Schmitt Industries, Inc.
Annual Report 2012

Plain-text annual report

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549 FORM 10-K (Mark One) xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended: May 31, 2012or ¨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 LLCSecurities registered pursuant to Section 12(g) of the Act:None Indicate 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 Exchange Act. 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 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has been subject to such filing requirements 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 File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 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. See definitions 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, 2011, the last business day of the registrant’s most recently completed second fiscal quarter, wasapproximately $7,975,000 based upon the closing price of $3.75 reported for such date on the NASDAQ Capital Market. For purposes of this disclosure, shares of Common Stock held by persons who holdmore than 10% of the outstanding shares of Common Stock and shares held by officers and directors of the registrant, have been excluded because such persons may be deemed to be affiliates. This determinationis not necessarily conclusive for other purposes.As of July 31, 2012, the registrant had 2,990,910 outstanding shares of Common Stock. Documents Incorporated by ReferencePortions of the registrant’s definitive Proxy Statement for its 2012 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 of Operations” inItem 7, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding future events and thefuture results of Schmitt Industries, Inc. and its consolidated subsidiaries (the “Company”) that are based on management’s current expectations, 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. These statements are not guarantees offuture performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differmaterially from what is expressed or forecasted in such forward-looking statements due to numerous factors, including, but not limited to, those discussed inthe “Risk Factors” section in Item 1A, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and elsewherein this Report as well as those discussed from time to time in the Company’s other Securities and Exchange Commission filings and reports. In addition, suchstatements could be affected by general industry and market conditions. Such forward-looking statements speak only as of the date of this Report or, in thecase of any document incorporated by reference, the date of that document, and we do not undertake any obligation to update any forward-lookingstatement to reflect events or circumstances after the date of this Report. If we update or correct one or more forward-looking statements, investors andothers should not conclude that we will make additional updates or corrections with respect to other forward-looking statements.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 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 registered 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, vibration sensor,spindle-mounting adapter, and balance head. It is designed as an economical yet highly accurate permanent installation on grinding machines. SBS productscan detect and correct for vibration as small as 0.02 microns. The Company acquired its original balancing equipment technology pursuant to a series ofagreements from 1987 through 1991, substantially enhancing and advancing the patented technology since that time. Since inception of the product line, thetargeted customer base has been manufacturers and operators of grinding machines for a variety of industries such as automotive, aerospace, medical andmachine tools, where operating tolerances on manufactured parts are exceedingly precise. Page 2The SBS System is fully automated, eliminating the need to pre-balance parts such as grinding wheels. This reduces machine setup time and ensures asmoother and more efficient operation. Operating on a principle of mass compensation for wheel imbalance, the balance head contains two movable eccentricweights, each driven by electric motors through a precision gear train. These weights are repositioned to offset any imbalance in a grinding wheel or otherapplication. Imbalance or vibration is picked up by the sensor that feeds a signal to a controller which 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 to monitorthe very high frequency signals generated on the grinding machine during key events in the grinding process. The AEMS system allows rapid, automaticgrinding wheel in-feed, right up to the point of initial contact with a new part loaded in the machine. The system can automatically detect the initial contactand very quickly report this event to the machine control, stopping the wheel in-feed without operator intervention. Part crash occurs when a part or fixture isincorrectly loaded into a grinding machine or some abnormal condition occurs. Rapid in-feed of the wheel may then result in a dangerous or expensive crash.The AEMS system allows the CNC control to monitor the acoustic levels on the machine and detect any unexpected contact when it happens. The systemthen 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 grinding 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 units ofmeasurement, instrument grade calibration, short balance process, measurement of both displacement and/or velocity and minimal operator 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 and taperedtypes), ceramics (precision shaping), electric motors (shafts), pumps (shafts and turbines), aircraft (engine parts), and general manufacturing. Precisiongrinding has an established worldwide presence in all industrialized countries and is expanding as a method of material removal and processing. 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 machine tool original equipment manufacturers (OEMs), who incorporatethe SBS System 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 tear the old machine apart and install new components, such as the SBS System. TheCompany currently sells its products directly to major machine rebuilders throughout the world. Page 3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, 2012, May 31, 2011 and May 31, 2010 (Fiscal 2012, 2011 and 2010), net sales of the Company’s balancing products totaled$9.3 million, $8.0 million and $4.7 million, respectively. Net sales of balancing products accounted for 64%, 70% and 69% of the Company’s total sales inFiscal 2012, 2011 and 2010, 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 products requirespecial setup and training or calibration to the specific machine. The Company believes the SBS System is currently one of the few products that can fit allmachines 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 electromechanical andwater 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 requested byusers. They require plumbing and water chambers to be machined into the wheel hub. To install these systems, the grinding machines must be disassembledand parts remachined or replaced within the spindle assembly. The water system is “tuned” or “calibrated” to the machine by a factory service technician andare suitable for mid and high speed spindle environments.Pricing of the SBS system is intended to maintain the status of the SBS system as the premier product in the industry, offering best quality, reliability andperformance and superior economic value.Measurement SegmentWithin the Measurement segment, the Company designs, manufactures and markets several laser-based precision test and measurement product lines and anultrasonic product for measuring the fill levels of 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, remote tankmonitoring, 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 surface measurement teststhat quantify surface micro-roughness. The technology is extremely precise, measuring surface roughness at the molecular (sub-Angstrom) level. Products aresold to manufacturers of hard disk drives, silicon wafers and optical products and industries with fabrication processes that require precise and reliablemeasurements. Page 4Computer hard disk drives require exact manufacturing control and a narrow tolerance band for acceptable roughness, with surface roughness outside thatnarrow band resulting in a reduction in data density or storage capacity. The Company’s technology simultaneously measures disk surface roughness in twodirections, radially, when the read/write head is moving to another disk sector, and circumferentially, when the read/write head is processing information onthe disk. The two separate roughness levels are required for proper head operation. The Company believes the precise measurement methods provided by itsproducts are not possible through any other cost effective measurement means.The following two products meet the challenges of disk drive manufacturers: • The TMS-2000-RC (Texture Measurement System) product is an accurate non-contact texture measurement system. The product (used onaluminum substrates) is currently used worldwide by most major disk drive manufacturers, providing fast, accurate and repeatablemicroroughness measurements while quadrupling production throughput when compared to other testing devices. Surface roughness can bemeasured to levels below 0.5 Angstroms (the point of a needle is one million Angstroms in diameter). • The TMS-2000-DUV-RC product measures the surface microroughness of ceramic/glass rather than aluminum substrates. Manufacturers requirethe technology and products to measure surface roughness of these ceramic/glass substrates to the same exact levels as those that measurealuminum. The deep ultra-violet (DUV) light 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 precision toincrease performance and capacity and these products help achieve those goals. Silicon wafers are carefully cut and polished to provide the base upon whicha computer or memory chip is produced. Therefore, chip manufacturing is extremely dependent on the beginning surface roughness of the wafer. Since allsilicon wafers exhibit a microscopic level of surface roughness, stemming from production techniques such as chemical deposition, grinding, polishing andetching, some method of measuring these surface characteristics is required. The Company’s wafer measurement products provide a way for customers in thisindustry to quantify and control their manufacturing process. The system provides measurements to less than 0.5 Angstroms, a level unachievable bycompeting devices.The Company also offers