Schmitt Industries, Inc.
Annual Report 2010

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, 2010or ¨¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to Commission File Number: 000-23996 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 whether the registrant has submitted electronically and posted on its Corporate Website, if any, every Interactive Data Filerequired to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes ¨ 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. ¨Indicate 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 ¨ 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, 2009, the last business day of the registrant’smost recently completed second fiscal quarter, was approximately $7,388,000 based upon the closing price of $3.50 reported for such date on the NASDAQCapital Market. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 10% of the outstanding shares of CommonStock and shares held by officers and directors of the registrant, have been excluded because such persons may be deemed to be affiliates. This determinationis not necessarily conclusive for other purposes.As of July 29, 2010, the registrant had 2,894,802 outstanding shares of Common Stock.Documents Incorporated by ReferencePortions of the registrant’s definitive Proxy Statement for its 2010 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 incorporated in 1995, designs, manufactures and markets computer-controlled vibrationdetection and balancing equipment (the Balancer Segment) primarily to the machine tool industry. The predecessor to the Company was originally organizedin 1984 under the laws of the Province of British Columbia. Through a statutory procedure, in 1995, the Company ceased to be domiciled in BritishColumbia and became an Oregon corporation. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), an Oregon corporation, theCompany designs, manufactures and markets precision laser-based surface measurement products for a wide variety of commercial applications in addition tothe disk drive, silicon wafer and optics industries; laser-based distance measurement products for a wide variety of industrial applications; and ultrasonicmeasurement products that accurately measure the fill levels of large liquefied propane tanks and transmit that data via satellite to a secure web site (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.“SBS,” “SMS,” “Acuity,” “Xact” and “Lasercheck” are trademarks owned by the Company.Balancer SegmentThe Company’s principal product line is the Schmitt Dynamic Balance System (the SBS System), consisting of a computerized control unit, vibrationsensor, spindle-mounting adapter, and balance head. It is designed as an inexpensive yet highly accurate permanent installation on grinding machines. 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 manufacturers and operators of grinding machines for a variety of industries such as automotive, aerospace, medical and machinetools, where operating tolerances on manufactured parts are exceedingly precise. 2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 driven by electric motors through a precision gear train. These weights are repositioned to offset any imbalance in a grinding wheel orother application. Imbalance or vibration is picked up by the sensor that feeds a signal to a controller that filters the signal by revolutions per minute. Thecontroller then automatically drives the balance head weights in a direction that reduces the amplitude of the vibration signal. The balance cycle is completewhen the weights are positioned to achieve the lowest vibration level.The SBS System also includes an optional Acoustical Emission Monitoring System (AEMS), which uses proprietary acoustic sensor technology tomonitor the very high frequency signals generated on the grinding machine during key events in the grinding process. The AEMS system allows rapid,automatic grinding wheel in-feed, right up to the point of initial contact with a new part loaded in the machine. The system can automatically detect theinitial contact and very quickly report this event to the machine control, stopping the wheel in-feed without operator intervention. Part crash occurs when apart or fixture is incorrectly loaded into a grinding machine or some abnormal condition occurs. Rapid in-feed of the wheel may then result in a dangerous orexpensive crash. The AEMS system allows the CNC control to monitor the acoustic levels on the machine and detect any unexpected contact when ithappens. The system then reports that abnormal contact and instructs the CNC program to stop the grinding process, usually within one millisecond.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 of using the SBS system include improved quality of finished parts, elimination of grinding gap time in the grind cycle resulting in increasedefficiency and part throughput, ease of product adaptation, monitoring and correction of part crash, 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 Shanghai Machine ToolWorks (China), ANCA (Australia), Capco Machinery (U.S.), Ecotech/SMTW (China/U.S.), Erwin Junker (U.S.), Shaanxi Qinchuan MachineryDevelopment Co. (China), Cinetic Landis Grinding (U.S.), Koyo Machinery (US, Japan), Micron Machinery Limited (Japan/U.S.), USACHTechnologies, Tschudin (U.S.) and Weldon Machine Tool (U.S.). The Company currently sells its products directly to major machine buildersthroughout the world.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 3tear the old machine apart and install new components, such as the SBS System. The Company currently sells its products directly to major machinerebuilders throughout the world.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, Cummins Engine, Ford Motor Company, General Electric,General Motors, Ingersoll Rand, Komatsu, Sumitomo Heavy Industries, SKF Bearing Industries, Timken, TRW Automotive Components and UniversalBearing.For the years ended May 31, 2010, May 31, 2009 and May 31, 2008 (Fiscal 2010, 2009 and 2008), net sales of the Company’s balancing productstotaled $4.7 million, $7.0 million and $8.4 million, respectively. Net sales of balancing products accounted for 69%, 73% and 74% of the Company’s totalsales in Fiscal 2010, 2009 and 2008, respectively. See Note 6 to Consolidated Financial Statements.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 one of the few products that canfit all machines with wheel sizes from 6 to 48 inches in diameter and spindle speeds 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.Competitors include Marposs S.p.A., Dittel Messtechnik GmbH, MPM Micro Prazision Marx GmbH and Balance Systems S.r.l.Water balancers (hydrokompensers) are an older European design still on the market that can be supplied by the Company when specifically requestedby users. They require plumbing and water chambers to be machined into the wheel hub. To install these systems, the grinding machines must bedisassembled and parts remachined or replaced within the spindle assembly. The water system is “tuned” or “calibrated” to the machine by a factory servicetechnician and are suitable for mid and high speed spindle environments.Pricing of the SBS system is geared toward maintaining the status of the SBS system as the premier product in the industry, offering best quality,reliability and performance and superior economic value.Measurement SegmentWithin the Measurement segment, the Company designs, manufactures and markets several laser-based precision test and measurement product linesand an ultrasonic product for measuring the fill levels of large liquid propane tanks and operates a precision laser light scatter measurement laboratory.There are five specific product lines: laser-based surface roughness measurement, laser-based distance measurement and dimensional sizing, remotetank monitoring, laser light-scatter surface measurement and a laser light-scatter measurement laboratory.Surface Roughness 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 4sold to manufacturers of hard disk drives, silicon wafers and optical products and industries with fabrication processes that require precise and reliablemeasurements.Computer hard disk drives require exact manufacturing control and a narrow tolerance band for acceptable roughness, with surface roughness outsidethat narrow band resulting in a reduction in data density or storage capacity. The Company’s technology simultaneously measures disk surface roughness intwo directions, radially, when the read/write head is moving to another disk sector, and circumferentially, when the read/write head is processing informationon the disk. The two separate roughness levels are required for proper head operation. The Company believes the precise measurement methods provided byits products 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 use the patented light scatter technology to measure the surface roughnessof 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 Company’s wafer measurement products provide a way forcustomers in this industry to quantify and control their manufacturing process. The system provides measurements to less than 0.5 Angstroms, a levelunachievable by competing devices.The Company also recently acquired the Lasercheck line of surface measurement gauges. Lasercheck is a unique laser-based non-contact roughnessgauge incorporating patented “laser light scatter” technology that can make precise repeatable surface roughness measurements in the 0.01 to 10 micron(0.40 to 400 micro inches) range. Lasercheck provides high-speed in-process measurements in a fraction of a second and is optimized for surfacemeasurements of ground, sanded, polished, hone, super-finished and shot-blasted surfaces. The Lasercheck line of surface measurements gauges is acomplementary fit to the TMS surface measurement products for ultra-smooth (sub-Angstrom) surfaces, such as silicon wafers and hard disk drives.Distance Measurement and Dimensional Sizing ProductsThese laser-based products, utilizing both triangulation and time-of-flight methods of measurement, are used in a wide range of industrial applicationsincluding manufacturing, lumber production, steel casting, glass and paper production, medical imaging, crane control and micron-level part and surfaceinspection. Presently, 5®there are six AccuRange (AR) product lines: the AR1000, AR3000 and AR4000 distance measurement sensors, the AR4000 Line Scanner and the AR700 andAR200 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.The AR1000 and AR3000 distance measurement lasers utilize pulsed time of flight measurement principles to accurately measure distances of up to 30meters (up to 300 meters with retro reflective tape) with the AR1000 and up to 300 meters (3000 meters with retro reflective tape) with the AR3000. Bothproducts are highly versatile, able to measure distances both indoors and outdoors. Applications include load confirmation, lumber positioning, cranemonitoring, fill level measurement, velocity measurement and laser altimeter.