed to interest rate risk atany time 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 in U.S. and European interest rates affect the interest earned on the Company's interest bearing cash equivalents and short term investments. TheCompany has a variable rate line of credit facility with a bank but there is no outstanding balance as of May 31, 2008. Also, there is no other long-termobligation whose interest rates are based on variable rates that may fluctuate over time based on economic changes in the environment. Therefore, at thistime, the Company is not subject to interest rate risk on outstanding interest bearing obligations if market interest rates fluctuate and does not expect anychange in the interest rates to have a material effect on the Company's results from operations.Foreign Currency RiskThe Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to account for asignificant portion of future revenue. The Company operates a subsidiary in the United Kingdom and acquires certain materials and services from vendorstransacted in foreign currencies. Therefore, the Company's business and financial condition is sensitive to currency exchange rates or any other restrictionsimposed on their currencies. For Fiscal 2008, 2007 and 2006, results of operations included gains (losses) on foreign currency translation of $25,000,$21,000 and $(10,000), respectively. The foreign exchange gains or losses in Fiscal 2008, 2007 and 2006 are primarily attributable to Company’s UnitedKingdom subsidiary, Schmitt Europe, Ltd. 22Item 8.Financial Statements and Supplementary DataSchmitt Industries, Inc.Consolidated Balance Sheets May 31, 2008 May 31, 2007 ASSETS Current assets Cash and cash equivalents $3,020,131 $1,513,061 Short-term investments 2,499,863 3,964,650 Accounts receivable, net 1,590,975 1,454,179 Inventories 3,910,431 3,690,363 Prepaid expenses 100,614 71,331 Deferred tax asset 158,810 144,957 11,280,824 10,838,541 Property and equipment Land 299,000 299,000 Buildings and improvements 1,548,104 1,336,181 Furniture, fixtures and equipment 918,232 826,380 Vehicles 95,848 97,955 2,861,184 2,559,516 Less accumulated depreciation and amortization (1,409,405) (1,333,738) 1,451,779 1,225,778 Other assets Long-term deferred tax asset 194,443 32,780 Other assets 2,800,437 373,797 2,994,880 406,577 TOTAL ASSETS $15,727,483 $12,470,896 LIABILITIES & STOCKHOLDERS’ EQUITY Current liabilities Accounts payable $528,485 $335,820 Accrued commissions 233,943 225,782 Accrued payroll liabilities 78,707 83,365 Other accrued liabilities 254,742 319,289 Income taxes payable 304,201 142,108 Total current liabilities 1,400,078 1,106,364 Long-term liabilities 570,942 — Stockholders’ equity Common stock, no par value, 20,000,000 shares authorized, 2,870,160 and 2,644,419 shares issued andoutstanding at May 31, 2008 and May 31, 2007, respectively 9,370,352 8,114,251 Accumulated other comprehensive loss (123,788) (122,050)Retained earnings 4,509,899 3,372,331 Total stockholders’ equity 13,756,463 11,364,532 TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $15,727,483 $12,470,896 The accompanying notes are an integral part of these consolidated financial statements 23Schmitt Industries, Inc.Consolidated Statements of Operations Year Ended May 31, 2008 2007 2006Net sales $11,421,257 $11,882,076 $11,503,360Cost of sales 5,305,144 5,254,205 5,029,714Gross profit 6,116,113 6,627,871 6,473,646Operating expenses: General, administration and sales 4,628,003 4,770,996 4,658,235Research and development 628,150 88,425 81,815Total operating expenses 5,256,153 4,859,421 4,740,050Operating income 859,960 1,768,450 1,733,596Other income 251,282 226,375 50,076Income before income taxes 1,111,242 1,994,825 1,783,672Provision for income taxes 8,138 710,000 433,543Net income $1,103,104 $1,284,825 $1,350,129Net income per common share, basic $0.40 $0.49 $0.52Weighted average number of common shares, basic 2,725,086 2,649,284 2,606,039Net income per common share, diluted $0.39 $0.47 $0.49Weighted average number of common shares, diluted 2,834,158 2,763,061 2,746,402The accompanying notes are an integral part of these consolidated financial statements 24Schmitt Industries, Inc.Consolidated Statements of Cash Flows Year Ended May 31, 2008 2007 2006 Cash flows relating to operating activities Net income $1,103,104 $1,284,825 $1,350,129 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 238,984 205,911 210,606 Loss on disposal of property and equipment 703 5,235 — Deferred taxes (405,895) 490,723 (28,460)Stock based compensation 52,957 46,423 — Tax benefit related to stock options 10,175 36,124 335,238 Excess tax benefit from stock based compensation (10,202) (56,843) — (Increase) decrease in: Accounts receivable (127,611) 549,186 126,053 Inventories (220,068) (441,984) 291,723 Prepaid expenses (29,354) 6,489 26,666 Increase (decrease) in: Accounts payable 184,331 (73,013) (93,716)Accrued liabilities (62,357) (4,200) 106,607 Income taxes payable 155,598 81,871 34,090 Net cash provided by operating activities 890,365 2,130,747 2,358,936 Cash flows relating to investing activities Purchase of short-term investments (10,059,693) (11,478,710) (1,985,940)Maturities of short-term investments 11,524,479 9,500,000 — Purchase of property and equipment (386,016) (197,235) (116,868)Advances and payments on asset acquisition (484,158) Proceeds from sale of property and equipment 100 5,000 — Advance on convertible promissory note — (200,000) — Net cash provided by (used in) investing activities 594,712 (2,370,945) (2,102,808)Cash flows relating to financing activities Repayments on long-term obligations — (21,612) (31,258)Common stock issued on exercise of stock options 13,104 84,728 115,640 Excess tax benefit from stock based compensation 10,202 56,843 — Net cash provided by financing activities 23,306 119,959 84,382 Effect of foreign exchange translation on cash (1,313) 81,228 34,603 Increase (decrease) in cash and cash equivalents 1,507,070 (39,011) 375,113 Cash and cash equivalents, beginning of period 1,513,061 1,552,072 1,176,959 Cash and cash equivalents, end of period $3,020,131 $1,513,061 $1,552,072 Supplemental Disclosure of Cash Flow Information Cash paid during the period for income taxes $247,842 $143,734 $139,065 The accompanying notes are an integral part of these consolidated financial statements 25Schmitt Industries, Inc.Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income Shares Amount Accumulatedothercomprehensiveloss Retainedearnings Total Totalcomprehensiveincome Balance, May 31, 2005 2,559,687 $7,496,098 $(254,654) $737,377 $7,978,821 Stock options exercised and related tax benefit of $335,238 65,358 450,878 — — 450,878 Net income — — — 1,350,129 1,350,129 $1,350,129 Other comprehensive income — — 34,603 — 34,603 34,603 Balance, May 31, 2006 2,625,045 $7,946,976 $(220,051) $2,087,506 $9,814,431 Comprehensive income, year ended May 31, 2006 $1,384,732 Stock options exercised and related tax benefit of $36,124 39,374 120,852 — — 120,852 Stock based compensation 46,423 — — 46,423 Net income — — — 1,284,825 1,284,825 $1,284,825 Other comprehensive income — — 98,001 — 98,001 98,001 Balance, May 31, 2007 2,664,419 $8,114,251 $(122,050) $3,372,331 $11,364,532 Comprehensive income, year ended May 31, 2007 $1,382,826 Adoption of FIN 48 34,464 34,464 Stock options exercised and related tax benefit of $10,175 5,764 23,279 — — 23,279 Stock based compensation 52,957 — — 52,957 Common stock issued in connection with asset acquisition 199,977 1,179,865 1,179,865 Net income — — — 1,103,104 1,103,104 $1,103,104 Other comprehensive income — — (1,738) — (1,738) (1,738)Balance, May 31, 2008 2,870,160 $9,370,352 $(123,788) $4,509,899 $13,756,463 Comprehensive income, year ended May 31, 2008 $1,101,366 The accompanying notes are an integral part of these consolidated statements 26Schmitt Industries, Inc.Notes to Consolidated Financial StatementsFor The Years Ended May 31, 2008, 2007 and 2006NOTE 1SIGNIFICANT ACCOUNTING POLICIESNature of OperationsSchmitt Industries, Inc. (the Company) designs, assembles, markets and distributes electronic and mechanical components for machine tool productsand laser measurement systems worldwide.Principles of ConsolidationThese consolidated financial statements include those of the Company and its wholly owned subsidiaries: Schmitt Measurement Systems, Inc. (SMS)and Schmitt Europe, Ltd. (SEL). All significant intercompany accounts and transactions have been eliminated in the preparation of the consolidated financialstatements.Revenue RecognitionThe Company recognizes revenue for sales and billing for freight charges upon delivery of the product to the customer at a fixed or determinable pricewith a reasonable assurance of collection, passage of title to the customer as indicated by shipping terms and fulfillment of all significant obligations,pursuant to the guidance provided by Staff Accounting Bulletin No. 104, “Revenue Recognition,” issued by the Securities and Exchange Commission inDecember 2003. For sales to all customers, including manufacturer representatives, distributors or their third-party customers, these criteria are met at the timeproduct is shipped. When other significant obligations remain after products are delivered, revenue is recognized only after such obligations are fulfilled. Inaddition, judgments are required in evaluating the credit worthiness of our customers. Credit is not extended to customers and revenue is not recognized untilwe have determined that collectibility is reasonable assured.Cash EquivalentsThe Company generally invests excess cash in money market funds and investment grade highly liquid securities. The Company considers securitiesthat are highly liquid, readily convertible into cash and have original maturities of less than three months when purchased to be cash equivalents.Short-Term InvestmentsAt May 31, 2008, short-term investments are classified as available-for-sale. The carrying amount of short-term investments is stated at cost, whichapproximates fair market value because of their short maturities. There were no related unrealized holding gains or losses at May 31, 2008.Accounts ReceivableThe Company maintains credit limits for all customers based upon several factors, included but not limited to payment history, published credit reportsand use of credit references. Management performs various analyses to evaluate accounts receivable balances to ensure recorded amounts reflect estimatednet realizable value. This review includes accounts receivable agings, other operating trends and relevant business conditions, including general economicfactors, as they relate to each of the Company's domestic and international customers. If these analyses lead management to the conclusion that potentialsignificant accounts are uncollectible, a reserve is provided. The allowance for doubtful accounts was $26,584 and $20,818 as of May 31, 2008 and 2007,respectively. 27Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 InventoryInventory is valued at the lower of cost or market with cost determined on the average cost basis. Costs included in inventories consist of materials,labor and manufacturing overhead, which are related to the purchase or production of inventories. As of May 31, 2008 and 2007, inventories consisted of: May 31, 2008 May 31, 2007Raw materials $1,784,580 $1,638,256Work-in-process 722,223 530,415Finished goods 1,403,628 1,521,692 $3,910,431 $3,690,363Property and EquipmentProperty and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three to seven yearsfor furniture fixtures, and equipment; three years for vehicles; and twenty-five years for buildings and improvements.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$107,539, $112,562 and $82,322 for the fiscal years ended May 31, 2008, 2007 and 2006, respectively.Research and Development CostsResearch and development costs, predominately internal labor costs and costs of materials, are charged to expense when incurred.Stock-Based CompensationStock-based compensation includes expense charges for all stock-based awards to employees and directors granted under the Company’s stock optionplan. On June 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment (Revised 2004)”,which requires the measurement and recognition of compensation for all stock-based awards made to employees and directors including stock options basedon estimated fair values. SFAS 123(R) supersedes previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees” (APB 25), for periods beginning in Fiscal 2007. In March 2005, the Securities and Exchange Commission issued Staff Accounting BulletinNo. 107 relating to application of SFAS 123(R). The Company has applied the provisions of SAB 107 in our adoption of SFAS 123(R). 28Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as ofJune 1, 2006, the first day of our 2007 fiscal year. In accordance with the modified prospective transition method, the Company’s Consolidated FinancialStatements for periods prior to the first quarter of Fiscal 2007 have not been restated to reflect this change. Stock-based compensation recognized during theperiod is based on the value of the portion of the stock-based award that will vest during the period, adjusted for expected forfeitures. The compensation costfor awards granted prior to May 31, 2006 is based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 whileawards granted on or after June 1, 2006 follow the provisions of SFAS 123(R) to determine the grant date fair value and compensation cost. Compensationcost for all stock-based awards is recognized using the straight-line method.Deferred TaxesThe Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities are determined,based on 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. The Company has historically had a valuation allowance against certain foreign net operating losses as well as domestic capitallosses. In Fiscal 2006, management concluded future operations would produce sufficient earnings so that a portion of the asset attributable to foreign netoperating losses could be used in future periods to reduce tax liabilities. In Fiscal 2007, based on current earnings, the remaining valuation allowance relatedto foreign net operating losses was released. Management continues to review the level of the valuation allowance on a quarterly basis. There can be noassurance that the Company’s future operations will produce sufficient earnings so that the deferred tax asset can be fully utilized.Intangible and Other Long Term AssetsOther long term assets include definite-lived intangible assets and a convertible promissory note. Amortizable intangible assets, purchased technologyand patents, are amortized over their estimated useful lives ranging from eleven to seventeen years. As of May 31, 2008, amortizable intangible assets of$3,128,127 net of accumulated amortization of $327,690 were included in Other Assets. Amortization expense is expected to be approximately $215,000 inFiscal 2009 through 2012 and $181,000 in Fiscal 2013.During Fiscal 2007, the Company entered into a convertible promissory note agreement with Xtero Datacom, Inc. (Xtero) of Vancouver, BritishColumbia pursuant to which the Company will loan up to $250,000 USD to Xtero to fund product development and testing of Xtero satellite measurementtechnologies. During Fiscal 2008, the maximum amount of the loan was increased to $500,000. The advances under the loan agreement are based onestablished milestones being achieved by Xtero in the beta field testing of their technology. The loan is convertible into equity of Xtero at the sole option ofSchmitt Industries, Inc. As of May 31, 2007, the Company had advanced $200,000 to Xtero. In the third quarter of Fiscal 2008, the Company forgave theoutstanding loan payable of $500,000 when the acquisition was completed. This amount was considered as additional consideration. See Note 11 to theConsolidated Financial Statements for more information.Intangible and other long-lived assets are reviewed for impairment whenever events or changes in circumstances that would indicate the carryingamount of the asset may not be recoverable. Recoverability is determined by comparing the forecasted future net cash flows from the operations to which theassets relate, 29Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 based on management's best estimates using the appropriate assumptions and projections at the time, to the carrying amount of the assets. If the carryingvalue is determined to be in excess of future operating cash flows, the asset is considered impaired and a loss is recognized equal to the amount by which thecarrying amount exceeds the estimated fair value of the assets. As of May 31, 2008, management does not believe 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 usingthe weighted 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 includea discount of 1.5% if the invoice is paid within ten days, with the net amount payable in 30 days.Financial InstrumentsThe carrying value of all other financial instruments potentially subject to valuation risk (principally consisting of cash and cash equivalents, shortterm investments, accounts receivable and accounts payable) also approximate fair value because of their short-term maturities.Shipping and Handling ChargesThe Company incurs costs related to shipping and handling of its manufactured products. These costs are expensed as incurred as a component of costof sales. Shipping and handling charges related to the receipt of raw materials are also incurred, which are recorded as a cost of the related inventory.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 pronouncementsIn September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS 157 defines fair value, establishes a framework for measuringfair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157are effective for the fiscal year beginning June 1, 2008. The Company’s adoption of SFAS 157 is not expected to impact its consolidated financial statements.In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities including an Amendment ofFASB Statement No. 115”. SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The provisions ofSFAS 159 are effective for the fiscal year beginning June 1, 2008. The Company’s adoption of SFAS 159 is not expected to impact its consolidated financialstatements. 30Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141(R)”), which replaces SFAS No 141. SFAS141(R) establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, and any controlling interest; recognizes and measures the goodwill acquired in the business combinationor a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financialeffects of the business combination. SFAS is to be applied prospectively to business combinations for which the acquisition date is after May 31, 2009. TheCompany will assess the impact of SFAS 141(R) if and when a future acquisition occurs after that date.ReclassificationsCertain reclassifications have been made to the 2007 and 2006 amounts to conform to 2008 presentations. These reclassifications do not have anyimpact on net income or shareholders’ equity.NOTE 2LINE OF CREDITThe Company has a $1.0 million bank line of credit agreement secured by U.S. accounts receivable, inventories and general intangibles. Interest ispayable at the bank’s prime rate, 5.0% as of May 31, 2008, and the agreement expires on March 1, 2009. There were no outstanding balances on the line ofcredit at May 31, 2008 and 2007.NOTE 3LONG-TERM OBLIGATIONSAs of May 31, 2008, there were no outstanding obligations under capital leases or purchase contracts. During Fiscal 2004, the Company entered intoan equipment lease, which was treated as a capital lease, and a purchase contract totaling $78,477. One lease expired in Fiscal 2006 and the second expired inFiscal 2007. Equipment recorded under the capital lease was $48,477, which was fully depreciated as of May 31, 2008.The Company leases certain facilities and equipment to support operations under non-cancelable operating leases and other contractual obligations.Total rent expense for the years ended May 31, 2008, 2007 and 2006 amounted to $32,370, $64,824 and $41,806, respectively.The approximate future minimum commitments under leases and contractual obligations for each of the years ending May 31 are as follows: Years ending May 31, 2009 $38,0002010 $5,000Thereafter $— 31Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 NOTE 4INCOME TAXESThe provision for income taxes is as follows: Years ended May 31, 2008 2007 2006 Current $590,761 $226,000 $109,100 Deferred (507,623) 501,936 604,666 Decrease in valuation allowance (75,000) (17,936) (280,223)Total provision for income taxes $8,138 $710,000 $433,543 Deferred tax assets (liabilities) are comprised of the following components: 2008 2007 Depreciation and amortization $(253,248) $89,789 Deferred taxes related to the decline in fair market value of long-term investment 694,696 694,696 Inventory related items 544,047 86,908 Other reserves and liabilities 49,934 58,050 Other deferred items, net 12,520 17,990 Gross deferred tax assets 1,047,949 947,433 Deferred tax asset valuation allowance (694,696) (769,696)Net deferred tax asset $353,253 $177,737 The net deferred tax asset is classified as follows: 2008 2007Current deferred tax asset $158,810 $144,957Long-term deferred tax asset 194,443 32,780Net deferred tax asset $353,253 $177,737Deferred 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 tax asset willnot be realized. The Company has recorded a substantial deferred tax asset related to temporary differences between book and tax bases of assets andliabilities. 32Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 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 incomedue to the following: Years ended May 31, 2008 2007 2006 Statutory federal tax rate 34.0% 34.0% 34.0%State taxes, net of federal benefit 4.4 4.4 4.4 Change in deferred tax valuation allowance — — (15.7)Domestic production incentives (1.0) (0.3) — Export tax incentives (8.2) — — Effect of foreign income tax rates (12.0) — — Foreign jurisdiction statutory gain exclusion (25.0) Effect of tax rate changes 5.6 Permanent and other differences 2.9 (2.5) 1.6 Effective tax rate 0.7% 35.6% 24.3%Adoption of FIN 48Each year the Company files income tax returns in the various federal, state and local income taxing jurisdictions in which it operates. These taxreturns are subject to examination and possible challenge by the taxing authorities. Positions challenged by the taxing authorities may be settled or appealedby the Company. As a result, there is an uncertainty in income taxes recognized in the Company’s financial statements in accordance with SFAS No. 109. In2006, the FASB issued FIN 48, which clarifies the application of SFAS 109 by defining criteria that an individual income tax position must meet for any partof the benefit of that position to be recognized in an enterprise’s financial statements and provides guidance on measurement, derecognition, classification,accounting for interest and penalties, accounting in interim periods, disclosure, and transition.On June 1, 2007, the Company adopted the provisions of FIN 48. The adoption of FIN 48 resulted in a $34,464 decrease in the Company’s liability forunrecognized tax benefits, which was accounted for as an increase to the June 1, 2007 retained earnings balance. At June 1, 2007 the gross amount ofunrecognized tax benefits was approximately $490,000, which includes approximately $150,000 of net unrecognized tax benefits that, if recognized, wouldreduce the Company’s effective income tax rate.A reconciliation of the beginning and ending amount of unrecognized income tax benefits is as follows: Balance at June 1, 2007 $489,599 Decrease for tax positions taken in prior years (payment of tax) (38,766)Balance at May 31, 2008 $450,833 Interest and penalties associated with uncertain tax positions are recognized as components of the “Provision for income taxes.” The Company’saccrual for interest and penalties was $96,500 upon adoption of FIN 48. The liability for payment of interest and penalties increased to $120,000 as ofMay 31, 2008.Several tax years are subject to examination by major tax jurisdictions. In the United States, federal tax years for Fiscal 2004 and after are subject toexamination. In the United Kingdom, tax years for Fiscal 2006 and after are subject to examination. In the United States, returns related to an acquiredsubsidiary for the year ended October 31, 1994 and final return for the period ended May 19, 1995 are also subject to examination. 33Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 NOTE 5COMMITMENTS AND CONTINGENCIESIn a transaction related to the acquisition of Schmitt Measurement Systems, Inc., formerly TMA Technologies, Inc. (TMA), the Company established aroyalty pool 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, 2008, 2007 and 2006 amounted to $47,344, $89,350 and$87,567, respectively.NOTE 6SEGMENT INFORMATIONThe Company has two reportable business segments: the design and assembly of dynamic balancing systems and components for the machine toolindustry (Balancer), and the design and assembly of laser-based test and measurement systems (Measurement). The Company operates in three principalgeographic markets: North America, Europe and Asia. Year Ended May 31, 2008 2007 2006 Balancer Measurement Balancer Measurement Balancer Measurement Gross sales $9,192,824 $3,039,809 $8,587,432 $4,077,510 $8,429,409 $3,765,191 Intercompany sales (778,704) (32,672) (663,805) (119,061) (610,740) (80,500)Net sales $8,414,120 $3,007,137 $7,923,627 $3,958,449 $7,818,669 $3,684,691 Operating income $1,053,310 $(193,350) $697,330 $1,071,120 $674,446 $1,059,150 Intercompany rent expense (income) $— $— $(30,000) $30,000 $(30,000) $30,000 Depreciation expense $122,353 $36,968 $143,569 $27,734 $139,905 $36,097 Amortization expense $— $79,663 $— $34,608 $— $34,604 Advances on convertible note $— $— $200,000 $— $— $— Capital expenditures $119,927 $265,989 $171,207 $26,028 $54,903 $61,965 34Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 Geographic Information Year Ended May 31, 2008 2007 2006North America $6,305,626 $6,055,129 $5,878,538Europe 1,842,008 2,098,677 1,764,347Asia 2,811,167 2,702,531 2,919,556Other markets 462,456 1,025,739 940,919Total Net Sales $11,421,257 $11,882,076 $11,503,360 Year Ended May 31, 2008 2007 2006 NorthAmerica Europe NorthAmerica Europe NorthAmerica EuropeOperating income (loss) $495,483 $364,477 $1,475,710 $292,740 $1,730,712 $2,884Depreciation expense $152,916 $6,405 $159,953 $11,350 $164,394 $11,608Amortization expense $79,663 $— $34,608 $— $34,604 $— Advances on convertible note $— $— $200,000 $— $— $— Capital expenditures $385,916 $— $196,787 $448 $112,101 $4,767Segment and Geographic Assets May 31, 2008 May 31, 2007Segment assets to total assets Balancer $4,613,456 $5,022,717Measurement 5,140,166 1,792,731Corporate assets 5,973,861 5,655,448Total assets $15,727,483 $12,470,896Geographic assets to long-lived assets North America $1,451,622 $1,218,520Europe 157 7,258Total assets $1,451,779 $1,225,778Geographic assets to total assets North America $15,224,281 $11,812,573Europe 503,202 658,323Total assets $15,727,483 $12,470,896Note—Europe is defined as the European subsidiary, Schmitt Europe, Ltd. 35Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 NOTE 7STOCK OPTIONS AND STOCK BASED COMPENSATIONThe Board of Directors adopted the 2004 Stock Option Plan (2004 