the Lasercheck line of surface roughness measurement gauges. Lasercheck is a unique laser-based non-contact roughness gaugeincorporating patented laser light-scatter technology that can make precise repeatable surface roughness measurements in the 0.025 to 2 micron (<1.0 to 80micro inches) range. Lasercheck provides high-speed in-process measurements in a fraction of a second and is optimized for surface measurements of ground,sanded, polished, hone, super-finished and shot-blasted surfaces. The Lasercheck line of surface measurements gauges is a complementary fit to the TMSsurface 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 and are sold under the Acuity brand. Presently, there are 11 product lines offered under the Acuity brand: The AccuRange (AR) 1000, AR2500,AR3000 and AR4000 distance measurement sensors, the AR4000 Line Scanner and the AR700, AR500 and AR200 series of triangulating laser displacementsensors, the AR CCS Prima, and the AccuProfile (AP) 620 and AP820 laser line scanners. Page 5The AR1000, AR2500 and AR3000 distance measurement lasers utilize pulsed time of flight measurement principles to accurately measure distances of up to30 meters (up to 300 meters with retro-reflective tape) with the AR1000, up to 50 meters (500 meters with retro-reflective tape) with the AR2500 and up to300 meters (3000 meters with retro-reflective tape) with the AR3000. Both products are highly versatile, being able to measure distances both indoors andoutdoors. Applications include load confirmation, alignment, lumber positioning, crane monitoring, fill level measurement, velocity measurement and laseraltimeter.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 AR4000 Line Scanner is used with the AR4000 to scan and collect distance data over a full circle. The scanner consists of a balanced, rotating mirror andmotor with position encoder and mounting hardware for use with the AR4000. The scanner deflects the beam 90 degrees, sweeping it through a full circle asit 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 and lightweight.The AR700 is a triangulation laser displacement sensor that provides superior performance in terms of accuracy, repeatability, and sample speed. The AR700boasts 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 single second. Theunit is also very compact, measuring approximately 80% smaller than its predecessor, the AR600. Model variations permit applications up to 50 inches inrange. Applications include high speed road profiling, product dimensional or thickness measurement, rubber thickness measurement, lumber or plywoodthickness measurement, carton dimensioning and product positioning.The AR500 is a compact triangulation laser displacement sensor that provides accurate measurements (+/- 0.015% linearity) at high speeds (standard to 9400Hz, high speed option up to 56K Hz). The same compact enclosure houses models with ranges from 5 to 1000 millimeters. Sensor options include blue laserdiodes, faster speeds and cooling jackets. Applications include radiating surfaces and high speed applications such as road texture, ballistics and high speedevent monitoring.The AR200 line is the Company’s most compact series of triangulating laser displacement sensors. Four models cover metric measurement ranges from 6 to50 millimeters. All models boast a 1/500 accuracy rating for measurements within twelve microns. The AR200 sensor is the only sensor of its kind to featurepushbutton selection of output signals. All models are standard with analog, limit switch and serial outputs. The AR200 sensors, much like the longer-rangeAR700 sensors, project a beam of visible laser light that creates a spot on the target surface. Reflected light from the surface is viewed from an angle by a linescan camera and the target’s distance is computed from the image pixel data. The AR200-6M, -12M, -25M and -50M have ranges in millimeters that matchtheir model number. The AR200 displacement sensor cannot be overloaded and measures accurately even when a mirror reflects the entire light beam back tothe detector.The AR CCS Prima white light confocal displacement sensor is the most precise measurement system from Acuity. Using a novel optical principle ofmeasuring the reflected light’s component wavelengths, these confocal sensors measure distance and position to within tens of nanometers. These compactprobes can measure to opaque, shiny or even transparent surfaces. Unlike the other Acuity distance sensors, the Prima Confocal systems are comprised of anoptical measurement “pen” and a separate controller. This controller houses all of the electronics, light source, etc. Only emitted white light and reflectedsignals are passed between the pen and the Page 6controller via a thin fiber-optic transmission cable. The Confocal-Chromatic Sensors (CCS) are offered in a variety of measurement ranges and standoffdistances, each with a corresponding resolution. The shortest-range models resolve to 5 nanometers of height change.The AccuProfile™ 620 Profile Measuring Sensor is Acuity’s short-range laser scanner for industrial contour and shape measuring applications. These laserprofile scanners quickly and accurately generate 2D profile scans of objects, surfaces or scenes using high-speed digital CMOS detectors and a tuned laserline generator. Individual profiles may be collected to create a 3D point cloud of that object. The laser profile sensor is the equivalent of using 1024 closely-spaced, single-point laser sensors to measure across a surface. Acuity has several AP620 sensors with varying ranges (Z axis) and Fields of View (x axis). Inaddition to measuring profiles and shapes, the line sensor is frequently used for measuring dimensions for radius, diameter, height, width, etc. This profilemeasuring instrument is fast, sampling up to 250 line scans per second. The profile data is transmitted directly from the sensor head via Ethernet to a hostcomputer. No special controller is required to operate the device.The AccuProfile™ 820 is a two dimensional laser scanner that measures surface height profiles by projecting a beam of visible laser light that creates a lineon a targeted surface. The AP820 is a highly accurate sensor for industrial surface dimensional and measurement applications. The scanner quickly andaccurately generates low-noise 2D or 3D profile scans of objects, surfaces or scenes. The sensor automatically adjusts laser power and detector exposure tocompensate for varying surface conditions. Typical scanner applications include weld gap tracking and weld bead profiling, positional control of objects andsurfaces, tire profiling, wheel profiling, surface profiling, 3D profile generation and dimensional measurement.Remote Tank Monitoring ProductsThe Company’s product line is called the Xact Tank Monitoring System. The Xact system utilizes ultrasonic technology to determine the fill levels of largeor small storage tanks, such as for liquefied propane. An ultrasonic sensor is applied externally to the tank to calculate the liquid level inside a large tank to+/- 2% (+/- 1% for small tanks) and transmit that data via the Globalstar™ satellite network to a secure website for display. Each sensor, which is affixed tothe exterior underside of each tank, produces a small electrical pulse, or a “ping,” that travels through the tank’s steel shell, which is reflected off the bottomsurface of the liquid stored in the tank in the form of an echo that is detected. The time of flight between the “ping” and the echo is then calculated todetermine, based upon additional data regarding tank size and shape, the volume of liquid the tank contains. This information is then remotely transmittedvia a satellite transceiver that is affixed to the top of the tank to a secure website on the internet, processed using proprietary software and displayed on thatwebsite or automatically directed to a customer’s automated inventory or delivery management system. Operators can now obtain highly accurate readingsand tank information from even the most remote tanks conveniently and cost-effectively using their desktop computer, laptop, iPad or smart phone. With theXact system, minimum or maximum alarm or fill levels can be set to automatically notify operators by email anytime a particular tank reading exceedsthresholds and needs filling. The Xact system can be used to monitor tanks as small as 125 gallons (473 liters) and as large as 90,000 gallons (340,686 liters).With Xact, operators can obtain timely and accurate readings of inventory levels and tank refill requirements instantly.Laser Light-Scatter Surface Measurement ProductsThe Company’s CASI Scatterometers are sold to companies and institutions involved in scientific research and development. The CASI Scatterometer usesvisible, 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. Page 7The MicroScan system is a portable device consisting of a hand-held control unit, an interchangeable measurement head and a separate charging unit. Toperform a measurement, the operator places the measurement head on the objective area and presses a button. Each measurement takes less than five secondswith results displayed and stored in system memory. The MicroScan can store 700 measurements in 255 files and provides the capability to program pass/failcriteria. Software is available for control, analysis and file conversion. From a single measurement, a user can determine RMS surface roughness, reflectanceand scatter light levels (BRDF) on flat or curved surfaces under any lighting conditions.Light-Scatter Measurement LaboratoryThe Company provides a highly advanced measurement services laboratory, using CASI Scatterometers, to a wide variety of industrial and commercialbusinesses that require precise measurements only advanced laser light scatter technology can provide. The value of the laboratory is not only its extremelyprecise measurement capability but also the test item is not altered, touched or destroyed. Thus, the laboratory is widely used by manufacturers of criticaloptical components in aerospace and defense systems and other industrial companies, universities and government agencies.In Fiscal 2012, 2011 and 2010, net sales of Measurement products totaled $5.2 million, $3.5 million and $2.1 million, respectively, and accounted for 36%,30% and 31% of the Company’s total sales in Fiscal 2012, 2011 and 2010, 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 customers including computer hard disk and silicon wafer manufacturers. The Companybelieves its surface measurement products are currently the only systems that can provide measurements as low as a few hundredths of an Angstrom (Å-a unitof measure equal to 1 hundred-millionth