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 AR700 is a triangulation laser displacement sensor that provides superior performance in terms of accuracy, repeatability, and sample speed. TheAR700 boasts output speeds up to 9400 Hz and resolutions as low as one sixth of a micrometer. The laser will output 9400 distance readings in a singlesecond. The unit is also very compact, measuring approximately 80% smaller than its predecessor, the AR600. Model variations permit applications up to 50inches in range. Applications include high speed road profiling, product dimensional or thickness measurement, rubber thickness measurement, lumber orplywood thickness measurement, carton dimensioning and product positioning.The AR200 line is the Company’s most compact series of triangulating laser displacement sensors. Four models cover metric measurement ranges fromsix to fifty millimeters. All models boast a 1/500 accuracy rating for measurements within twelve microns. The AR200 sensor is the only sensor of its kind tofeature pushbutton selection of output signals. All models are standard with analog, limit switch and serial outputs. The AR200 sensors, much like the longer-range AR700 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 bya line scan camera and the target’s distance is computed from the image pixel data. The AR200-6M, -12M, -25M and -50M have ranges in millimeters thatmatch their model number. The AR200 displacement sensor cannot be overloaded and measures accurately even when a mirror reflects the entire light beamback to the detector.Remote Tank Monitoring ProductsThe Company’s primary product for this new market is called Xact. The Xact product utilizes ultrasonic technology to detect and measure the capacityand 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, producesa 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 the form of anecho that is detected. The time of flight between the “ping” and the echo is then calculated to determine, based upon additional data regarding tank size andshape, the volume of liquid the tank contains. This information is then remotely transmitted via a satellite transceiver that is affixed to the top of the tank to asecure website on the internet, processed using proprietary software and displayed on that website. 6Each tank can be remotely monitored simultaneously anywhere in the world. The user has the ability to schedule when each tank is to be measured simply byadjusting the settings for each tank.Research and Other Measurement ProductsThe Company’s CASI Scatterometers are sold to companies and institutions involved in scientific research and development. The CASI Scatterometeruses 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.The MicroScan system is a portable device consisting of a hand-held control unit, an interchangeable measurement head and a separate charging unit.To perform a measurement, the operator places the measurement head on the objective area and presses a button. Each measurement takes less than fiveseconds with results displayed and stored in system memory. The MicroScan can store 700 measurements in 255 files and provides the capability to programpass/fail criteria. Software is available for control, analysis and file conversion. From a single measurement, a user can determine RMS surface roughness,reflectance and 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 2010, 2009 and 2008, net sales of Measurement products totaled $2.1 million, $2.5 million and $3.0 million, respectively, and accounted for31%, 27% and 26% of the Company’s total sales in Fiscal 2010, 2009 and 2008, respectively. See Note 6 to Consolidated Financial Statements.CompetitionManagement believes our TMS and Lasercheck surface measurement products are one of only a few systems that provide fast, accurate, repeatablemicroroughness measurements for a wide variety of commercial applications including the computer hard disk manufacturing and the silicon waferindustries. The Company believes its surface measurement products are currently the only systems that can provide measurements as low as a few hundredthsof an angstrom (Å-a unit of measure equal to 1 hundred-millionth of a centimeter) with reproducibility +/- 0.2Å or 1% and repeatability of +/- 0.1Å. There aredifferences between our surface measurement products and other optical techniques (which include profilometers, scanning tunneling microscopes, atomicforce microscopes or interferometers). These other technologies require the intervention of a skilled operator and perform measurements relatively slowly,whereas our surface measurement products are much simpler and, consequently, can make measurements more rapidly while still maintaining excellentrepeatability and accuracy. Stylus profilometers are simpler devices which require less skilled operators. However, measurements must be conducted undervibration isolation conditions, and large areas require numerous scans; thus, stylus profilometers are generally destructive to soft materials such as mostcoated optics.The market for distance measurement and dimensional sizing products is extremely competitive, characterized by rapidly changing technology. TheCompany believes the principal elements of competition 7include quality of ongoing technical support and maintenance coupled with responsiveness to customer needs, as well as price, product quality, reliabilityand performance. The differences between the Company’s sensors and competitive products include pushbutton selection of output signals in certain modelsand sensors that can be programmed using serial commands through a PC computer. The AR200 displacement sensor cannot be overloaded and measuresaccurately 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, most of which aresignificantly larger and have greater financial, engineering, manufacturing and marketing resources. Company pricing is geared to obtaining market shareand meeting competitive supplier prices. The market strategy is to establish measurement products as products with the best quality, reliability andperformance and superior economic value.Sales by Geographic AreaIn Fiscal 2010, 2009 and 2008, the Company recorded net sales of its products in the United States, its country of domicile, of $3.1 million, $4.8million and $6.0 million, respectively. Net sales in the last three fiscal years by geographic areas are: North America Europe Asia OthersFiscal 2010 $3,308,958 $1,148,857 $2,171,993 $175,940Fiscal 2009 $5,075,254 $1,370,388 $2,722,762 $332,804Fiscal 2008 $6,305,626 $1,842,008 $2,811,167 $462,456Business and Marketing StrategyThe Company designs, manufactures and markets all of its products with operations divided into a number of different areas.Balancer Segment ProductsThe Company markets and sells the Balancer segment products in a variety of ways. First are the channels provided by independent manufacturers’representatives and distributors. There are currently approximately 100 individuals and/or organizations throughout the world acting in one of thesecapacities, including approximately 25 in the United States and 30 in China.Second, OEMs incorporate 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 the CEO or President, 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 ProductsSimilar to the Balancer segment, the Measurement segment uses a variety of methods to market and sell its products. First, a Marketing Manager directsthe overall worldwide marketing efforts for surface measurement products. Second, both a marketing and a sales manager, direct the overall worldwidemarketing and sales efforts for distance measurement and dimensional sizing products. Third, the Company has an exclusive distribution agreement with acompany in Asia for the promotion and sale of surface measurement products in China, Taiwan, Malaysia, Singapore, Thailand and the Philippines. Inaddition, there are distribution agreements with one company in Japan and two in Korea. Trade shows also represent a significant amount of marketing/saleseffort. Company representatives operate a display booth featuring demonstrations of Measurement segment products along with product and technicalliterature. Representatives from all facets of the market to which the Company directs its sales efforts attend these trade shows. Finally, one of the bestmarketing channels is the testing laboratory. Once customers see the capabilities of the technology, it can lead to orders for the Company’s laser based lightscatter 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.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 Eagle Industries of Newberg, Oregon; Asco Machine, Inc. ofVancouver, Washington; Davis Tool of Portland, Oregon; and Forest City Gear of Roscoe, Illinois.The Company uses in-house skilled assemblers to construct and test vendor-supplied components. Component inventory of finished vendor-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 and received its recertification in December 2008. 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.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 its business segments. The goalof 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. Forexample, in the past fiscal year, the Company has developed and introduced the SB-5500, a new controller for the Balancer segment with new digitalelectronics, multi-language display and several communication options.During Fiscal 2010, 2009 and 2008, the Company’s research and development expense totaled $585,000, $1.0 million and $628,000, respectively.The Fiscal 2009 increase in product development costs relates primarily to the acquisition of the Xact product technology and further development of thattechnology.EmployeesAs of July 29, 2010, the Company employed 42 individuals worldwide on a full-time basis. There were no regular part-time employees. None of theCompany’s employees is covered by a collective bargaining agreement. Item 1A.RISK 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. 