Plan) in August 2004 and the 1995 Stock Option Plan (1995 Plan) in December1995, which plan was amended in August 1996 and restated in August 1998. An option granted under the 2004 Plan and/or 1995 Plan (the Plans) might beeither an incentive stock option (ISO), or a nonstatutory stock option (NSO). ISOs may be granted only to employees and members of the Board of Directorsof the Company and are subject to certain limitations, in addition to restrictions applicable to all stock options under the Plan. Options not meeting theselimitations will be treated as NSOs. The purchase price of ISOs is fair market value on the date of grant; the purchase price of NSOs may vary from fair marketvalue. Vesting is at the discretion of the compensation committee of the Board of Directors, but is either 50% at grant date and 16.7% on each anniversarythereafter or 50% at grant date and 25% on each anniversary thereafter. The Company initially reserved 400,000 shares for issuance under the 1995 Plan and300,000 shares for issuance under the 2004 Plan. The 1995 Plan expired in December 2005 and no additional options may be issued under the 1995 Plan,although expiration of the 1995 Plan did not affect the rights of persons who received stock grants under the 1995 Plan. Stock-based compensationrecognized in the Company’s Consolidated Financial Statements for the years ended May 31, 2008 and 2007 includes compensation cost for stock-basedawards granted prior to, but not fully vested as of, May 31, 2006. For those awards granted subsequent to June 1, 2006, compensation expense has beenrecognized in accordance with FAS123R. All outstanding options will expire no later than 2015.Upon adoption of SFAS 123(R), the Company continued to use the Black-Scholes option pricing model as its method of valuation for stock-basedawards. The Company’s determination of the fair value of stock-based awards on the date of grant using an option pricing model is affected by our stock priceas well as assumptions regarding a number of highly complex and subjective variables. Although the fair value of stock-based awards is determined inaccordance with SFAS 123(R) and SAB 107, the Black-Scholes option pricing model requires the input of highly subjective assumptions, and otherreasonable assumptions could provide differing results. These variables include, but are not limited to: • Risk-Free Interest Rate. The Company bases the risk-free interest rate on the implied yield currently available on U.S. Treasury issues with anequivalent remaining term approximately equal to the expected life of the award. • Expected Life. The expected life of awards granted represents the period of time that they are expected to be outstanding. The Companydetermines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedulesand pre-vesting and post-vesting forfeitures. • Expected Volatility. The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of itscommon stock. The volatility factor the Company uses is based on its historical stock prices over the most recent period commensurate with theestimated expected life of the award. These historical periods may exclude portions of time when unusual transactions occurred. • Expected Dividend Yield. The Company has never paid any cash dividends on its common stock and does not anticipate paying any cashdividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero. • Expected Forfeitures. The Company uses relevant historical data to estimate pre-vesting option forfeitures. The Company records stock-basedcompensation only for those awards that are expected to vest. 36Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 The Company has computed, to determine stock-based compensation expense recognized for the years ended May 31, 2008 and 2007 and for proforma disclosure purposes for the year ended May 31, 2006 and for grants awarded subsequent to June 1, 2006, the value of all stock options granted usingthe Black-Scholes option pricing model as prescribed by SFAS No. 123(R) using the following assumptions: Year ended May 31, 2008 Prior to May 31, 2006Risk-free interest rate 3.6% 3.8 - 4.45%Expected life 4.8 years 4.0 - 4.7 yearsExpected volatility 56.7% 95 - 102%Stock-Based Compensation Under FAS 123(R)The total stock-based compensation expense recognized for stock based under SFAS 123(R) was $52,957 and $46,423 during Fiscal 2008 and 2007,respectively. All stock-based compensation expense has been recorded as General, administration and sales expense in the Consolidated FinancialStatements.At May 31, 2008 the Company had a total of 188,484 outstanding stock options (169,734 vested and exercisable and 18,750 non-vested) with aweighted average exercise price of $2.89. The Company estimates that a total of approximately $56,412 will be recorded as additional stock-basedcompensation expense over the period beginning with the year ending May 31, 2009 through the fiscal year ending May 31, 2010, for all options which areoutstanding as of May 31, 2008, but which were not yet vested. Outstanding Options Exercisable Options Number of Shares Weighted AverageExercise Price Weighted AverageRemaining ContractualLife (yrs) Number of Shares Weighted AverageExercise Price 76,110 $1.20 3.8 76,110 $1.20 62,499 2.30 6.0 62,499 2.30 5,000 5.80 7.4 5,000 5.80 44,875 6.25 5.6 26,125 6.44 188,484 $2.89 5.0 169,734 $2.55 37Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 Options granted, exercised, canceled and expired under the Company’s stock option plan during the years ended May 31, 2008, 2007 and 2006 aresummarized as follows: Number ofShares WeightedAverageExercise PriceOptions outstanding—May 31, 2005 250,790 $1.79Options granted 34,000 6.47Options exercised (63,294) 1.83Options forfeited/cancelled (5,000) 2.30Options outstanding—May 31, 2006 216,496 2.52Options granted — — Options exercised (39,374) 2.15Options forfeited/cancelled (1,251) 6.58Options outstanding—May 31, 2007 175,871 2.57Options granted 25,000 5.98Options exercised (5,764) 2.27Options forfeited/cancelled (6,623) 6.58Options outstanding—May 31, 2008 188,484 2.89The total intrinsic value of outstanding and exercisable options at May 31, 2008 was $544,357 and $432,232, respectively. The total intrinsic value ofoptions exercised during the years ended May 31, 2008, 2007 and 2006 was $34,242, $198,207 and $402,122, respectively.Pro Forma Information under SFAS 123 and APB 25Prior to June 1, 2006, the Company elected to follow the accounting provisions of APB 25 for stock-based compensation and to furnish the pro formadisclosures required under SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” No stock-based employee compensationcost was reflected in net income because all options granted under the Company’s stock option plan had an exercise price equal to the market value of theunderlying common stock on the date of the grant. 38Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 The following table illustrates the effect on the Company’s net income and basic and diluted net income per share for the year ended May 31, 2006 hadcompensation cost for the plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS123. Year EndedMay 31, 2006 Net income, as reported $1,350,129 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax (120,411)Pro forma net income $1,229,718 Earnings per share—basic As reported $0.52 Pro forma $0.47 Earnings per share—diluted As reported $0.49 Pro forma $0.45 NOTE 8EARNINGS PER SHAREBasic earnings per share is computed using the weighted average number of shares outstanding. Diluted earnings per share is computed using theweighted average number of shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase common stock. Thefollowing table is a reconciliation of the numerators and denominators of the basic and diluted per share computations for each of the three years in theperiod ended May 31, 2008: Income(Numerator) WeightedAverage Shares(Denominator) PerShareAmountYear ended May 31, 2008 Basic earnings per share Income available to common stockholders $1,103,104 2,725,086 $0.40Effect of dilutive securities stock options — 109,072 Diluted earnings per share Income available to common stockholders $1,103,104 2,834,158 $0.39Year ended May 31, 2007 Basic earnings per share Income available to common stockholders $1,284,825 2,649,284 $0.49Effect of dilutive securities stock options — 113,777 Diluted earnings per share Income available to common stockholders $1,284,825 2,763,061 $0.47Year ended May 31, 2006 Basic earnings per share Income available to common stockholders $1,350,129 2,606,039 $0.52Effect of dilutive securities stock options — 140,363 Diluted earnings per share Income available to common stockholders $1,350,129 2,746,402 $0.49 39Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 NOTE 9EMPLOYEE BENEFIT PLANSThe Company adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan & Trust effective June 1, 1996. Employees must meet certain age andservice requirements to be eligible. Participants may contribute up to 15% of their eligible compensation which may be partially matched by the Company.The Company 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 $49,252, $68,662 and $45,041 during Fiscal 2008,2007 and 2006, respectively.NOTE 10RELATED PARTY TRANSACTIONSEffective June 1, 2004, the Company entered into a contract to provide consulting services to PulverDryer USA, Inc., (“PulverDryer”) pursuant towhich PulverDryer paid the Company $8,000 a month from June 2004 through October 2004. PulverDryer also buys certain products from the Company atnormal prevailing rates. The Company and PulverDryer extended the contract from November 1, 2004 forward at that same monthly fee of $8,000. Productsales to PulverDryer during the fiscal years ended May 31, 2008, 2007 and 2006 totaled $16,468, $35,300 and $152,305, respectively.In connection with the contract, the Board authorized Wayne Case, the Company’s Chief Executive Officer, to provide advisory services toPulverDryer, and permitted 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 CompensationCommittee. Mr. Case also serves on the board of directors of PulverDryer.NOTE 11ACQUISITIONOn February 20, 2008, the Company, through its newly formed wholly owned subsidiary, Schmitt Industries (Canada) Limited, a British Columbiacorporation (SICL), acquired all of the issued and outstanding common shares of Xtero Datacom Inc., a British Columbia corporation. As consideration forthe Xtero shares, the Company issued 199,977 shares of Company common stock to the Xtero shareholders. In addition, Xtero shareholders will be eligible toreceive shares of SICL stock that are exchangeable for shares of Schmitt common stock on a one-for-one basis based on 50% of the after-tax earnings derivedfrom Xtero products during a five-year earn-out program ending on May 31, 2013. The issuance of the 199,977 shares was not registered, and was made withreliance upon Section 3(a) (10) of the Securities Act of 1933 (the Act), which exempts judicially approved share exchanges from the Act’s registrationrequirements. On January 29, 2008, the Supreme Court of British Columbia granted a final order approving the transaction. Based upon the closing price ofthe Company’s common stock of $5.90 on February 20, 2008 as reported on the NASDAQ Capital Market, the aggregate value of the Company’s 199,977shares issued to the Xtero shareholders was approximately $1,179,865. The aggregate purchase price for the acquisition was $1,797,367 which includes thevalue of shares issued, advances of $500,000 to Xtero prior to February 20, 2008 on a convertible promissory note and other transaction costs. 40Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition: Tangible assets and liabilities assumed: Receivables $182,000 Accounts payable and other current liabilities (248,657)Deferred tax liabilities (842,280)Intangible assets Purchased technology 2,706,304 $1,797,367 The allocation process requires an analysis and valuation of acquired assets, including deferred tax assets, technologies, customer contracts andrelationships, trade names and liabilities assumed, including contractual commitments and legal contingencies. During the fourth quarter of Fiscal 2008, totalpurchase accounting adjustments recorded were approximately $842,000 arising from deferred tax liabilities with certain assets acquired. In addition duringthe fourth quarter of Fiscal 2008, the Canadian subsidiary sold the technology acquired to a US subsidiary resulting in net tax benefits related to a gainexclusion provision in Canada of $211,000, which reduced the Company’s effective tax rate. The values assigned to certain acquired assets and liabilities arepreliminary, are based on information available as of May 31, 2008, and may be adjusted as further information becomes available. Additional informationthat may become available subsequently and may result in changes in the values allocated to various assets and liabilities includes, but is not limited to,unidentified claims from suppliers or other contingent obligations, the amounts required to settle them, and the value of deferred tax assets and liabilities.Any changes in the values allocated to tangible and specifically identified intangible assets acquired and liabilities assumed during the allocation periodmay result in adjustments to intangible assets.Purchased technology relates to Xtero’s remote satellite sensing of large chemical storage tanks that have reached technological feasibility. The fairvalue of the purchased technology is being amortized over the expected remaining useful life of 15 years.NOTE 12QUARTERLY FINANCIAL DATAIn thousands, except per share information (unaudited)2008 Quarter Ended August 31 November 30 February 29 May 31Sales $2,339 $3,111 $2,811 $3,160Gross profit $1,235 $1,689 $1,451 $1,740Net income $184 $265 $228 $426Net income per share, basic $.07 $.10 $.09 $.15Net income per share, diluted $.07 $.10 $.08 $.14Market Price of Common Stock High $11.69 $7.80 $7.01 $6.38Low $7.50 $6.01 $5.52 $5.30 41Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2008, 2007 and 2006 2007 Quarter Ended August 31 November 30 February 28 May 31Sales $3,073 $2,930 $2,971 $2,909Gross profit $1,598 $1,642 $1,250 $1,667Net income $271 $271(1) $388 $355Net income per share, basic $.10 $.10(1) $.15 $.13Net income per share, diluted $.10 $.10(1) $.14 $.13Market Price of Common Stock High $7.99 $7.86 $7.98 $8.20Low $6.58 $6.27 $7.04 $7.20 (1)As reported in the Company’s Quarterly Report on Form 10-Q for the three and nine months ended February 28, 2007, net income as previouslyreported in the Quarterly Report on Form 10-Q for the three and six months ended November 30, 2006 was restated as the provision for income taxesdid not consider certain income taxes on a portion of net income from the Company’s wholly owned subsidiary located in the United Kingdom. 42Report of Independent Registered Public Accounting FirmBoard 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, 2008 and 2007, and therelated consolidated statements of operations, changes in stockholders' equity and comprehensive income and cash flows for each of the three years in theperiod ended May 31, 2008. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion onthese financial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. TheCompany is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration ofinternal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose ofexpressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Schmitt Industries, Inc. as ofMay 31, 2008 and 2007 and the results of its operations and its cash flows for each of the three years in the period ended May 31, 2008 in conformity withaccounting principles generally accepted in the United States of America.As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation as aresult of adopting Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (Revised 2004), effective June 1, 2006.As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for uncertain tax positions as a resultof adopting Statement of Financial Accounting Standards No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB StatementNo. 109, effective June 1, 2007./s/ GRANT THORNTON LLPPortland, OregonAugust 14, 2008 43Item 9.Changes in and Disagreements with Accountants on Accounting and Financial DisclosureNone. Item 9A(T).Controls and ProceduresEvaluation of Disclosure Controls and ProceduresWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submittedunder the Securities Exchange Act of 1934, as amended (Exchange Act), is recorded, processed, summarized and reported within the time periods specified inSEC rules and forms. Our disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that informationrequired to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management as appropriate to allow timelydecisions regarding required disclosures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including thepossibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls andprocedures can only provide reasonable assurance of achieving their control objectives, and management necessarily is required to use its judgment inevaluating the cost-benefit relationship of possible controls and procedures.An evaluation was carried out under the supervision and with the participation of the Company’s management, including the Chief Executive Officer(CEO) and Chief Financial Officer (CFO), of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report.Based on that evaluation and the material weakness described below, the CEO and CFO have concluded that the Company’s disclosure controls andprocedures are not effective.Management’s Report on Internal Control Over Financial ReportingOur management is responsible for establishing and maintaining adequate internal controls over financial reporting (as defined in Exchange Act Rules13a-15(f) or 15d-15(f)). Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of theeffectiveness of our internal controls over financial reporting based on the framework in Internal Controls—Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control—Integrated Framework, ourmanagement concluded that our internal controls over financial reporting were not effective as of May 31, 2008 as a result of material weakness in internalcontrols as described below. A material weakness is a deficiency or a combination of deficiencies, in internal control over financial reporting, such that thereis a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timelybasis.Management determined the controls around the review of significant non-routine transactions did not operate effectively, resulting in auditadjustments to the Fiscal 2008 consolidated financial statements. These deficiencies, if left unremediated, could result in the failure to prevent or detect amaterial misstatement in the Company’s consolidated financial statements.This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financialreporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SECthat permit the Company to provide only management’s report in the annual report.Changes in Internal Control over Financial ReportingThere were no changes in our internal control over financial reporting ( as defined in Exchange Rules 13a-15(f) and 15d-15(f)) that occurred during thequarter ended May 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B.Other InformationNone. 44PART IIICertain information required by Part III is included in the Company’s definitive Proxy Statement for its 2008 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. Item 10.Directors, Executive Officers and Corporate GovernanceThe information required by this item is included in the Company’s Proxy Statement relating to the 2008 Annual Meeting of Shareholders and isincorporated herein by reference. Item 11.Executive CompensationThe information required by this item is included in the Company’s Proxy Statement relating to the 2008 Annual Meeting of Shareholders and isincorporated herein by reference. Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersThe information required by this item is included in the Company’s Proxy Statement relating to the 2008 Annual Meeting of Shareholders and isincorporated herein by reference. Item 13.Certain Relationships and Related Transactions and Director IndependenceThe information required by this item is included in the Company’s Proxy Statement relating to the 2008 Annual Meeting of Shareholders and isincorporated herein by reference. Item 14.Principal Accounting Fees and ServicesThe information required by this item is included in the Company’s Proxy Statement relating to the 2008 Annual Meeting of Shareholders and isincorporated herein by reference. 