of a centimeter) with reproducibility +/- 0.2Å or 1% and repeatability of +/-0.1Å. There are differences between oursurface measurement products and other optical techniques (which include profilometers, scanning tunneling microscopes, atomic force microscopes orinterferometers). These other technologies require the intervention of a skilled operator and perform measurements relatively slowly, whereas our surfacemeasurement products are much simpler and, consequently, can make measurements more rapidly while still maintaining excellent repeatability andaccuracy. Stylus profilometers are simpler devices that require less skilled operators. However, measurements must be conducted under vibration isolationconditions, and large areas require numerous scans; thus, stylus profilometers are generally destructive to soft materials such as most coated optics.The market for distance measurement and dimensional sizing products is extremely competitive, characterized by rapidly changing technology. TheCompany believes the principal elements of competition include quality of ongoing technical support and maintenance coupled with responsiveness tocustomer needs, as well as price, product quality, reliability and performance. The differences between the Company’s sensors and competitive productsinclude pushbutton selection of output signals in certain models and sensors that can be programmed using serial commands through a PC computer. TheAR200 displacement sensor cannot be overloaded and measures accurately even when a mirror reflects the entire light beam back to the detector.Competing surface measurement products and dimensional sizing products come from established multinational competitors, most of which are significantlylarger and have greater financial, engineering, manufacturing and marketing resources. Company pricing is intended to obtain market share and meetcompetitive supplier prices. The market strategy is to establish measurement products with the best quality, reliability and performance and superioreconomic value. Page 8Sales by Geographic AreaIn Fiscal 2012, 2011 and 2010, the Company recorded net sales of its products in the United States, its country of domicile, of $8.1 million, $5.6 million and$3.1 million, respectively. Net sales in the last three fiscal years by geographic areas are: NorthAmerica Europe Asia Others Fiscal 2012 $9,074,152 $1,145,449 $3,814,656 $402,765 Fiscal 2011 $6,037,847 $1,130,480 $3,990,371 $334,161 Fiscal 2010 $3,308,958 $1,148,857 $2,171,993 $175,940 Business and Marketing StrategyThe Company designs, manufactures and markets all of its products with operations divided into a number of different channels and geographies.Balancer Segment ProductsThe Company markets and sells its SBS products in a variety of ways. First are the channels provided by independent manufacturers’ representatives anddistributors. There are currently approximately 100 individuals and/or organizations throughout the world acting in one of these capacities, includingapproximately 25 in the United States and 30 in China.Second, OEMs integrate the Balancer segment products on the machine tools they produce. Users thus purchase the SBS products concurrently with themachine tools. Conversely, end users of grinding machines that have purchased the SBS system directly from the Company, and after enjoying the benefits ofthe products, often request that SBS products be included with the new equipment they order from OEMs. The SBS Systems are often installed by machinetool builders prior to displaying their own machine tools at various trade shows, becoming endorsements that prove beneficial to the Company’s sales efforts.Third, worldwide trade shows have proven to be an excellent source of business. Company representatives, usually one or more of the marketing managersand the CEO or President, attend these events along with local Company representatives. These individuals operate a display booth featuring an SBS Systemdemonstration stand and product and technical literature. Representatives from all facets of the Company’s target markets attend these trade shows.In North America and Asia, products are shipped directly to customers from the Company’s distribution center in Portland, Oregon. Where the Company hasdistributors, the product is shipped to the distributor, who in turn pays the Company directly and then delivers and installs the product for the end user.European distribution to customers is handled by shipping the product directly from the Company’s Portland headquarters to its European subsidiary in theUnited Kingdom, which in turn sells and distributes the products.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 directs theoverall worldwide marketing efforts for surface measurement and remote tank monitoring products. Second, both a marketing and a sales manager, direct theoverall worldwide marketing and sales efforts for distance measurement and dimensional sizing products. Third, the Company has an exclusive distributionagreement with a company in Asia for the promotion and sale of surface measurement products in China, Taiwan, Malaysia, Singapore, Thailand and thePhilippines. In addition, there are distribution agreements with one company in Japan and two in Korea. Trade shows also represent a significant amount ofmarketing/sales effort. Company representatives operate a display booth featuring Page 9demonstrations of Measurement segment products along with product and technical literature. Representatives from all facets of the market to which theCompany directs its sales efforts attend these trade shows. Finally, one of the best marketing channels is the testing laboratory. Once customers see thecapabilities of the technology, it can lead to orders for the Company’s laser-based light-scatter measurement products.All Measurement segment products are assembled in the Portland, Oregon facility and shipped worldwide directly to customers. The Balancer andMeasurement segment customer bases each consist of over 250 companies.BacklogThe Company does not generally track backlog. Normally, orders are shipped within a week or two 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.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. In the event of supply problems, the Company believes that two or three alternatives could be developed within 30 days. TheCompany is subject to availability and pricing on the various components parts purchased, which has had, and may continue to have, a material impact onoperations.The Company uses in-house skilled assemblers to construct and test vendor-supplied components. Component inventory of finished vendor-supplied parts isheld on Company property to assure adequate flow of parts to meet customer order requirements. Inventory is monitored by a computer control systemdesigned to assure timely re-ordering of components. 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. In 2005, the Company received its certification to the newer ISO9001:2000 requirements and in 2011 received its recertification.Proprietary TechnologyThe Company’s success depends in part on its proprietary technology, which the Company protects through patents, copyrights, trademarks, trade secrets andother measures. The Company has U.S. patents covering both Balancer and Measurement products, processes and methods that the Company believesprovide it with a competitive advantage. The Company has a policy of seeking patents where appropriate on inventions concerning new products andimprovements developed as part of its ongoing research, development and manufacturing activities. While patents provide certain legal rights ofenforceability, there can be no assurance the historic legal standards surrounding questions of validity and enforceability will continue to be applied or thatcurrent defenses with respect to issued patents will, in fact, be considered substantial in the future. There can be no assurance as to the degree and range ofprotection any patent will afford and whether patents will be issued or the extent to which the Company may inadvertently infringe upon patents granted toothers. Page 10The Company manufactures its Balancer segment products under copyright protection in the U.S. for electronic board designs. Encapsulation of the finishedproduct further protects the Company’s technologies including software.The Company also relies upon trade secret protection for its confidential and proprietary information. There can be no assurance that others will notindependently develop substantially equivalent proprietary information and techniques or otherwise gain access to the Company’s trade secrets or disclosesuch technology or that the Company can meaningfully protect its trade secrets.While the Company pursues patent, trademark, trade secret and copyright protection for products and various marks, it also relies on know-how andcontinuing technology advancement, manufacturing capabilities, affordable high-quality products, new product introduction and direct marketing efforts todevelop and maintain its competitive position.Product DevelopmentThe Company maintains an ongoing research and development program to expand the product lines and capabilities of its business segments. The goal ofthis program is to expand the product base in historic markets and to enter new market areas so as to reduce reliance on historic market segments. Forexample, in the past fiscal year, the Company has developed and introduced the SB-1000 in manual balancing mode together with a docking station, acontrol card to control the dressing process of grinding wheels, and a new internal balancer design. The Company has also introduced several new lasersunder the Acuity line and introduced the Xact Tank Monitoring System for small propane tanks.During Fiscal 2012, 2011 and 2010, the Company’s research and development expense totaled $318,000, $504,000 and $585,000, respectively.EmployeesAs of July 31, 2012, the Company employed 48 individuals worldwide on a full-time basis. There were also seven part-time or temporary employees. None ofthe Company’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-looking statements madeby 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 anduncertainties described below are not the only ones that the Company faces. Unforeseen risks could arise and problems or issues that the Company now viewsas minor could become more significant. If the Company were unable to adequately respond to any risks, the Company’s business, financial condition orresults of operations could be materially adversely affected. In addition, the Company cannot be certain that any actions taken to reduce known or unknownrisks and uncertainties