10The general economic conditions and the global financial crisis may adversely affect the Company’s business, operating results and financial conditionThe Company’s operations and performance depend significantly on worldwide economic conditions, particularly in the manufacturing sector, andtheir impact on levels of capital investment, which have recently deteriorated significantly over the past two fiscal years and may remain depressed, or besubject to further deterioration. Economic factors that could adversely influence demand for the Company’s products include uncertainty about globaleconomic conditions leading to reduced levels of investment, customers’ and suppliers’ access to credit, unemployment and other macroeconomic factorsaffecting commercial and industrial spending behavior.The past distress in the financial markets and global economy has resulted in reduced liquidity and a tightening of credit markets. As a result of theseconditions, the Company could experience several potential adverse effects, including the inability of customers to obtain credit to finance purchases of theCompany’s products, the insolvency of customers resulting in reduced sales and bad debts, and the insolvency of key suppliers resulting in productdevelopment and production delays.The Company’s primary markets are volatile and unpredictableThe Company’s business depends on the demand for our various products in a variety of commercial and industrial markets. In the past, demand for ourproducts in these markets has fluctuated due to variety of factors, some of which are beyond our control, including: general economic conditions, bothdomestically and internationally, the timing, number and size of orders from, and shipments to, our customers as well as the relative mix of those orders andvariations in the volume of orders for a particular product line in a particular quarter.The Xact tank monitoring system may not become commercially viable and satisfy expected demandOn May 13, 2009, the Company announced the introduction of the Xact tank monitoring system for measuring fill levels of industrial liquefiedpropane tanks and communicating that data via satellite to a secure web site. Although the initial acquisition and further development of the Xact producthas negatively impacted current operating results, the product should allow the Company to enter new measurement markets and is expected to add sales andprofits to the Company in future years. However, the Xact product may not be successful, anticipated market demand for the product may not materialize andadditional product or market opportunities may not be identified and developed and brought to market in a timely and cost-effective manner, each of whichcould continue to negatively impact future operating results and result in 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. 11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 factors 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.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 or that other highly qualified technical and sales personnel as requiredcan be attracted, assimilated and retained. There is also no guarantee that key employees will not leave and subsequently compete against the Company. Theinability to attract and retain key personnel could adversely impact the business, financial condition and results of operations.Changes in the effective tax rate may have an adverse effect on the Company’s results of operationsThe Company’s future effective tax rate may be adversely affected by a number of factors including: the jurisdictions in which profits are determined tobe earned and taxed; the resolution of issues arising from future 12potential tax audits with various tax authorities; changes in the valuation of our deferred tax assets and liabilities; adjustments to estimated taxes uponfinalization of various tax returns; increases in expenses not deductible for tax purposes; changes in available tax credits; changes in stock-basedcompensation expense; changes in tax laws or the interpretations of such tax laws and changes in generally accepted accounting principles.Changes in securities laws and regulations have increased and could 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 could continue to increase Company expenses as the Company devotes resources to ensurecompliance with all applicable laws and regulations. In particular, the Company could incur significant additional administrative expense and a diversion ofmanagement’s time in Fiscal 2011 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 reduced 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 that these factors will not have amaterial adverse effect on future international sales and operations and, consequently, on business, financial condition and results of operations. 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 totalingapproximately 40,500 square feet. SEL occupies a 755-square foot facility in Coventry, England pursuant to a two-year lease beginning May 7, 2009 with abasic monthly rent of £975 (approximately $1,425 as of May 31, 2010). Item 3.Legal ProceedingsThere are no material legal proceedings currently pending against the Company. Item 4.(Remove and Reserved) 13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, 2009 High Low First Quarter $6.40 $4.50Second Quarter $7.08 $4.25Third Quarter $4.68 $3.00Fourth Quarter $3.75 $2.55Year Ended May 31, 2010 High LowFirst Quarter $5.53 $2.95Second Quarter $5.00 $3.35Third Quarter $4.00 $3.37Fourth Quarter $4.08 $3.47As of July 29, 2010, there were 2,894,802 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, 2010: Plan Category Number of Securitiesto be issued uponexercise ofoutstanding options Weighted-averageexercise price ofoutstandingoptions Number of Securitiesremaining availablefor future issuanceunder equitycompensation plans(excluding securitiesin column a) a b cEquity compensation plans approved by security holders 218,609 $3.32 238,875Equity compensation plans not approved by security holders — — — 218,609 $3.32 238,875Recent Sales of Unregistered SecuritiesOn September 30, 2009, the Company completed an Asset Purchase Agreement with Optical Dimensions, a sole proprietorship, pursuant to which theCompany acquired all of the assets and assumed certain liabilities of Optical Dimensions. As partial consideration for the assets, the Company issued 24,642restricted shares of 14common stock of the Company to Optical Dimensions. The number of shares issued was equal to $100,000 in value based on the average closing price of theCompany’s common stock, as reported on the NASDAQ National Market, over the five-day period immediately prior to closing. The sale of shares to OpticalDimensions was effected pursuant to Section 4(2) of the Securities Act of 1933.Issuer Purchases of Equity SecuritiesNone. Item 6.Selected Financial DataIn thousands, except per share informationYear Ended 5/31/10 5/31/09 5/31/08 5/31/07 5/31/06Sales $6,806 $9,501 $11,421 $11,882 $11,503Net Income (Loss) $(1,711) $(2,154) $1,103 $1,285 $1,350Net Income (Loss) Per Share, Basic $(.59) $(.75) $.40 $.49 $.52Weighted Average No. Shares, Basic 2,887 2,870 2,725 2,649 2,606Net Income (Loss) Per Share, Diluted $(.59) $(.75) $.39 $.47 $.49Weighted Average No. Shares, Diluted 2,887 2,870 2,834 2,763 2,746Stockholders’ Equity $10,121 $11,718 $13,756 $11,365 $9,814Total Assets $11,352 $12,624 $15,247 $12,471 $10,927Long-term Debt (including current portion) $— $— $— $— $22 15Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsRESULTS OF OPERATIONSOverviewSchmitt Industries, Inc. designs, manufactures and markets computer controlled vibration detection and balancing equipment (the Balancer segment) tothe worldwide machine tool industry and, through its wholly owned subsidiary, Schmitt Measurement Systems, Inc., precision laser-based surface roughnessmeasurement products, laser-based distance measurement products and ultrasonic measurement systems (the Measurement segment) for a variety of industrialapplications worldwide. The Company sells and markets its products in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL) located inthe United Kingdom. The Company is organized into two operating segments: the Balancer segment and the Measurement segment.For the year ended May 31, 2010 (Fiscal 2010), total sales decreased $2.7 million, or 28.4%, to $6.8 million from $9.5 million in the year endedMay 31, 2009 (Fiscal 2009). Balancer segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers of grindingmachines with the target geographic markets in North America, Asia and Europe. Balancer sales decreased $2.3 million, or 33.0%, to $4.7 million in Fiscal2010 compared to $7.0 million in Fiscal 2009. The Fiscal 2010 decrease in worldwide balancer sales is due to lower volumes of shipments as the worldwideautomotive industry has been severely impacted by the global economic downturn. The Measurement segment product line consists of both laser-basedlight-scatter and distance measurement and dimensional sizing products. Total Measurement sales decreased $395,000, or 15.6%, to $2.1 million in Fiscal2010 compared to $2.5 million in Fiscal 2009. The decrease is primarily due to the lower volumes of shipments of laser-based measurement products.In response to the significant decreases in revenues during the past year, the Company has been reducing its operating expenses. Operating expensesdecreased $1.3 million, or 21.2%, to $4.8 million in Fiscal 2010 from $6.1 million in Fiscal 2009. General, administrative and sales expenses decreased$850,000, or 16.9%, in Fiscal 2010 to $4.2 million as compared to $5.0 million in the prior fiscal year. Research and development expenses decreased$435,000, or 42.7%, to $585,000 in Fiscal 2010 from $1.0 million in Fiscal 2009.Net loss was $1.7 million, or $0.59 per fully diluted share, for the year ended May 31, 2010 as compared to net loss of $2.2 million, or $0.75 per fullydiluted share, for the year ended May 31, 2009.AcquisitionOn September 30, 2009, the Company completed an Asset Purchase Agreement (the “Agreement”) with Optical Dimensions, a sole proprietorship,pursuant to which the Company acquired all of the assets and assumed certain liabilities of Optical Dimensions, As a result, the Company now owns andoperates Optical Dimensions’ business, including its patented laser light scatter roughness measurement technology. The total purchase price for theacquisition was approximately $200,000 which includes the value of the shares issued and the cash paid. The Agreement provided that the Company paycash of $100,000 and issue 24,642 shares of common stock of the Company. The number of shares issued was equal to $100,000 in value based on theaverage closing price of the Company’s common stock, as reported on the NASDAQ National Market, over the five-day period immediately prior to closing.