45PART IV Item 15.Exhibits and Financial Statement Schedules (a)Financial Statements: (1) Consolidated Balance Sheets as of May 31, 2008 and 2007 Consolidated Statements of Operations for the years ended May 31, 2008, 2007 and 2006 Consolidated Statements of Cash Flows for the years ended May 31, 2008, 2007 and 2006 Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the years ended May 31, 2008, 2007 and 2006 Notes to Consolidated Financial Statements for the years ended May 31, 2008, 2007 and 2006 Report of Independent Registered Public Accounting Firm(2) Financial Statement Schedules: All financial statement schedules are omitted either because they are not applicable, not required, or the requiredinformation is included in the financial statements or notes thereto.(3) Exhibits: Reference is made to the list on page 48 of the Exhibits filed with this report. 46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, Presidentand Chief Executive OfficerDate: August 13, 2008Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of theregistrant and in the capacities indicated on August 13, 2008. Signature Title/s/ WAYNE A. CASE Wayne A. Case Chairman of the Board, President and Chief Executive Officer(Principal Executive Officer)/s/ JEFFREY T SIEGAL Jeffrey T Siegal Chief Financial Officer and Treasurer(Principal Financial and Accounting Officer)/s/ MAYNARD BROWN Maynard Brown Director/s/ TIMOTHY D.J. HENNESSY Timothy D.J. Hennessy Director/s/ DAVID M. HUDSON David M. Hudson Director/s/ MICHAEL J. ELLSWORTH Michael J. Ellsworth Director 47INDEX TO EXHIBITS Exhibits DescriptionExhibits marked with an asterisk (*) are incorporated by reference to exhibits or appendices previously filed with the Securities and Exchange Commission,as indicated by the references in brackets. All other exhibits are filed herewith. *2.1 Arrangement Agreement by and among Schmitt Industries, Inc., Schmitt Industries (Canada) Limited, and Xtero Datacom Inc. datedDecember 14, 2007.[Form 10-Q for the fiscal quarter ended February 29, 2008, Exhibit 2.1] *2.2 Amending Agreement to Arrangement Agreement by and among Schmitt Industries, Inc., Schmitt Industries (Canada) Limited, and XteroDatacom Inc. dated February 7, 2008.[Form 10-Q for the fiscal quarter ended February 29, 2008, Exhibit 2.2] *3.1 Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the Company).[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 3(i)] *3.2 Second Restated Bylaws of the Company.[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 3(ii)] *4.1 See exhibits 3.1 and 3.2 for provisions of the Articles of Incorporation and Bylaws defining the rights of security holders.*10.1† Schmitt Industries, Inc. Amended & Restated Stock Option Plan (the 1995 Plan).[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 10.1]*10.2† Employment Agreement of Wayne A. Case dated January 1, 2004.[Form 10-Q for the fiscal quarter ended February 29, 2004, Exhibit 10.1]*10.3† Schmitt Industries, Inc. 2004 Stock Option Plan.[Appendix B to Schedule 14A filed on August 23, 2004]*14.1 Code of Ethics and Business Conduct.[Form 10-K for the fiscal year ended May 31, 2004, Exhibit 14.1] 21.1 Subsidiaries of Schmitt Industries, Inc. as of May 31, 2008. 23.1 Consent of Independent Registered Public Accounting Firm. 31.1 Certification of Principal Executive Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-OxleyAct of 2002. 31.2 Certification of Principal Financial Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-OxleyAct of 2002. 32.1 Certification 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 or arrangement required to be filed as an exhibit to this Form 10-K. 48EXHIBIT 21.1SUBSIDIARIES OF SCHMITT INDUSTRIES, INC.AS OF MAY 31, 2008 Subsidiary State of Incorporation orCountry in Which OrganizedSchmitt Measurement Systems, Inc. OregonSchmitt Europe, Ltd. United KingdomSchmitt Industries Canada, Ltd. CanadaEXHIBIT 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe have issued our report dated August 14, 2008, accompanying the consolidated financial statements included in the Annual Report of SchmittIndustries, Inc. on Form 10-K for the year ended May 31, 2008. We hereby consent to the incorporation by reference of said report in the RegistrationStatement of Schmitt Industries, Inc. on Form S-8 (File No. 333-3910, effective August 18, 2004)./s/Grant Thornton LLPPortland, OregonAugust 14, 2008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 thisreport; 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 and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13-15(f) and 15d-15(f))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 thoseentities, particularly during the period in which this report is being prepared; (b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles; (c)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 (d)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 materiallyaffect, the registrant's internal control over financial reporting; and 5.The registrant's other certifying officer 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 13, 2008 /s/ WAYNE A. CASE Wayne A. Case,Chairman of the Board, President and CEOEXHIBIT 31.2CERTIFICATION PURSUANT TO18 U.S. C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Jeffrey T Siegal, 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 thisreport; 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 and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13-15(f) and 15d-15(f))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 thoseentities, particularly during the period in which this report is being prepared; (b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles; (c)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 (d)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 materiallyaffect, the registrant's internal control over financial reporting; and 5.The registrant's other certifying officer 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 13, 2008 /s/ JEFFREY T SIEGAL Jeffrey T Siegal,Chief Financial Officer and TreasurerExhibit 32.1CERTIFICATION PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 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, 2008 as filed withthe Securities and Exchange Commission on the date hereof (the “Report”), we, Wayne A. Case and Jeffrey T Siegal, Chairman of the Board, President andChief Executive Officer and Chief Financial Officer and Treasurer, respectively, of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to§ 906 of the Sarbanes-Oxley Act of 2002, that to 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. /s/ WAYNE A. CASE Wayne A. CaseChairman of the Board, Presidentand Chief Executive OfficerAugust 13, 2008/s/ JEFFREY T SIEGAL Jeffrey T SiegalChief Financial Officer and TreasurerAugust 13, 2008

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