will be effective.The general economic conditions and uncertainties 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 and automotivesectors, and their impact on levels of capital investment, which have deteriorated significantly in the past and may become depressed, or be subject to furtherdeterioration. Economic factors that could adversely influence demand for the Company’s products include uncertainty about global economic conditionsleading to reduced levels of investment, customers’ and suppliers’ access to credit, unemployment and other macroeconomic factors affecting commercialand industrial spending behavior. Page 11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 introduction of the Xact Tank Monitoring System may not become commercially viable and satisfy expected demandIn May 2009, the Company announced the introduction of the Xact Tank Monitoring System for measuring fill levels of industrial liquefied propane tanksand communicating that data via satellite to a secure web site. Although the initial acquisition and further development of the Xact product have negativelyimpacted recent operating results, the product should allow the Company to enter new measurement markets and is expected to add sales and profits to theCompany in future years. However, the introduction of the Xact product may not be successful, anticipated market demand for the product may notmaterialize, and additional product or market opportunities may not be identified and developed and brought to market in a timely and cost-effectivemanner. Also, the Company may not be able to meet the manufacturing requirements of large orders in a timely and cost-effective manner. All of this couldcontinue 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, which couldresult in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design, develop, manufacture,assemble, test, market and support new products and enhancements on a timely and cost-effective basis. New product opportunities may not be identified anddeveloped and brought to market in a timely and cost-effective manner. Products or technologies developed by other companies may render products ortechnologies obsolete or noncompetitive, or a fundamental shift in technologies in the product markets could have a material adverse effect on theCompany’s competitive position within historic industries.Failure to protect intellectual property rights could adversely affect future performance and growthFailure to protect existing intellectual property rights may result in the loss of valuable technologies or paying other companies for infringing on theirintellectual property rights. The Company relies on patent, trade secret, trademark and copyright law to protect such technologies. There is no assurance anyof the Company’s U.S. patents will not be invalidated, circumvented, challenged or licensed to other companies.Competition is intense and the Company’s failure to compete effectively would adversely affect its businessCompetition in the markets for the Company’s products is intense. The speed with which companies can identify new applications for the Company’s varioustechnologies, develop products to meet those needs and supply commercial quantities at low prices to those new markets are important competitive factors.The principal Page 12competitive factors in the Company’s markets are product features, performance, reliability and price. Many of the Company’s competitors have greaterfinancial, technical, research and development and marketing resources. No assurance can be given that the Company will be able to compete effectively inthe future, and the failure to do so would have a material adverse effect on the Company’s business, financial condition and results of operations.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 adversely affectedif adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increased significantly.The Company may not be able to ramp up manufacturing to satisfy increasing orders, which may lead to the loss of significant revenue opportunitiesThe Company manufactures several different product lines, all of which involve complicated technology and individual attention for each product made.The production time for each product can vary, depending on a variety of circumstances, including component availability, timing of delivery ofcomponents from suppliers and employee availability. Should the Company receive a large increase in orders, an increase in the size of orders or a shorteningof the required delivery time on existing orders, the Company may not be able to ramp up manufacturing to satisfy customer expectations, which may lead tothe loss of significant revenue opportunities.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 aresult of quarterly operating fluctuations, it is important to realize quarter-to-quarter comparisons of operating results are not necessarily meaningful andshould not be relied upon as indicators of future performance.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, thereis no guarantee management could take actions that would further reduce operating expenses in either a timely manner or without seriously impacting theoperations of the Company.The Company maintains a significant investment in inventories in anticipation of future 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 Page 13and retained. There is also no guarantee that key employees will not leave and subsequently compete against the Company. The inability to attract and retainkey 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 to beearned and taxed; the resolution of issues arising from future, potential tax audits with various tax authorities; changes in the valuation of our deferred taxassets and liabilities; adjustments to estimated taxes upon finalization of various tax returns; increases in expenses not deductible for tax purposes; changesin available tax credits; changes in stock-based compensation expense; changes in tax laws or the interpretations of such tax laws and changes in generallyaccepted 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 by theSecurities and Exchange Commission, have increased and will continue to increase Company expenses as the Company devotes resources to ensurecompliance with all applicable laws and regulations. In 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, the Company’s board members, Chief Executive Officer and Chief Financial Officer could facean increased 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 a significantportion of future revenue. International sales are subject to a number of risks, including: the imposition of governmental controls; trade restrictions; difficultyin collecting receivables; changes in tariffs and taxes; difficulties in staffing and managing international operations; political and economic instability;general economic conditions; and fluctuations in foreign currencies. No assurances can be given that these factors will not have a material adverse effect onfuture 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 1,080-square foot facility in Coventry, England pursuant to a three-year lease beginning March 29, 2011with a basic monthly rent of £917 (approximately $1,400 as of May 31, 2012). Page 14Item 3.Legal ProceedingsThere are no material legal proceedings currently pending against the Company. Item 4.Mine Safety DisclosuresNone. Page 15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 the periodsindicated. Year Ended May 31, 2011 High Low First Quarter $ 3.65 $ 2.98 Second Quarter $3.01 $2.22 Third Quarter $3.90 $2.80 Fourth Quarter $4.20 $3.30 Year Ended May 31, 2012 High Low First Quarter $3.87 $3.18 Second Quarter $4.00 $3.20 Third Quarter $3.75 $3.10 Fourth Quarter $3.65 $3.06 As of July 31, 2012, there were 2,990,910 shares of Common Stock outstanding held by approximately 175 holders of record. The number of holders does notinclude individual participants in security position listings; the Company believes that there are more than 1,750 individual holders of shares of CommonStock.The Company has not paid any dividends on its Common Stock since 1994. The Company’s current policy is to retain earnings to finance the Company’sbusiness. Future dividends will be dependent upon the Company’s financial condition, results of operations, current and anticipated cash requirements,acquisition plans and plans for expansion and any other factors that the Company’s Board of Directors deems relevant. The Company has no presentintention of paying dividends on its Common Stock in the foreseeable future.This table shows information about equity awards under the Company’s equity compensation plans at May 31, 2012: Plan Category Number of Securities tobe issued upon exercise ofoutstanding options Weighted-averageexercise price ofoutstanding options Number of Securities remaining availablefor future issuance under equitycompensation plans (excluding securitiesin column a) a b c Equity compensation plans approved bysecurity holders 281,666 $4.16 65,000 Equity compensation plans not approvedby security holders — — — 281,666 $4.16 65,000 Recent Sales of Unregistered SecuritiesNone.Issuer Purchases of Equity SecuritiesNone. Page 16Item 6.Selected Financial DataIn thousands, except per share information Year Ended 5/31/12 5/31/11 5/31/10 5/31/09 5/31/08 Sales $14,437 $11,493 $6,806 $9,501 $11,421 Net Income (Loss) $77 $(205) $(1,711) $(2,154) $1,103 Net Income (Loss) Per Share, Basic $.03 $(.07) $(.59) $(.75) $.40 Weighted Average No. Shares, Basic 2,930 2,895 2,887 2,870 2,725 Net Income (Loss) Per Share, Diluted $.03 $(.07) $(.59) $(.75) $.39 Weighted Average No. Shares, Diluted 2,944 2,895 2,887 2,870 2,834 Stockholders’ Equity $10,484 $10,157 $10,121 $11,718 $13,756 Total Assets $12,026 $11,589 $11,352 $12,624 $15,247 Long-term Debt (including current portion) $— $— $— $— $— 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) to theworldwide 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, 2012 (Fiscal 2012), total sales increased $2.9 million, or 25.6%, to $14.4 million from $11.5 million in the year ended May 31,2011 (Fiscal 2011). Balancer segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers of grinding machineswith the target geographic markets in North America, South America, Asia and Europe. Balancer sales increased $1.3 million, or 15.7%, to $9.3 million inFiscal 2012 compared to $8.0 million in Fiscal 2011. The Fiscal 2012 increase in balancer sales is due to higher volumes of shipments as the worldwideautomotive and manufacturing industries continue to recover from the global economic downturn, particularly in North America. The Measurement segmentproduct line consists