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 Accounting Standards Codification Topic 605. For sales to all customers, includingmanufacturer representatives, distributors or their third-party customers, these criteria are met at the 16time product is shipped. When other significant obligations remain after products are delivered, revenue is recognized only after such obligations arefulfilled. In addition, judgments are required in evaluating the credit worthiness of our customers. Credit is not extended to customers and revenue is notrecognized until we have determined that collectability is reasonably 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 meet 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 to, 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 undiscounted net cash flows from the operations to which the assets relate, based on management’s best estimates using the appropriateassumptions and projections 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 is considered impaired and a loss is recognized equal to the amount by which the carrying amount exceeds the estimated fair value of the assets.Recently issued accounting pronouncementsRefer to Note 1 of the Notes to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements. 17Discussion of Operating Results Year Ended May 31, 2010 2009 2008 Balancer sales $4,670,723 68.6% $6,971,079 73.4% $8,414,120 73.7% Measurement sales 2,135,025 31.4% 2,530,129 26.6% 3,007,137 26.3% Total sales 6,805,748 100.0% 9,501,208 100.0% 11,421,257 100.0% Cost of sales 3,763,756 55.3% 5,361,088 56.4% 5,305,144 46.4% Gross profit 3,041,992 44.7% 4,140,120 43.6% 6,116,113 53.6% Operating expenses: General, administration and sales 4,184,100 61.5% 5,033,617 53.0% 4,628,003 40.5% Research and development 584,582 8.6% 1,019,440 10.7% 628,150 5.5% Total operating expenses 4,768,682 70.1% 6,053,057 63.7% 5,256,153 46.0% Operating income (loss) (1,726,690) (25.4%) (1,912,937) (20.1%) 859,960 7.5% Other income 31,107 0.5% 49,682 0.5% 251,282 2.2% Income (loss) before income taxes (1,695,583) (24.9%) (1,863,255) (19.6%) 1,111,242 9.7% Provision for income taxes 15,430 0.2% 290,269 3.1% 8,138 0.1% Net income (loss) $(1,711,013) (25.1%) $(2,153,524) (22.7%) $1,103,104 9.7% Sales—Sales in the Balancer segment decreased $2.3 million, or 33.0%, to $4.7 million for Fiscal 2010 compared to $7.0 million for Fiscal 2009. Thisdecrease is primarily due to lower unit sales volumes in Asia, North America and Europe during the year. North American sales decreased $1.2 million, or40.6%, in Fiscal 2010 compared to the prior year. Asia sales decreased $601,000, or 23.3%, in Fiscal 2010 compared to Fiscal 2009. European sales decreased$372,000, or 31.7%, in Fiscal 2010 compared to Fiscal 2009. The decreases across all geographies are primarily due to lower volumes of shipments caused bycontinuing weaknesses in the global economy and the softening of the worldwide automotive, bearing and aircraft industries which has impacted themachine tool industry. The levels of demand in our geographic markets cannot be forecasted with any certainty given the recent weaknesses in the globaleconomy.Sales in the Measurement segment decreased $395,000, or 15.6%, to $2.1 million in Fiscal 2010 compared to $2.5 million in Fiscal 2009. Sales oflaser-based dimensional sizing products decreased $455,000, or 21.8%, primarily due to the lower unit sales volumes in North America. Sales of laser-basedsurface measurement products increased $50,000, or 11.3%, primarily due to the September 30, 2009 acquisition of Optical Dimensions which resulted inproduct sales of $114,000; these sales were partially offset by a decrease in sales to disk drive and silicon wafer manufacturers of $64,000.Sales in the Balancer segment decreased $1.4 million, or 17.2%, to $7.0 million for Fiscal 2009 compared to $8.4 million for Fiscal 2008. This decreaseis primarily due to decreased sales in North America and Europe during the year. North American sales decreased $1.0 million, or 25.1%, in Fiscal 2009compared to the prior year. European sales decreased $411,000, or 25.9%, in Fiscal 2009 compared to Fiscal 2008. Market demand in Asia for the Balancersegment products was flat with that region showing a decrease of $22,000, or 0.8%, for Fiscal 2009 compared to the prior year. The decreases in NorthAmerica and Europe are primarily due to lower volumes of shipments caused by weaknesses in the global economy and softening of the worldwideautomotive, bearing and aircraft industries and its impact on the machine tool industry. The European market is also negatively impacted by greatercompetition with other European companies. The global economic crisis has not impacted the Chinese market as much as other regions of the world resultingin relatively flat sales in Asia.Sales in the Measurement segment decreased $477,000, or 15.9%, to $2.5 million in Fiscal 2009 compared to $3.0 million in Fiscal 2008. The decreaseis primarily due to the lower volumes of shipments of laser-based surface measurement products to disk drive and silicon wafer manufacturers. Theseindustries have undergone 18significant consolidation as manufacturers merged or exited the markets resulting in a redeployment of equipment rather than making additional investmentsin capital equipment. Fiscal 2009 sales of laser-based dimensional sizing products increased slightly, $18,000 or 0.9%, as compared to Fiscal 2008.Gross margin—Gross margin for Fiscal 2010 increased to 44.7% compared to 43.6% for Fiscal 2009. This increase is primarily due to lower increasesto reserves for excess and obsolete inventory in the current year offset by a shift in the sales product mix to lower margin products and the impact ofsignificantly lower sales volumes. Gross margin for Fiscal 2009 decreased to 43.6% as compared to 53.6% for Fiscal 2008. This decrease is due to changes inthe product sales mix shifting towards lower margin products and increases in reserves for excess and obsolete inventory. Balancer margins were alsonegatively impacted as a result of higher sales in foreign markets as a large portion of those sales are made through distributors who receive favorable pricing.Operating expenses—Operating expenses decreased $1.3 million, or 21.2%, to $4.8 million for Fiscal 2010 compared to $6.1 million in Fiscal 2009.General, administrative and sales expenses decreased $850,000, or 16.9%, to $4.2 million in Fiscal 2010 compared to $5.0 million in the prior year. Thisdecrease is due primarily to lower personnel costs resulting from both salary reductions and mandatory furloughs and lower stock-based compensation, lowercommissions related to the decrease in sales and the expense and spending controls put in place due to the significant decline in revenue, offset by higherbad debt expense in the current year. Research and development expenses decreased $435,000, or 42.7%, to $585,000 in Fiscal 2010 compared to $1.0million in Fiscal 2009. The decrease in research and development expense is primarily due to lower material costs associated with new product developmentrelated to technologies acquired from Xtero and to existing product lines and lower personnel costs associated with salary reductions. Operating expensesincreased $797,000, or 15.2%, to $6.1 million for Fiscal 2009 as compared to $5.3 million for Fiscal 2008. General, administrative and selling expensesincreased $406,000 or 8.8% for Fiscal 2009 as compared to Fiscal 2008. This increase is primarily due to higher personnel costs resulting from increasedheadcount, higher stock-based compensation and higher amortization expenses related to the identifiable intangible assets acquired from Xtero, offset bylower commissions related to the decrease in sales. Research and development expenses increased $391,000 or 62.3% as compared to the prior year primarilydue to new product development associated with the technologies acquired from Xtero and new product development related to existing product lines.Other income—Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was$11,000, $74,000 and $227,000 in Fiscal 2010, 2009 and 2008, respectively. Interest income has decreased due to lower investment balances and lowerinterest rates. Foreign currency exchange gain was $19,000 and $25,000 in Fiscal 2010 and 2008, respectively. Foreign currency exchange loss was $24,000in Fiscal 2009.Income tax provision—The effective tax rate in Fiscal 2010 was (0.9)%. The effective tax rate on consolidated net loss in Fiscal 2010 differs from thefederal statutory tax rate primarily due to the amount of income from foreign jurisdictions, changes in the deferred tax valuation allowance and certainexpenses not being deductible for income tax reporting, offset by tax credits related to research and experimentation expenses. The effective tax rate in Fiscal2009 was 15.6%. The effective tax rate on consolidated net loss in Fiscal 2009 differs from the federal statutory tax rate primarily due to research andexperimentation credits, lower effective tax rates on net income reported by SEL and the effect of changes in tax contingencies, offset by changes in thedeferred tax valuation allowance, the expiration of capital loss carryforwards, a foreign jurisdiction statutory gain exclusion and certain expenses not beingdeductible for income tax reporting. The effective tax rate in Fiscal 2008 was 0.7%. The effective tax rate on consolidated net income in Fiscal 2008 differsfrom the federal statutory tax rate primarily due to export tax incentives claimed during the year related to prior years, domestic manufacturing deduction,lower effective tax rates on net income reported by the Company’s wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom, thenet tax benefits related to a gain exclusion provision provided in Canada on the sale of technology from the Canadian subsidiary to a US subsidiary and areduction in the valuation allowance, offset by certain expenses not deductible for income tax reporting. 19Net income—Net loss decreased $443,000 to a net loss of $1.7 million, or $0.59 per diluted share, for Fiscal 2010 as compared to net loss of $2.2million, or $0.75 per diluted share, for Fiscal 2009. Net loss decreased due primarily to lower sales and related gross profit, offset by lower general,administrative and selling expenses, lower research and development expenses and a lower effective tax rate during Fiscal 2010. Net income decreased $3.3million to a net loss of $2.2 million, or $0.75 per diluted share, for Fiscal 2009 as compared to net income of $1.1 million, or $0.39 per diluted share, forFiscal 2008. Net income decreased due primarily to lower sales, lower gross profit and higher operating expenses during Fiscal 2009.LIQUIDITY AND CAPITAL RESOURCESThe Company’s working capital decreased $1.4 million to $7.3 million as of May 31, 2010 compared to $8.7 million as of May 31, 2009. Cash andcash equivalents decreased $628,000 to $3.5 million as of May 31, 2010 from $4.2 million as of May 31, 2009.Cash used in operating activities was $417,000 in Fiscal 2010 as compared to $1.2 million in Fiscal 2009. The decrease was primarily due to decreasesin net loss, deferred taxes, depreciation and amortization, stock-based compensation, inventories, income taxes receivable, income taxes payable and otheraccrued liabilities, offset by increases in accounts receivable and accounts payable.At both May 31, 2010 and 2009, we had accounts receivable of $1.1 million. At May 31, 2010, inventories decreased $222,000 to $3.6 millioncompared to $3.9 million at May 31, 2009 due to the timing of purchase and inventory receipts. At May 31, 2010, income taxes receivable decreased$309,000 to $22,000 compared to $330,000 at May 31, 2009 due to the receipt of income tax refunds from the government. At May 31, 2010, total currentliabilities increased $322,000 to $1.2 million as compared to $906,000 at May 31, 2009. The increase is primarily due to the timing of accounts payablepayments as compared to the prior year.During the year ended May 31, 2010, net cash used in investing activities was $160,000, which consisted of $100,000 used for the acquisition ofOptical Dimensions during the second quarter of Fiscal 2010 and by additions to property and equipment of $55,000. Additions to property and equipmentconsisted primarily of new manufacturing and office equipment.The 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 (3.25% as of May 31, 2010), or LIBOR plus 2.0%, (2.35% as of May 31, 2010). The agreement expires on March 1, 2011.There were no outstanding balances on the line of credit at May 31, 2010 and 2009.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. 20QUARTERLY FINANCIAL DATAIn thousands, except per share information (unaudited) 2009 Quarter Ended August 31 November 30 February 28 May 31 Sales $3,193 $2,989 $1,761 $1,557 Gross profit $1,657 $1,403 $808 $272 Net income (loss) $34 $(114) $(261) $(1,813) Net income (loss) per share, basic $.01 $(.04) $(.09) $(.63) Net income (loss) per share, diluted $.01 $(.04) $(.09) $(.63) 2010 Quarter Ended August 31 November 30 February 28 May 31 Sales $1,223 $1,922 $1,542 $2,118 Gross profit $549 $943 $795 $755 Net loss $(575) $(224) $(443) $(469) Net loss per share, basic $(.20) $(.08) $(.15) $(.16) Net loss per share, diluted $(.20) $(.08) $(.15) $(.16) Item 7A.Quantitative and Qualitative Disclosures about Market RiskInterest Rate RiskThe Company did not have any derivative financial instruments as of May 31, 2010. 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, 2010. 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 2010, 2009 and 2008, results of operations included gains (losses) on foreign currency translation of $19,000,($24,000) and $25,000, respectively. The foreign exchange gains or losses in Fiscal 2010, 2009 and 2008 were primarily attributable to Company’s UnitedKingdom subsidiary, Schmitt Europe, Ltd. 21Item 8.Financial Statements and Supplementary DataSchmitt Industries, Inc.Consolidated Balance Sheets May 31, 2010 May 31, 2009 ASSETS Current assets Cash and cash equivalents $3,545,986 $4,174,335 Accounts receivable, net 1,144,420 1,110,850 Inventories 3,645,303 3,866,971 Prepaid expenses 192,167 171,178 Income taxes receivable 21,570 330,134 8,549,446 9,653,468 Property and equipment Land 299,000 299,000 Buildings and improvements 1,564,880 1,564,880 Furniture, fixtures and equipment 1,059,496 1,037,346 Vehicles 90,452 90,452 3,013,828 2,991,678 Less accumulated depreciation and amortization (1,720,880) (1,563,840) 1,292,948 1,427,838 Other assets Intangible assets, net 1,509,711 1,542,694 TOTAL ASSETS $11,352,105 $12,624,000 LIABILITIES & STOCKHOLDERS’ EQUITY Current liabilities Accounts payable $665,044 $335,609 Accrued commissions 170,614 172,755 Accrued payroll liabilities 231,390 228,887 Other accrued liabilities 160,717 168,325 Total current liabilities 1,227,765 905,576 Long-term liabilities 3,591 — Stockholders’ equity Common stock, no par value, 20,000,000 shares authorized, 2,894,802 and 2,870,160 shares issued andoutstanding at May 31, 2010 and May 31, 2009, respectively 9,739,391 9,545,678 Accumulated other comprehensive loss (264,004) (183,629) Retained earnings 645,362 2,356,375 Total stockholders’ equity 10,120,749 11,718,424 TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $11,352,105 $12,624,000 The accompanying notes are an integral part of these consolidated financial statements 22Schmitt Industries, Inc.Consolidated Statements of Operations Year Ended May 31, 2010 2009 2008Net sales $6,805,748 $9,501,208 $11,421,257Cost of sales 3,763,756 5,361,088 5,305,144Gross profit 3,041,992 4,140,120 6,116,113Operating expenses: General, administration and sales 4,184,100 5,033,617 4,628,003Research and development 584,582 1,019,440 628,150Total operating expenses 4,768,682 6,053,057 5,256,153Operating income (loss) (1,726,690) (1,912,937) 859,960Other income 31,107 49,682 251,282Income (loss) before income taxes (1,695,583) (1,863,255) 1,111,242Provision for income taxes 15,430 290,269 8,138Net income (loss) $(1,711,013) $(2,153,524) $1,103,104Net income (loss) per common share, basic $(0.59) $(0.75) $0.40Weighted average number of common shares, basic 2,886,633 2,870,160 2,725,086Net income (loss) per common share, diluted $(0.59) $(0.75) $0.39Weighted average number of common shares, diluted 2,886,633 2,870,160 2,834,158 The accompanying notes are an integral part of these consolidated financial statements 23Schmitt Industries, Inc.Consolidated Statements of Cash Flows Year Ended May 31, 2010 2009 2008 Cash flows relating to operating activities Net income (loss) $(1,711,013) $(2,153,524) $1,103,104 Adjustments to reconcile net income (loss) to net cash provided by (used in) operatingactivities: Depreciation and amortization 362,027 410,653 238,984 (Gain) loss on disposal of property and equipment (1,200) — 703 Deferred taxes — 353,253 (405,895) Stock based compensation 93,420 175,326 52,957 Tax benefit related to stock options — — 10,175 Excess tax benefit from stock-based compensation — — (10,202) (Increase) decrease in: Accounts receivable (21,075) 416,604 (127,611) Inventories 247,986 20,554 (220,068) Prepaid expenses (18,257) (72,462) (29,354) Income taxes receivable 308,425 (330,134) — Increase (decrease) in: Accounts payable 324,569 (183,508) 184,331 Accrued liabilities and customer deposits (1,394) 485,037 (62,357) Income taxes payable — (304,201) 155,598 Net cash provided by (used in) operating activities (416,512) (1,182,402) 890,365 Cash flows relating to investing activities Purchase of short-term investments (1,000,000) (1,019,199) (10,059,693) Maturities of short-term investments 1,000,000 3,519,062 11,524,479 Purchase of property and equipment (54,838) (171,733) (386,016) Advances and payments on asset acquisition (100,000) — (484,158) Proceeds from sale of property and equipment 1,200 — 100 Other long-term assets (6,039) — — Net cash provided by (used in) investing activities (159,677) 2,328,130 594,712 Cash flows relating to financing activities Common stock issued on exercise of stock options — — 13,104 Excess tax benefit from stock-based compensation — — 10,202 Net cash provided by financing activities — — 23,306 Effect of foreign exchange translation on cash (52,160) 8,476 (1,313) Increase (decrease) in cash and cash equivalents (628,349) 1,154,204 1,507,070 Cash and cash equivalents, beginning of period 4,174,335 3,020,131 1,513,061 Cash and cash equivalents, end of period $3,545,986 $4,174,335 $3,020,131 Supplemental Disclosure of Cash Flow Information Cash paid (received) during the year for income taxes $(293,876) $92,190 $247,842 The accompanying notes are an integral part of these consolidated financial statements 24Schmitt Industries, Inc.Consolidated Statements of Changes in Stockholders’ Equity And Comprehensive Income Shares Amount Accumulatedothercomprehensiveloss Retainedearnings Total Totalcomprehensiveincome (loss) Balance, May 31, 2007 2,664,419 $8,114,251 $(122,050) $3,372,331 $11,364,532 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 loss — — (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 Stock based compensation — 175,326 — — 175,326 Net loss — — — (2,153,524) (2,153,524) $(2,153,524) Other comprehensive loss — — (59,841) — (59,841) (59,841) Balance, May 31, 2009 2,870,160 9,545,678 (183,629) 2,356,375 11,718,424 Comprehensive loss, year ended May 31, 2009 $(2,213,365) Stock based compensation — 93,420 — — 93,420 Common stock issued in connection with asset acquisition 24,642 100,293 — — 100,293 Net loss — — — (1,711,013) (1,711,013) $(1,711,013) Other comprehensive loss — — (80,375) — (80,375) (80,375) Balance, May 31, 2010 2,894,802 $9,739,391 $(264,004) $645,362 $10,120,749 Comprehensive loss, year ended May 31, 2010 $(1,791,388) The accompanying notes are an integral part of these consolidated statements 25Schmitt Industries, Inc.Notes to Consolidated Financial StatementsFor The Years Ended May 31, 2010, 2009 and 2008NOTE 1SIGNIFICANT ACCOUNTING POLICIESNature of OperationsSchmitt Industries, Inc. (the “Company”) designs, manufactures, and markets computer controlled vibration detection and balancing equipmentprimarily to the machine tool industry. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc., the Company designs, manufactures andmarkets precision laser-based surface measurement systems for the disk drive, silicon wafer and optics industries; laser-based distance measurement anddimensional sizing products for a wide variety of commercial and industrial applications; and ultrasonic measurement products that accurately measure thefill levels of large liquefied propane tanks and transmit that data via satellite to a secure web site.Principles of ConsolidationThese consolidated financial statements include those of the Company and its wholly owned subsidiaries: Schmitt Measurement Systems, Inc.(“SMS”), Schmitt Europe, Ltd. (“SEL”) and Schmitt Industries (Canada) Limited. All significant intercompany accounts and transactions have beeneliminated in the preparation of the consolidated financial statements.Revenue RecognitionThe Company recognizes revenue for sales and billing for freight charges upon delivery of the product to the customer at a fixed and determinableprice with 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 Accounting Standards Codification (“ASC”) Topic 605. For sales to all customers, including manufacturerrepresentatives, distributors or their third-party customers, these criteria are met at the time product is shipped. When other significant obligations remainafter products are delivered, revenue is recognized only after such obligations are fulfilled. In addition, judgments are required in evaluating the creditworthiness of our customers. Credit is not extended to customers and revenue is not recognized until we have determined that collectability is reasonablyassured.