of laser-based light-scatter, distance measurement and dimensional sizing products and remote tank monitoring products. TotalMeasurement sales increased $1.7 million, or 48.5%, to $5.2 million in Fiscal 2012 compared to $3.5 million in Fiscal 2011. The increase is primarily due tohigher volumes of shipments across all of the Measurement segment product lines.Operating expenses have increased $484,000, or 8.3%, to $6.3 million in Fiscal 2012 from $5.8 million in Fiscal 2011. General, administrative and salesexpenses increased $670,000, or 12.7%, in Fiscal 2012 to $6.0 million as compared to $5.3 million in the prior fiscal year. Research and developmentexpenses decreased $186,000, or 36.9%, to $318,000 in Fiscal 2012 from $504,000 in Fiscal 2011.Net income was $77,000, or $0.03 per fully diluted share, for the year ended May 31, 2012 as compared to a net loss of $205,000, or $0.07 per fully dilutedshare, for the year ended May 31, 2011.Critical Accounting PoliciesRevenue Recognition – The Company recognizes revenue for sales and billing for freight charges upon delivery of the product to the customer at a fixed ordeterminable price with a reasonable assurance of collection, passage of title to the customer as indicated by shipping terms and fulfillment of all significantobligations, pursuant to Page 17the guidance provided by Accounting Standards Codification Topic 605. For sales to all customers, including manufacturer representatives, distributors ortheir third-party customers, these criteria are met at the time product is shipped. When other significant obligations remain after products are delivered,revenue is recognized only after such obligations are fulfilled. In addition, judgments are required in evaluating the credit worthiness of our customers. Creditis not extended to customers and revenue is not recognized 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 make requiredpayments. Credit limits for all customers are established based upon several factors, including but not limited to financial condition and stability, paymenthistory, published credit reports and use of credit references. On a monthly basis, management performs various analyses to evaluate accounts receivablebalances to ensure recorded amounts reflect estimated net realizable value. This review includes accounts receivable agings, other operating trends andrelevant business conditions, including general economic factors, as they relate to the Company’s domestic and international customers. When a customer’saccount balance becomes past due, we initiate dialogue with the customer to determine the cause. If it is determined that the customer will be unable to meetits financial obligation to us, such as in the case of a bankruptcy filing, we record a specific allowance to reduce the related receivable to the amount weexpect 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 could result inportions of our inventories becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes inour markets, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components fromour suppliers. Our policy is to record inventory write-downs when conditions exist that suggest our inventories may be in excess of anticipated demand forour products and market conditions. We regularly evaluate the ability to realize the value of our inventories based upon a combination of factors includingthe following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values and new productintroductions. Purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventory exposure. When recorded,our write-downs are intended to reduce the carrying value of our inventories to their net realizable value and establish a new cost basis.Deferred Taxes– The Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities aredetermined, based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax ratesand 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. Page 18Discussion of Operating Results Year Ended May 31, 2012 2011 2010 Balancer sales $9,265,008 64.2% $8,011,179 69.7% $4,670,723 68.6% Measurement sales 5,172,014 35.8% 3,481,680 30.3% 2,135,025 31.4% Total sales 14,437,022 100.0% 11,492,859 100.0% 6,805,748 100.0% Cost of sales 8,094,386 56.1% 5,887,207 51.2% 3,763,756 55.3% Gross profit 6,342,636 43.9% 5,605,652 48.8% 3,041,992 44.7% Operating expenses: General, administration and sales 5,967,359 41.3% 5,297,083 46.1% 4,184,100 61.5% Research and development 317,993 2.2% 504,251 4.4% 584,582 8.6% Total operating expenses 6,285,352 43.5% 5,801,334 50.5% 4,768,682 70.1% Operating income (loss) 57,284 0.4% (195,682) (1.7%) (1,726,690) (25.4%) Other income (expense) 37,260 0.3% (8,042) (0.1%) 31,107 0.5% Income (loss) before income taxes 94,544 0.7% (203,724) (1.8%) (1,695,583) (24.9%) Provision for income taxes 17,123 0.1% 1,659 0.0% 15,430 0.2% Net income (loss) $77,421 0.5% $(205,383) (1.8%) $(1,711,013) (25.1%) Sales – Sales in the Balancer segment increased $1.3 million, or 15.7%, to $9.3 million for Fiscal 2012 compared to $8.0 million for Fiscal 2011. Thisincrease is primarily due to higher unit sales volumes in North America offset by decreases in unit sales volumes in Asia and Europe during the year. NorthAmerican sales increased $1.5 million, or 45.9%, in Fiscal 2012 compared to Fiscal 2011. Sales into Asia decreased $370,000, or 9.7%, in Fiscal 2012compared to the prior year. Sales into Europe decreased $14,000, or 1.6%, in Fiscal 2012 compared to Fiscal 2011. Sales on other regions of the worldincreased $187,000, or 162.3%, during Fiscal 2012 as compared to the prior year. The increases in North America and other regions of the world are primarilydue to higher volumes of shipments as the worldwide automotive and industrial markets in these regions continue to recover from the global economicdownturn. The decreases in Asia and Europe are due to a reduction in orders as economic growth in China is slowing and the uncertainty regarding theEuropean economy continues to have a negative impact on manufacturing. The levels of demand for our Balancer products in any of these geographicmarkets cannot be forecasted with any certainty given current economic trends and the historical volatility experienced in this market.Sales in the Measurement segment increased $1.7 million, or 48.5%, to $5.2 million in Fiscal 2012 compared to $3.5 million in Fiscal 2011. Sales of laser-based distance measurement and dimensional-sizing products increased $772,000, or 28.3%, primarily due to a large, non-recurring sale during the fourthquarter of Fiscal 2012. Sales of remote tank monitoring products increased $479,000 to $581,000 during Fiscal 2012 due to the higher volume of shipments.Sales of laser-based surface measurement products increased $439,000, or 67.1%, primarily due to the sale of two CASI scatterometers. Future sales of laser-based or ultrasonic measurement products cannot be forecasted with any certainty given the historical volatility experienced in this market.Sales in the Balancer segment increased $3.3 million, or 71.5%, to $8.0 million for Fiscal 2011 compared to $4.7 million for Fiscal 2010. This increase isprimarily due to higher unit sales volumes in Asia, North America and Europe during the year. Asia sales increased $1.8 million, or 93.5%, in Fiscal 2011compared to Fiscal 2010. North American sales increased $1.4 million, or 77.9%, in Fiscal 2011 compared to the prior year. European sales increased$108,000, or 13.5%, in Fiscal 2011 compared to Fiscal 2010. The increases across all geographies are primarily due to higher volumes of shipments as theworldwide automotive and industrial markets in these regions have begun to recover from the previous low levels due to the global economic downturn. Page 19Sales in the Measurement segment increased $1.3 million, or 63.1%, to $3.5 million in Fiscal 2011 compared to $2.1 million in Fiscal 2010. Sales of laser-based distance measurement and dimensional sizing products increased $1.1 million, or 67.1%, primarily due to the higher volume of shipments in thecurrent fiscal year resulting from the economic recovery in the commercial and industrial markets. Sales of laser-based surface measurement productsincreased $160,000, or 32.3%, primarily due to the sale of a CASI scatterometer and the September 30, 2009 acquisition of Optical Dimensions whichresulted in product sales of $202,000 during Fiscal 2011. During Fiscal 2011, we started to ship our Xact ultrasonic measurement product which resulted in$102,000 of revenues.Gross margin – Gross margin in Fiscal 2012 decreased to 43.9% compared to 48.8% in Fiscal 2011. This decrease was primarily due to higher inventoryreserves associated with an end-of-life SBS balancer product, higher labor and overhead costs related to the increased sales volumes offset by a reduction ininventory component costs. Gross margin in Fiscal 2011 increased to 48.8% compared to 44.7% in Fiscal 2010. This increase is primarily due to a shift inproduct sales mix with sales increasing in the Measurement segment, which typically have higher gross margins than the Balancer segment, and sales in theBalancer segment rebounding positively in the North American market, which generally have slightly higher margins than Asia due to the channel anddistributor discounts required in Asia.Operating expenses – Operating expenses increased $484,000, or 8.3%, to $6.3 million for Fiscal 2012 compared to $5.8 million in Fiscal 2011. General,administrative and sales expenses increased $670,000, or 12.7%, to $6.0 million in Fiscal 2012 compared to $5.3 million in the prior year. This increase isdue primarily to higher personnel costs, higher commissions related to the increased sales and higher sales and marketing expenses. Research anddevelopment expenses decreased $186,000, or 36.9%, to $318,000 in Fiscal 2012 compared to $504,000 in Fiscal 2011. The decrease in research anddevelopment expense is primarily due to lower material costs associated with new product development related to existing product lines.Operating expenses increased $1.0 million, or 21.7%, to $5.8 million for Fiscal 2011 compared to $4.8 million in Fiscal 2010. General, administrative andsales expenses increased $1.1 million, or 26.6%, to $5.3 million in Fiscal 2011 compared to $4.2 million in the prior year. This increase is due primarily tohigher commissions related to the increase in sales, higher stock-based compensation and higher expenses associated with an international trade show thatoccurs every two years. Research and development expenses decreased $80,000, or 13.7%, to $504,000 in Fiscal 2011 as compared to $585,000 in Fiscal2010. Research and development expenses decreased primarily due to lower material