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. TheCompany’s cash consists of demand deposits in large financial institutions. At times, balances may exceed federally insured limits.Short-Term InvestmentsAt both May 31, 2010 and 2009, short-term investments were $0. The carrying amount of short-term investments is stated at cost, which approximatesfair market value because of their short maturities. There were no related unrealized holding gains or losses at May 31, 2010 and 2009. 26Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 Accounts ReceivableThe Company maintains credit limits for all customers based upon several factors, including but not limited to payment history, published creditreports and use of credit references. Management performs various analyses to evaluate accounts receivable balances to ensure recorded amounts reflectestimated net realizable value. This review includes using accounts receivable agings, other operating trends and relevant business conditions, includinggeneral economic factors, as they relate to each of the Company’s domestic and international customers. If these analyses lead management to the conclusionthat potential significant accounts are uncollectible, a reserve is provided. The allowance for doubtful accounts was $23,387 and $38,233 as of May 31, 2010and 2009, respectively.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. Write-downs, when required, are made to reduce excessinventories to their net realizable values. Such estimates are based on assumptions regarding future demand and market conditions. If actual conditionsbecome less favorable than the assumptions used, an additional inventory write-down may be required. As of May 31, 2010 and 2009, inventories consistedof: May 31, 2010 May 31, 2009Raw materials $1,070,902 $1,525,618Work-in-process 980,971 730,609Finished goods 1,593,430 1,610,744 $3,645,303 $3,866,971Property 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. Expenditures for maintenance andrepairs are charged to expense as incurred.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.” Transaction gains and losses are included in net income (loss).AdvertisingAdvertising costs included in general, administrative and selling, are expensed when the advertising first takes place. Advertising expense was$56,463, $82,512 and $107,539 for the fiscal years ended May 31, 2010, 2009 and 2008, respectively. 27Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 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. The Company has adopted ASC Topic 718, which requires the measurement and recognition of compensation for all stock-based awards made toemployees and directors including stock options based on estimated fair values.Stock-based compensation recognized during the period is based on the value of the portion of the stock-based award that will vest during the period,adjusted for expected forfeitures. Compensation cost for all stock-based awards is recognized using the straight-line method.Income 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 currently has a valuation allowance against all of their net deferred tax assets. Management continues to review thelevel of the valuation allowance on a quarterly basis. There can be no assurance that the Company’s future operations will produce sufficient earnings so thatthe deferred tax asset can be fully utilized.Intangible AssetsAmortizable intangible assets, purchased technology and patents, are amortized over their estimated useful lives ranging from five to seventeen years.As of May 31, 2010 and 2009, amortizable intangible assets were $2,200,883 and $2,085,363 and accumulated amortization was $697,212 and $542,669,respectively. Amortization expense is expected to be approximately $162,000 in Fiscal 2011 and 2012, $129,000 in Fiscal 2013, $128,000 in Fiscal 2014and $113,000 in Fiscal 2015.Intangible and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of theasset may not be recoverable. Recoverability is determined by comparing the forecasted future net cash flows from the operations to which the assets relate,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, 2010, management did not believe impairment, as defined above, existed.Earnings (Loss) Per ShareBasic earnings (loss) per share is computed using the weighted average number of common shares outstanding. Diluted earnings (loss) per share iscomputed using the weighted average number of common shares 28Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase common stock. Common stock equivalents for stockoptions are computed using the treasury stock method. In periods in which a net loss is incurred, no common stock equivalents are included since they areantidilutive and as such all stock options outstanding are excluded from the computation of diluted net loss in those periods. 78,241 and 86,187 potentiallydilutive common shares from outstanding stock options have been excluded from diluted earnings (loss) per share for the years ended May 31, 2010 and2009, respectively.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 June 2009, the FASB issued SFAS No.168, “The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted AccountingPrinciples – a Replacement of FASB Statement No.162,” which establishes the FASB Accounting Standards Codification™ (the “Codification” or “ASC”) asthe source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by FASB to be applied by nongovernmental entities. Rulesand interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritativeGAAP for SEC registrants. On the effective date of this guidance, the Codification superseded all then-existing non-SEC accounting and reporting standards.All other non-grandfathered non-SEC accounting literature not included in the codification will become non-authoritative. The Company adopted ASCTopic 105 in the second quarter of Fiscal 2010. The adoption of ASC Topic 105 did not have a material impact on the Company’s financial statements.In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations”, which was incorporated into the Codification with ASCTopic 805 “ Business Combinations” This guidance establishes principles and requirements for how an acquirer in a business combination recognizes andmeasures in its financial statements the identifiable assets acquired, the liabilities assumed, and any controlling interest; 29Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to discloseto enable users of the financial statements to evaluate the nature and financial effects of the business combination. This guidance is to be appliedprospectively to business combinations for which the acquisition date is after May 31, 2009.In May 2009, the FASB issued SFAS No 165, “Subsequent Events”. The provisions of this standard were incorporated into the Codification with ASCTopic 855, Subsequent Events. This guidance is intended to establish general standards of accounting for and disclosure of events that occur after thebalance sheet date but before financial statements are issued or available to be issued. This guidance is effective for interim or annual financial periodsending after June 15, 2009. The Company has adopted this guidance.NOTE 2LINE OF CREDITIn February 2009, the Company renewed its $1.0 million bank line of credit agreement secured by U.S. accounts receivable, inventories and generalintangibles which expires on March 1, 2011. Interest is payable at the bank’s prime rate (3.25% as of May 31, 2010) or LIBOR plus 2.0%, (2.35% as ofMay 31, 2010). There were no outstanding balances on the line of credit at May 31, 2010 and 2009.NOTE 3LONG-TERM OBLIGATIONSAs of May 31, 2010, there were no outstanding obligations under capital leases or purchase contracts. The Company leases certain facilities andequipment to support operations under non-cancelable operating leases and other contractual obligations. Total rent expense for the years ended May 31,2010, 2009 and 2008 amounted to $36,348, $36,394 and $32,370, 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, 2011 $28,2502012 1,7882013 1,7882014 1,7882015 447Thereafter — NOTE 4INCOME TAXESThe provision for income taxes is as follows: Years ended May 31, 2010 2009 2008 Current $18,573 $(62,984) $590,761 Deferred (661,882) 144,858 (507,623) Change in valuation allowance 665,025 208,395 (75,000) Total provision for income taxes $15,430 $290,269 $8,138 30Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 Deferred tax assets are comprised of the following components: 2010 2009 Depreciation and amortization $378,140 $352,934 Inventory related items 251,228 202,475 Other reserves and liabilities 62,056 53,976 Net operating loss carryforward 676,249 72,055 General business and other credit carryforward 194,980 213,054 Other deferred items, net 5,463 8,597 Gross deferred tax assets 1,568,116 903,091 Deferred tax asset valuation allowance (1,568,116) (903,091) Net deferred tax asset $— $— 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 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. During Fiscal 2010, the Company increased its valuation allowance $665,025 as a result of the write-down of deferred tax assets. During Fiscal2009, the Company increased its valuation allowance $903,091 as a result of the write-down of deferred tax assets. This increase was partially offset by adecrease of $694,696 due to the expiration of the related capital losses. The Company has provided a full valuation allowance against all of its deferred taxassets as the recent losses have been given more weight than projected future income when determining the need for a valuation allowance.The Company has federal net operating loss carryforwards of approximately $1.7 million which expire in 2029 and 2030 along with the federal generalbusiness and other credit carryforwards. The Company has state net operating loss carryforwards of approximately $2.5 million which expire in 2024 and2025.The provision for income taxes differs from the amount of income taxes determined by applying the U.S. statutory federal tax rate to pre-tax income(loss) due to the following: Years ended May 31, 2010 2009 2008 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 39.2 11.2 — Expiration of capital loss carryforward — 37.3 — Stock-based compensation 1.9 3.2 1.6 Domestic production incentives — — (1.0) Export tax incentives — — (8.2) R&E tax credits (3.6) (6.4) — Effect of foreign income tax rates 0.3 (1.6) (12.0) Foreign jurisdiction statutory