costs associated with new product development.Other income – Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was $2,000,$4,000 and $11,000 in Fiscal 2012, 2011 and 2010, respectively. Interest income has decreased due to lower average cash and investment balances and lowerinterest rates. Foreign currency exchange gain was $18,000 and $19,000 in Fiscal 2012 and 2010, respectively. Foreign currency exchange loss was $10,000in Fiscal 2011. The foreign currency exchange gain (loss) fluctuated with the strength of foreign currencies against the U.S. dollar during the respectiveperiods. Other income consisted of an $18,000 gain on the sales of fixed assets for Fiscal 2012.Income tax provision – The effective tax rate in Fiscal 2012 was 18.1%. The effective tax rate on consolidated net income in Fiscal 2012 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 onconsolidated net loss was (0.8)% for Fiscal 2011. The Company’s effective tax rate on consolidated net loss differs from the federal statutory rate primarilydue to the amount of income from foreign jurisdictions, changes in the deferred tax valuation allowance and certain expenses not being deductible forincome tax reporting purposes, offset by tax credits related to research and experimentation expenses. The effective tax rate in Fiscal 2010 was (0.9)%. Theeffective tax rate on consolidated net loss in Fiscal 2010 differs from the federal statutory tax rate primarily due to the amount of income from foreignjurisdictions, changes in the deferred tax valuation allowance and certain expenses not being deductible for income tax reporting, offset by tax credits relatedto research and experimentation expenses. Page 20Net income – Net income increased $283,000 to net income of $77,000, or $0.03 per diluted share, for Fiscal 2012 as compared to a net loss of $205,000, or$0.07 per diluted share, for Fiscal 2011. Net income increased due primarily to higher sales and related gross profit and lower research and developmentexpenses, offset by higher general, administrative and selling expenses and a lower gross margin percentage during Fiscal 2012. Net loss decreased $1.5million to a net loss of $205,000, or $0.07 per diluted share, for Fiscal 2011 compared to a net loss of $1.7 million, or $0.59 per diluted share, for Fiscal 2010.The net loss decreased due primarily to higher sales and related gross profit offset by higher general, administrative and sales expenses during Fiscal 2011.LIQUIDITY AND CAPITAL RESOURCESThe Company’s working capital increased $432,000 to $7.9 million as of May 31, 2012 compared to $7.5 million as of May 31, 2011. Cash and cashequivalents increased $16,000 from May 31, 2011 to $2.8 million as of May 31, 2012.Cash provided by operating activities was $163,000 in Fiscal 2012 as compared to cash used in operations of $559,000 in Fiscal 2011. The increase isprimarily due to increases in net income, decrease in inventory and an increase in accrued liabilities, offset by increases in accounts receivable and prepaidexpenses and decreases in accounts payable.At May 31, 2012, accounts receivable increased $662,000 to $2.5 million compared to $1.8 million as of May 31, 2011. The increase in accounts receivableis due to the increase in sales during Fiscal 2012. Inventories decreased $171,000 to $4.0 million as of May 31, 2012 compared to $4.1 million at May 31,2011 due to increased inventory reserves related to an end-of-life SBS product. At May 31, 2012, total current liabilities increased $103,000 to $1.5 millionas compared to $1.4 million at May 31, 2011. The increase is primarily due to an increase in other accrued liabilities associated with a customer deposit on afuture order offset by lower accounts payables as compared to the prior year.During the year ended May 31, 2012, net cash used in investing activities was $228,000, which primarily consisted of additions to property and equipmentfor new manufacturing and computer equipment and vehicles offset by the cash proceeds received from the sale of property and equipment.The Company has a $2.0 million bank line of credit agreement secured by U.S. accounts receivable, inventories and general intangibles. Interest is payable atthe bank’s prime rate (3.25% as of May 31, 2012), or LIBOR plus 2.0%, (2.24% as of May 31, 2012). The agreement expires on March 1, 2014. There were nooutstanding balances on the line of credit at May 31, 2012 and 2011.We believe that our existing cash and investments combined with the cash we anticipate to generate from operating activities, and our available line of creditand 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.QUARTERLY FINANCIAL DATAIn thousands, except per share information (unaudited) 2011 Quarter Ended August 31 November 30 February 28 May 31 Sales $2,404 $2,914 $2,920 $3,254 Gross profit $1,100 $1,429 $1,309 $1,769 Net income (loss) $(113) $41 $(192) $58 Net income (loss) per share, basic $(.04) $.01 $(.07) $.02 Net income (loss) per share, diluted $(.04) $.01 $(.07) $.02 Page 212012 Quarter Ended August 31 November 30 February 29 May 31 Sales $3,471 $3,476 $3,156 $4,332 Gross profit $1,708 $1,467 $1,540 $1,628 Net income (loss) $137 $(78) $13 $6 Net income (loss) per share, basic $.05 $(.03) $.00 $.00 Net income (loss) per share, diluted $.05 $(.03) $.00 $.00 Item 7A.Quantitative and Qualitative Disclosures about Market RiskInterest Rate RiskThe Company did not have any derivative financial instruments as of May 31, 2012. However, the Company could be exposed to interest rate risk at any timein the future and, therefore, employs established policies and procedures to manage its exposure to changes in the market risk of its cash equivalents.The Company’s interest income and expense are most sensitive to changes in the general level of U.S. and European interest rates. In this regard, changes inU.S. and European interest rates affect the interest earned on the Company’s interest bearing cash equivalents and short term investments. The Company has avariable rate line of credit facility with a bank but there is no outstanding balance as of May 31, 2012. Also, there is no other long-term obligation whoseinterest rates are based on variable rates that may fluctuate over time based on economic changes in the environment. Therefore, at this time, the Company isnot subject to interest rate risk on outstanding interest bearing obligations if market interest rates fluctuate and does not expect any change in the interestrates to have a material effect on the Company’s results from operations.Foreign Currency RiskThe Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to account for a significantportion of future revenue. The Company operates a subsidiary in the United Kingdom and acquires certain materials and services from vendors transacted inforeign currencies. Therefore, the Company’s business and financial condition is sensitive to currency exchange rates or any other restrictions imposed ontheir currencies. For Fiscal 2012, 2011 and 2010, results of operations included gains (losses) on foreign currency translation of $18,000, ($10,000) and$19,000, respectively. The foreign exchange gains or losses in Fiscal 2012, 2011 and 2010 were primarily attributable to Company’s United Kingdomsubsidiary, Schmitt Europe, Ltd. Page 22Item 8.Financial Statements and Supplementary DataSCHMITT INDUSTRIES, INC.CONSOLIDATED BALANCE SHEETS May 31, 2012 May 31, 2011 ASSETS Current assets Cash and cash equivalents $2,776,817 $2,760,506 Accounts receivable, net 2,493,889 1,831,811 Inventories 3,975,600 4,146,408 Prepaid expenses 186,489 166,779 Income taxes receivable 7,780 — 9,440,575 8,905,504 Property and equipment Land 299,000 299,000 Buildings and improvements 1,723,273 1,582,936 Furniture, fixtures and equipment 1,247,720 1,199,143 Vehicles 121,835 129,330 3,391,828 3,210,409 Less accumulated depreciation (2,019,692) (1,876,234) 1,372,136 1,334,175 Other assets Intangible assets, net 1,213,204 1,349,583 TOTAL ASSETS $12,025,915 $11,589,262 LIABILITIES & STOCKHOLDERS’ EQUITY Current liabilities Accounts payable $770,586 $841,416 Accrued commissions 335,104 308,396 Accrued payroll liabilities 142,665 116,129 Other accrued liabilities 286,319 163,940 Income taxes payable — 2,073 Total current liabilities 1,534,674 1,431,954 Long-term liabilities 7,500 — Stockholders’ equity Common stock, no par value, 20,000,000 shares authorized, 2,990,910 and 2,895,635 shares issued andoutstanding at May 31, 2012 and 2011, respectively 10,279,636 9,943,910 Accumulated other comprehensive loss (313,295) (226,581) Retained earnings 517,400 439,979 Total stockholders’ equity 10,483,741 10,157,308 TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $12,025,915 $11,589,262 The accompanying notes are an integral part of these consolidated financial statements. Page 23SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF OPERATIONS Year Ended May 31, 2012 2011 2010 Net sales $14,437,022 $11,492,859 $6,805,748 Cost of sales 8,094,386 5,887,207 3,763,756 Gross profit 6,342,636 5,605,652 3,041,992 Operating expenses: General, administration and sales 5,967,359 5,297,083 4,184,100 Research and development 317,993 504,251 584,582 Total operating expenses 6,285,352 5,801,334 4,768,682 Operating income (loss) 57,284 (195,682) (1,726,690) Other income (expense) 37,260 (8,042) 31,107 Income (loss) before income taxes 94,544 (203,724) (1,695,583) Provision for income taxes 17,123 1,659 15,430 Net income (loss) $77,421 $(205,383) $(1,711,013) Net income (loss) per common share, basic $0.03 $(0.07) $(0.59) Weighted average number of common shares, basic 2,930,314 2,895,042 2,886,633 Net income (loss) per common share, diluted $0.03 $(0.07) $(0.59) Weighted average number of common shares, diluted 2,944,081 2,895,042 2,886,633 The accompanying notes are an integral part of these consolidated financial statements. Page 24SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended May 31, 2012 2011 2010 Cash flows relating to operating activities Net income (loss) $77,421 $(205,383) $(1,711,013) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 344,553 340,689 362,027 (Gain) loss on disposal of property and equipment (18,014) 1,828 (1,200) Stock based compensation 199,396 202,603 93,420 Tax benefit related to stock options (1,134) (114) — (Increase) decrease in: Accounts receivable (686,578) (652,700) (21,075) Inventories 159,002 (483,802) 247,986 Prepaid expenses (20,529) 26,055 (18,257) Income taxes receivable (7,780) 21,570 308,425 Increase (decrease) in: Accounts payable (66,729) 169,772 324,569 Accrued liabilities and customer deposits 185,863 17,980 (1,394) Income taxes payable (2,073) 2,073 — Net cash provided by (used in) operating activities 163,398 (559,429) (416,512) Cash flows relating to investing activities Purchase of short-term investments — — (1,000,000) Maturities of short-term investments — — 1,000,000 Purchase of property and equipment (277,045) (227,620) (54,838) Advances and payments on asset acquisition — — (100,000) Proceeds from sale of property and equipment 47,180 — 1,200 Other long-term assets 1,745 4,004 (6,039) Net cash used in investing activities (228,120) (223,616) (159,677) Cash flows relating to financing activities Common stock issued on exercise of stock options 136,330 1,916 — Excess tax benefit from stock-based compensation 1,134 114 — Net cash provided by financing activities 137,464 2,030 — Effect of foreign exchange translation on cash (56,431) (4,465) (52,160) Increase (decrease) in cash and cash equivalents 16,311 (785,480) (628,349) Cash and cash equivalents, beginning of period 2,760,506 3,545,986 4,174,335 Cash and cash equivalents, end of period $2,776,817 $2,760,506 $3,545,986 Supplemental Disclosure of Cash Flow Information Cash paid (received) during the year for income taxes $19,476 $(21,709) $(293,876) The accompanying notes are an integral part of these consolidated financial statements. Page 25SCHMITT INDUSTRIES, INC.Consolidated Statements of Changes in Stockholders’ EquityAND COMPREHENSIVE INCOME Shares Amount Accumulatedothercomprehensiveloss Retainedearnings Total Totalcomprehensiveincome (loss) Balance, May 31, 2009 2,870,160 $9,545,678 $(183,629) $2,356,375 $11,718,424 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) Stock options exercised net of related tax benefit of $ 114 833 1,916 — — 1,916 Stock based compensation — 202,603 — — 202,603 Net loss — — — (205,383) (205,383) $(205,383) Other comprehensive income — — 37,423 — 37,423 37,423 Balance, May 31, 2011 2,895,635 9,943,910 (226,581) 439,979 10,157,308 Comprehensive loss, year ended May 31, 2011 $(167,960) Stock options exercised net of related tax benefit of $1,134 95,275 136,330 — — 136,330 Stock based compensation — 199,396 — — 199,396 Net income — — — 77,421 77,421 $77,421 Other comprehensive loss — — (86,714) — (86,714) (86,714) Balance, May 31, 2012 2,990,910 $10,279,636 $(313,295) $517,400 $10,483,741 Comprehensive loss, year ended May 31, 2012 $(9,293) The accompanying notes are an integral part of these consolidated statements. Page 26Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 NOTE 1SIGNIFICANT ACCOUNTING POLICIESNature of OperationsSchmitt Industries, Inc. (the “Company”) designs, manufactures, and markets computer-controlled vibration detection and balancing equipment primarily tothe machine tool industry. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc., the Company designs, manufactures and marketsprecision laser-based surface measurement systems for the disk drive, silicon wafer and optics industries; laser-based distance measurement and dimensionalsizing products for a wide variety of commercial and industrial applications; and ultrasonic measurement products that accurately measure the fill levels oflarge 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 been eliminated in thepreparation 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 determinable price witha reasonable assurance of collection, passage of title to the customer as indicated by shipping terms and fulfillment of all significant obligations, pursuant tothe guidance provided by Accounting Standards Codification (“ASC”) Topic 605. For sales to all customers, including manufacturer representatives,distributors or their third-party customers, these criteria are met at the time product is shipped. When other significant obligations remain after products aredelivered, revenue is recognized only after such obligations are fulfilled. In addition, judgments are required in evaluating the credit worthiness of ourcustomers. Credit is not extended to customers and revenue is not recognized until we have determined that collectability is reasonably assured.Cash EquivalentsThe Company generally invests excess cash in money market funds and investment grade highly liquid securities. The Company considers securities that arehighly liquid, readily convertible into cash and have original maturities of less than three months when purchased to be cash equivalents. The Company’scash consists of demand deposits in large financial institutions. At times, balances may exceed federally insured limits.Accounts ReceivableThe Company maintains credit limits for all customers based upon several factors, including but not limited to payment history, published credit reports anduse of credit references. Management performs various analyses to evaluate accounts receivable balances to ensure recorded amounts reflect estimated netrealizable value. This review includes using accounts receivable agings, other operating trends and relevant business conditions, including general economicfactors, as they relate to each of the Company’s domestic and international customers. If these analyses lead management to the conclusion that potentialsignificant accounts are uncollectible, a reserve is provided. The allowance for doubtful accounts was $26,720 and $21,580 as of May 31, 2012 and 2011,respectively. Page 27Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 InventoriesInventory 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 andmanufacturing overhead, which are related to the purchase or production of inventories. Write-downs, when required, are made to reduce excess inventoriesto their net realizable values. Such estimates are based on assumptions regarding future demand and market conditions. If actual conditions become lessfavorable than the assumptions used, an additional inventory write-down may be required. As of May 31 inventories consisted of: 2012 2011 Raw materials $1,638,280 $1,649,925 Work-in-process 980,092 892,541 Finished goods 1,357,228 1,603,942 $3,975,600 $4,146,408 Property and EquipmentProperty and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three to seven years forfurniture, fixtures, and equipment; three years for vehicles; and twenty-five years for buildings and improvements. Expenditures for maintenance and repairsare 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 $98,093,$70,411 and $56,463 for the fiscal years ended May 31, 2012, 2011 and 2010, respectively.Research and Development CostsResearch and development costs, predominately internal labor costs and costs of materials, are charged to expense when incurred.Stock-Based CompensationStock-based compensation includes expense charges for all stock-based awards to employees and directors granted under the Company’s stock option plan.The Company requires the measurement and recognition of compensation for all stock-based awards made to employees and directors including stockoptions based on estimated fair values. Page 28Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 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, basedon the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws.Additionally, deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred taxasset will not be realized. 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, which include purchased technology and patents, are amortized over their estimated useful lives ranging from five toseventeen years. As of May 31, 2012 and 2011, amortizable intangible assets were $2,200,883 and accumulated amortization was $987,971 and $853,336,respectively. Amortization expense is expected to be approximately $135,000 in Fiscal 2013 and 2014, $119,000 in Fiscal 2015 and $112,000 in Fiscal2016 and 2017.Intangible and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of the assetmay not be recoverable. Recoverability is determined by comparing the forecasted future net cash flows from the operations to which the assets relate, basedon management’s best estimates using the appropriate assumptions and projections at the time, to the carrying amount of the assets. If the carrying value isdetermined 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 carryingamount exceeds the estimated fair value of the assets. As of May 31, 2012, 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 is computedusing the weighted average number of common shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchasecommon stock. Common stock equivalents for stock options are computed using the treasury stock method. In periods in which a net loss is incurred, nocommon stock equivalents are included since they are antidilutive and as such all stock options outstanding are excluded from the computation of dilutednet loss in those periods. 0, 66,489 and 78,241 potentially dilutive common shares from outstanding stock options have been excluded from diluted earnings(loss) per share for the years ended May 31, 2012, 2011 and 2010, respectively.Concentration of Credit RiskFinancial instruments that potentially expose the Company to concentration of credit risk are trade accounts receivable. Credit terms generally include adiscount of 1.5% if the invoice is paid within ten days, with the net amount payable in 30 days. Page 29Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 Financial InstrumentsThe carrying value of all other financial instruments potentially subject to valuation risk (principally consisting of cash and cash equivalents, accountsreceivable and accounts payable) approximates 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 cost ofsales. 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 2011, the FASB issued Accounting Standards Update No. 