gain exclusion — 18.0 (25.0) Effect of tax rate changes — — 5.6 Effect of changes in tax contingencies — (7.0) — Permanent and other differences 1.5 (0.7) 1.3 Effective tax rate 0.9% 15.6% 0.7% 31Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 Each 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 ASC Topic 740.The Company applies this guidance by defining criteria that an individual income tax position must meet for any part of the benefit of that position to berecognized 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 ASC Topic 740. The adoption of ASC Topic 740 resulted in a $34,464 decrease in theCompany’s liability for unrecognized tax benefits, which was accounted for as an increase to the June 1, 2007 retained earnings balance. At June 1, 2007, thegross amount of unrecognized tax benefits was approximately $586,000, which included approximately $150,000 of net unrecognized tax benefits that, ifrecognized, would reduce the Company’s effective income tax rate. During the third quarter of Fiscal 2009, the Company completed an examination of itsfederal tax returns for the years ended May 31, 2005 through 2007. The Company recognized tax benefits of approximately $150,000 including interest andpenalties during Fiscal 2009.A reconciliation of the beginning and ending amount of unrecognized income tax benefits is as follows: 2010 2009 2008 Balance at beginning of year $— $450,833 $489,599 Decrease for tax positions taken (payment of tax) — — (38,766) Decrease for tax positions settled — (450,833) — Balance at end of year $— $— $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 ASC Topic 740. The liability for interest and penalties decreased to $0 due to the completionof the federal examination. The liability for payment of interest and penalties was $0 as of May 31, 2010 and 2009, respectively.Several tax years are subject to examination by major tax jurisdictions. In the United States, federal tax years for Fiscal 2007 and after are subject toexamination. In the United Kingdom, tax years for Fiscal 2006 and after are subject to examination. In Canada, tax years for 2005 and after are subject toexamination. In the United States, returns related to an acquired subsidiary for the year ended October 31, 1994 and final return for the period ended May 19,1995 are also subject to examination.NOTE 5COMMITMENTS AND CONTINGENCIESIn a transaction related to the acquisition of Schmitt Measurement Systems, Inc., formerly TMA Technologies, Inc. (“TMA”), the Company establisheda royalty 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 32Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 pool agreement, each former shareholder and debt holder released TMA from any claims with regard to the acquisition except their rights to future royalties.Royalty expense applicable to the years ended May 31, 2010, 2009 and 2008 amounted to $16,358, $19,352 and $47,344, 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: United States, Europe and Asia. Year Ended May 31, 2010 2009 2008 Balancer Measurement Balancer Measurement Balancer Measurement Gross sales $5,203,773 $2,225,083 $7,689,975 $2,573,139 $9,192,824 $3,039,809 Intercompany sales (533,050) (90,058) (718,896) (43,010) (778,704) (32,672) Net sales $4,670,723 $2,135,025 $6,971,079 $2,530,129 $8,414,120 $3,007,137 Operating income (loss) $(990,867) $(735,823) $(922,199) $(990,738) $1,053,310 $(193,350) Depreciation expense $147,775 $59,709 $143,084 $52,591 $122,353 $36,968 Amortization expense $— $154,543 $— $214,978 $— $79,663 Capital expenditures $46,201 $8,637 $134,476 $37,257 $119,927 $266,089 Geographic Information Year Ended May 31, 2010 2009 2008North America $3,308,958 $5,075,254 $6,305,626Europe 1,148,857 1,370,388 1,842,008Asia 2,171,993 2,722,762 2,811,167Other markets 175,940 332,804 462,456Total Net Sales $6,805,748 $9,501,208 $11,421,257 Year Ended May 31, 2010 2009 2008 United States Europe United States Europe United States EuropeOperating income (loss) $(1,746,621) $19,931 $(2,104,070) $191,133 $495,483 $364,477Depreciation expense $207,484 $— $195,518 $157 $152,916 $6,405Amortization expense $154,543 $— $214,978 $— $79,663 $— Capital expenditures $54,838 $— $171,733 $— $386,016 $— 33Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 Segment and Geographic Assets May 31, 2010 May 31, 2009Segment assets to total assets Balancer $4,425,280 $4,674,279Measurement 3,359,269 3,445,253Corporate assets 3,567,556 4,504,468Total assets $11,352,105 $12,624,000Geographic assets to long-lived assets United States $1,292,948 $1,427,838Europe — — Total assets $1,292,948 $1,427,838Geographic assets to total assets United States $10,947,605 $12,042,035Europe 404,500 581,965Total assets $11,352,105 $12,624,000Note—Europe is defined as the European subsidiary, Schmitt Europe, Ltd.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 25% 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, 2010, 2009 and 2008 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, May 31, 2006. All outstanding options will expire no later than 2018.Upon adoption of ASC Topic 718, 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 ASC Topic 718, the Black-Scholes option pricing model requires the input of 34Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 highly subjective assumptions, and other reasonable 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 does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Companyuses 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.The Company has computed, to determine stock-based compensation expense recognized for the years ended May 31, 2010, 2009 and 2008, the valueof all stock options granted using the Black-Scholes option pricing model as prescribed by ASC Topic 718 using the following assumptions: Year ended May 31, 2010 Year ended May 31, 2009 Year ended May 31, 2008Risk-free interest rate — 4.0% 3.6%Expected life — 4.8 years 4.8 yearsExpected volatility — 54.4% 56.7%Stock-Based Compensation Under ASC Topic 718The total stock-based compensation expense recognized under ASC Topic 718 was $93,420, $175,326 and $52,957 during Fiscal 2010, 2009 and2008, respectively. All stock-based compensation expense has been recorded as General, administration and sales expense in the Consolidated FinancialStatements. 35Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 At May 31, 2010, the Company had a total of 218,609 outstanding stock options (187,359 vested and exercisable and 31,250 non-vested) with aweighted average exercise price of $3.32. The Company estimates that a total of approximately $36,561 will be recorded as additional stock-basedcompensation expense during the fiscal year ending May 31, 2011, for all options which were outstanding as of May 31, 2010, but which were not yetvested. Outstanding Options Exercisable OptionsNumber of Shares Weighted AverageExercise Price Weighted AverageRemainingContractual Life (yrs) Number of Shares Weighted AverageExercise Price76,110 $1.20 1.8 76,110 $1.2062,499 2.30 4.0 62,499 2.305,000 5.80 5.4 5,000 5.8075,000 6.16 8 43,750 6.13218,609 $3.32 4.6 187,359 $2.84Options granted, exercised, canceled and expired under the Company’s stock option plan during the years ended May 31, 2010, 2009 and 2008 aresummarized as follows: Numberof Shares WeightedAverageExercise PriceOptions 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 2.89Options granted 50,000 6.25Options exercised — — Options forfeited/cancelled (19,875) 6.58Options outstanding—May 31, 2009 218,609 3.32Options granted — — Options exercised — — Options forfeited/cancelled — — Options outstanding—May 31, 2010 218,609 3.32The total intrinsic value of outstanding and exercisable options at May 31, 2010 was $726,080 and $532,455, respectively. The total intrinsic value ofoptions exercised during the years ended May 31, 2010, 2009 and 2008 was $0, $0 and $34,242, respectively.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 36Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 reconciliation of the numerators and denominators of the basic and diluted per share computations for each of the three years in the period ended May 31,2010: Income(Numerator) WeightedAverage Shares(Denominator) PerShareAmount Year ended May 31, 2010 Basic earnings per share Loss available to common stockholders $(1,711,013) 2,886,633 $(0.59) Effect of dilutive securities stock options — — Diluted earnings per share Loss available to common stockholders $(1,711,013) 2,886,633 $(0.59) Year ended May 31, 2009 Basic earnings per share Loss available to common stockholders $(2,153,524) 2,870,160 $(0.75) Effect of dilutive securities stock options — — Diluted earnings per share Income available to common stockholders $(2,153,524) 2,870,160 $(0.75) Year ended May 31, 2008 Basic earnings per share Income available to common stockholders $1,103,104 2,725,086 $0.40 Effect of dilutive securities stock options — 109,072 Diluted earnings per share Income available to common stockholders $1,103,104 2,834,158 $0.39 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. The Company made matching contributions inconjunction with employee contributions to the plan totaling $56,532, $55,122 and $49,252 during Fiscal 2010, 2009 and 2008, 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. Thecontract was terminated in February 2010. Product sales to PulverDryer during the fiscal years ended May 31, 2010, 2009 and 2008 totaled $1,408, $2,367and $16,468, respectively.In connection with the contract, the Board authorized Wayne Case, the Company’s Chief Executive Officer, to provide advisory services to PulverDryer, andpermitted Mr. Case to receive as compensation the total consulting 37Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 fees paid by PulverDryer from June 2004 through October 2004. From November 2004 to February 2010, Mr. Case received 40% of the ongoing consultingfee from PulverDryer, which percentage was determined by the Compensation Committee. Mr. Case also served on the board of directors of PulverDryerthrough the termination of the contract.NOTE 11ACQUISITIONSOptical DimensionsOn September 30, 2009, the Company completed an Asset Purchase Agreement (the “Agreement”) with Optical Dimensions, a sole proprietorship,pursuant to which the Company acquired all of the assets and assumed certain liabilities of Optical Dimensions. As a result, the Company now owns andoperates Optical Dimensions’ business, including its patented laser light scatter roughness measurement technology. The total purchase price for theacquisition was $200,293 which includes the value of the shares issued and the cash paid. The Agreement provided that the Company pay cash of $100,000and issue 24,642 shares of common stock of the Company. The number of shares issued was equal to $100,000 of value based on the average closing price ofthe Company’s common stock, as reported on the NASDAQ National Market, over the five-day period immediately prior to closing. Based upon the closingprice on September 30, 2009, as reported on the NASDAQ Capital Market, the aggregate non-cash value of the Company’s 24,642 shares issued was$100,293.The following table summarizes the estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition: Tangible assets and liabilities assumed: Receivables $33,434 Inventory 40,000 Property and equipment 17,757 Prepaid expenses 2,955 Accounts payable (9,374) Intangible assets Purchased technology 115,521 $200,293 The allocation process requires an analysis and valuation of acquired assets, including technologies, customer contracts and relationships and tradenames, and liabilities assumed, including contractual commitments and legal contingencies. The values assigned to certain acquired assets and liabilities arepreliminary, are based upon information available as November 30, 2009, and may be adjusted as further information becomes available. Additionalinformation that may become available subsequently and may result in changes in the values allocated to various assets and liabilities includes, but is notlimited to, unidentified claims from suppliers or other contingent obligations and the amounts required to settle them. Any changes in the values allocated totangible and specifically identified intangible assets acquired and liabilities assumed during the allocation period may result in an adjustment to intangibleassets.Purchased technology relates to Optical Dimensions’ patented laser light scatter roughness measurement technology that has reached technologicalfeasibility. The fair value of the purchased technology is being amortized over the expected useful life of five years. 38Schmitt Industries, Inc.Notes to Consolidated Financial Statements—(Continued)For The Years Ended May 31, 2010, 2009 and 2008 Xtero Datacom IncOn 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”). Asconsideration for the Xtero shares, the Company issued 199,977 shares of Company common stock to the Xtero shareholders. In addition, Xtero shareholderswill be eligible to receive 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-taxearnings derived from 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 with reliance upon Section 3(a) (10) of the Securities Act of 1933 (the Act), which exempts judicially approved share exchanges from the Act’sregistration requirements. On January 29, 2008, the Supreme Court of British Columbia granted a final order approving the transaction. Based upon theclosing price of the Company’s common stock of $5.90 on February 20, 2008 as reported on the NASDAQ Capital Market, the aggregate value of theCompany’s 199,977 shares issued to the Xtero shareholders was approximately $1,179,865. The aggregate purchase price for the acquisition was $1,797,367which includes the value of shares issued, advances of $500,000 to Xtero prior to February 20, 2008 on a convertible promissory note and other transactioncosts.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. The values assigned to certain acquiredassets and liabilities are preliminary, are based on information available as of May 31, 2008, and may be adjusted as further information becomes available.Additional information that 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 taxassets and liabilities. Any changes in the values allocated to tangible and specifically identified intangible assets acquired and liabilities assumed during theallocation period may result in adjustments to intangible assets. During the fourth quarter of Fiscal 2009, the Company filed tax returns in Canada related tothis acquisition which resulted in changes to the preliminary values assigned to the deferred tax liabilities and the intangible asset. Based on the tax returnfilings and elections available to treat the Xtero acquisition as a purchase of assets for tax purposes, the tax basis of the underlying assets was increased whicheliminated the deferred tax liability originally recognized at the acquisition date. As a result of the elimination of the deferred tax liability originallyrecorded, the value of the intangible asset decreased to $1,663,539.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 original useful life of 15 years. 39Report of Independent Registered Public Accounting FirmBoard of Directors and ShareholdersSchmitt Industries, Inc.We have audited the accompanying consolidated balance sheet of Schmitt Industries, Inc. and its subsidiaries as of May 31, 2010, and the relatedconsolidated statement of operations, changes in stockholders’ equity and comprehensive income and cash flows for the year ended May 31, 2010. Thesefinancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based onour audit.We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company isnot required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonablebasis 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, 2010 and the results of its operations and its cash flows for the year ended May 31, 2010 in conformity with accounting principles generallyaccepted in the United States of America./s/ MOSS-ADAMS LLPPortland, OregonJuly 30, 2010 40Report of Independent Registered Public Accounting FirmBoard of Directors and ShareholdersSchmitt Industries, Inc.We have audited the accompanying consolidated balance sheet of Schmitt Industries, Inc. and its subsidiaries as of May 31, 2009 and the relatedconsolidated statements of operations, changes in stockholders’ equity and comprehensive income and cash flows for each of the two years in the periodended May 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal controlover financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinionon the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining,on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis forour opinion.In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Schmitt Industries, Inc.as of May 31, 2009 and the results of its operations and its cash flows for each of the two years in the period ended May 31, 2009 in conformity withaccounting principles generally accepted in the United States of America./s/ GRANT THORNTON LLPPortland, OregonJuly 31, 2009 41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, the CEO and CFO have concluded that the Company’s disclosure controls and procedures are 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 effective as of May 31, 2010.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, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B.Other InformationNone. 42PART IIICertain information required by Part III is included in the Company’s definitive Proxy Statement for its 2010 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 2010 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 2010 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 2010 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 2010 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 2010 Annual Meeting of Shareholders and isincorporated herein by reference. 43PART IV Item 15.Exhibits and Financial Statement Schedules (a)Financial Statements: (1) Consolidated Balance Sheets as of May 31, 2010 and 2009 Consolidated Statements of Operations for the years ended May 31, 2010, 2009 and 2008 Consolidated Statements of Cash Flows for the years ended May 31, 2010, 2009 and 2008 Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the years ended May 31, 2010, 2009 and 2008 Notes to Consolidated Financial Statements for the years ended May 31, 2010, 2009 and 2008 Reports of Independent Registered Public Accounting Firms(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 44 of the Exhibits filed with this report. 44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 Boardand Chief Executive OfficerDate: July 30, 2010Pursuant 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 July 30, 2010. Signature Title/s/ WAYNE A. CASE Wayne A. Case Chairman of the Board and Chief Executive Officer (Principal ExecutiveOfficer)/s/ JAMES A. FITZHENRY James A. Fitzhenry Director and President/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 45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] *2.3 Asset Purchase Agreement between Schmitt Industries, Inc., and Glenn Valliant, an individual doing business as Optical Dimensions, datedSeptember 30, 2009.[Form 10-Q for the fiscal quarter ended November 30, 2009, Exhibit 2.1] *3.1 Second Restated Articles of Incorporation of Schmitt Industries, Inc.[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 3(i)] *3.2 Second Restated Bylaws of Schmitt Industries, Inc.[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.[Form 10-K for the fiscal year ended May 31, 1999, Exhibit 10.1]*10.2† 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, 2010. 23.1 Consent of Independent Registered Public Accounting Firm. 23.2 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-Oxley Actof 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. 46EXHIBIT 21.1SUBSIDIARIES OF SCHMITT INDUSTRIES, INC.AS OF MAY 31, 2010 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 consent to the incorporation by reference in the Registration Statement (No. 333-03910) on Form S-8 of our report dated July 30, 2010, relating tothe consolidated financial statements appearing in this Annual Report on Form 10-K of Schmitt Industries, Inc. for the year ended May 31, 2010./s/ Moss-Adams LLPPortland, OregonJuly 30, 2010EXHIBIT 23.2CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe have issued our report dated July 31, 2009, with respect to the consolidated financial statements included in the Annual Report of SchmittIndustries, Inc. on Form 10-K for the year ended May 31, 2010. We hereby consent to the incorporation by reference of said report in the RegistrationStatement of Schmitt Industries, Inc. on Form S-8 (No. 333-03910, effective August 18, 2004)./s/ Grant Thornton LLPPortland, OregonJuly 30, 2010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: July 30, 2010 /s/ WAYNE A. CASE Wayne A. Case,Chairman of the Board 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: July 30, 2010 /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, 2010 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 and ChiefExecutive 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 Boardand Chief Executive OfficerJuly 30, 2010/s/ JEFFREY T SIEGAL Jeffrey T SiegalChief Financial Officer and TreasurerJuly 30, 2010

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