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”) to improve thecomparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. ASU2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Accordingly, the Company adopted ASU1011-05 on June 1, 2012.In September 2011, the FASB issued Accounting Standards Update No. 2011-08, “Testing Goodwill for Impairment” (“ASU 2011-08”) to simplify howentities test goodwill for impairment. ASU 2011-08 is effective for annual and interim goodwill tests performed for fiscal years beginning after December 15,2011. Accordingly, the Company adopted ASU 2011-08 on June 1, 2012. NOTE 2LINE OF CREDITIn February 2012, the Company extended its bank line of credit secured by U.S. accounts receivable, inventories and general intangibles through March 1,2014 and raised the lending limit from $1.0 million to $2.0 million. Interest is payable at the bank’s prime rate (3.25% as of May 31, 2012) or LIBOR plus2.0%, (2.24% as of May 31, 2012). There were no outstanding balances on the line of credit at May 31, 2012 and 2011. NOTE 3LONG-TERM OBLIGATIONSAs of May 31, 2012, there were no outstanding obligations under capital leases or purchase contracts. The Company leases certain facilities and equipment tosupport operations under non-cancelable operating leases and other contractual obligations. Total rent expense for the years ended May 31, 2012, 2011 and2010 amounted to $75,005, $56,913 and $36,348, respectively. Page 30Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 The approximate future minimum commitments under leases and contractual obligations for each of the years ending May 31 are as follows: Year ending May 31, 2013 $ 34,454 2014 27,964 NOTE 4INCOME TAXESThe provision for income taxes is as follows: Year ended May 31, 2012 2011 2010 Current $17,123 $1,659 $18,573 Deferred (6,753) (3,953) (661,882) Change in valuation allowance 6,753 3,953 665,025 Total provision for income taxes $17,123 $1,659 $15,430 Deferred tax assets are comprised of the following components: 2012 2011 Basis difference of assets $316,123 $355,216 Inventory related items 264,764 227,569 Other reserves and liabilities 95,099 69,486 Net operating loss carryforward 512,101 645,346 General business and other credit carryforward 388,264 270,772 Other deferred items, net 2,471 3,680 Gross deferred tax assets 1,578,822 1,572,069 Deferred tax asset valuation allowance (1,578,822) (1,572,069) 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 will not berealized. The Company has recorded a substantial deferred tax asset related to temporary differences between book and tax bases of assets and liabilities.During Fiscal 2012, 2011 and 2010, the Company increased its valuation allowance $6,753, $3,953, and $665,025 respectively, as a result of the write-downof deferred tax assets. The Company has provided a full valuation allowance against all of its deferred tax assets as the recent losses have been given moreweight than projected future income when determining the need for a valuation allowance.The Company has federal net operating loss carryforwards of approximately $1.2 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 $2.9 million which expire in 2024 and2025. Page 31Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 The provision for income taxes differs from the amount of income taxes determined by applying the U.S. statutory federal tax rate to pre-tax loss due to thefollowing: Year ended May 31, 2012 2011 2010 Statutory federal tax rate 34.0% (34.0)% (34.0)% State taxes, net of federal benefit 4.40 (4.4) (4.4) Change in deferred tax valuation allowance 7.1 23.8 39.2 Stock-based compensation 71.7 33.8 1.9 R&E tax credits (42.3) (29.4) (3.6) Effect of foreign income tax rates 3.2 2.0 0.3 Permanent and other differences (60.0) 9.0 1.5 Effective tax rate 18.1% 0.8% 0.9% Each year the Company files income tax returns in the various federal, state and local income taxing jurisdictions in which it operates. These tax returns aresubject to examination and possible challenge by the taxing authorities. Positions challenged by the taxing authorities may be settled or appealed by theCompany. As a result, there is an uncertainty in income taxes recognized in the Company’s financial statements in accordance with ASC Topic 740. TheCompany 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. The liability for unrecognized tax benefits was $7,500 and $0 as of May 31, 2012 and 2011,respectively.Interest and penalties associated with uncertain tax positions are recognized as components of the “Provision for income taxes.” The liability for payment ofinterest and penalties was $0 as of both May 31, 2012 and 2011.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 established aroyalty pool and vested in each shareholder and debt holder of the acquired company an interest in the royalty pool equal to the amount invested or loanedincluding interest payable through March 1995. The royalty pool is funded at 5% of net sales (defined as gross sales less returns, allowances and salescommissions) of the Company’s surface measurement products and future derivative products developed by Schmitt Industries, Inc., which utilize thesetechnologies. As part of the royalty pool agreement, each former shareholder and debt holder released TMA from any claims with regard to the acquisitionexcept their rights to future royalties. Royalty expense applicable to the years ended May 31, 2012, 2011 and 2010 amounted to $40,840, $22,128 and$16,358, respectively. Page 32Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 In a transaction related to the acquisition of Xtero Datacom Inc., a British Columbia corporation (“Xtero”), former Xtero shareholders will be eligible toreceive shares of stock that are exchangeable for shares of Schmitt common stock on a one-for-one basis based on 50% of the after-tax earnings derived fromXtero products during a five-year earn-out program ending on May 31, 2013. This additional consideration, if any, would increase the value of the intangibleasset recorded in connection with the acquisition. No additional shares of stock have been issued to former Xtero shareholders as of May 31, 2012. NOTE 6SEGMENT INFORMATIONThe Company has two reportable business segments: the design and assembly of dynamic balancing systems and components for the machine tool industry(Balancer), and the design and assembly of laser-based test and measurement systems (Measurement). The Company operates in three principal geographicmarkets: United States, Europe and Asia. Year Ended May 31, 2012 2011 2010 Balancer Measurement Balancer Measurement Balancer Measurement Gross sales $10,194,525 $5,231,238 $8,732,900 $3,533,634 $5,203,773 $2,225,083 Intercompany sales (929,517) (59,224) (721,721) (51,954) (533,050) (90,058) Net sales $9,265,008 $5,172,014 $8,011,179 $3,481,680 $4,670,723 $2,135,025 Operating income (loss) $422,528 $(365,244) $249,657 $(445,339) $(990,867) $(735,823) Depreciation expense $142,576 $67,342 $123,958 $60,607 $147,775 $59,709 Amortization expense $— $134,635 $— $156,124 $— $154,543 Capital expenditures $129,148 $147,897 $176,578 $51,042 $46,201 $8,637 Geographic Information Year Ended May 31, 2012 2011 2010 North America $9,074,152 $6,037,847 $3,308,958 Europe 1,145,449 1,130,480 1,148,857 Asia 3,814,656 3,990,371 2,171,993 Other markets 402,765 334,161 175,940 Total Net Sales $14,437,022 $11,492,859 $6,805,748 Year Ended May 31, 2012 2011 2010 United States Europe United States Europe United States Europe Operating income (loss) $54,265 $3,019 $(84,885) $(110,797) $(1,746,621) $19,931 Depreciation expense $209,918 $— $184,565 $— $207,484 $— Amortization expense $134,635 $— $156,124 $— $154,543 $— Capital expenditures $277,045 $— $227,620 $— $54,838 $— Page 33Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 Segment and Geographic Assets May 31, 2012 May 31, 2011 Segment assets to total assets Balancer $4,872,664 $5,284,244 Measurement 4,368,654 3,544,512 Corporate assets 2,784,597 2,760,506 Total assets $12,025,915 $11,589,262 Geographic assets to long-lived assets United States $1,372,136 $1,334,175 Europe — — Total assets $1,372,136 $1,334,175 Geographic assets to total assets United States $11,246,431 $10,882,569 Europe 779,484 706,693 Total assets $12,025,915 $11,589,262 Note – 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 December 1995,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 be eitheran incentive stock option (ISO), or a nonstatutory stock option (NSO). ISOs may be granted only to employees and members of the Board of Directors of theCompany 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, 2012, 2011 and 2010 includes compensation cost for stock-based awards granted. All outstanding options will expire no later than 2021.The Company uses the Black-Scholes option pricing model as its method of valuation for stock-based awards. The Company’s determination of the fair valueof stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highlycomplex and subjective variables. Although the fair value of stock-based awards is determined in accordance with ASC Topic 718, the Black-Scholes optionpricing model requires the input of 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. Page 34Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 • 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, 2012, 2011 and 2010, the value of allstock options granted using the Black-Scholes option pricing model as prescribed by ASC Topic 718 using the following assumptions: Year ended May 31, 2012 Year ended May 31, 2011 Year ended May 31, 2010 Risk-free interest rate — 3.8% — Expected life — 4.8 years — Expected volatility — 62.4% — Stock-Based Compensation Under ASC Topic 718The total stock-based compensation expense recognized under ASC Topic 718 was $199,396, $202,603 and $93,420 during Fiscal 2012, 2011 and 2010,respectively. All stock-based compensation expense has been recorded as general, administration and sales expense in the Consolidated FinancialStatements.At May 31, 2012, the Company had a total of 281,666 outstanding stock options (228,330 vested and exercisable and 53,336 non-vested) with a weightedaverage exercise price of $4.16. The Company estimates that a total of approximately $63,000 will be recorded as additional stock-based compensationexpense during the fiscal year ending May 31, 2013, for all options which were outstanding as of May 31, 2012, but which were not yet vested.Options outstanding and exercisable consist of the following at May 31, 2012: Outstanding Options Exercisable Options Numberof Shares WeightedAverageExercisePrice WeightedAverageRemainingContractualLife (yrs) Numberof Shares WeightedAverageExercisePrice 41,666 $2.30 2.0 41,666 $2.30 160,000 3.65 9.0 106,664 3.65 5,000 5.80 3.4 5,000 5.80 75,000 6.16 6.0 75,000 6.16 281,666 4.16 7.1 228,330 4.28 Page 35Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 Options granted, exercised, canceled and expired under the Company’s stock option plan during the years ended May 31, 2012, 2011 and 2010 aresummarized as follows: Numberof Shares WeightedAverageExercise Price Options outstanding - May 31, 2009 218,609 $3.32 Options granted — 0.00 Options exercised — — Options forfeited/cancelled — 0.00 Options outstanding - May 31, 2010 218,609 3.32 Options granted 170,000 3.65 Options exercised (833) 2.30 Options forfeited/cancelled — — Options outstanding - May 31, 2011 387,776 3.47 Options granted — — Options exercised (95,275) 1.43 Options forfeited/cancelled (10,835) 3.46 Options outstanding - May 31, 2012 281,666 4.16 The total intrinsic value of both outstanding and exercisable options at May 31, 2012 and 2011 was $52,083 and $269,719, respectively. The total intrinsicvalue of options exercised during the years ended May 31, 2012, 2011 and 2010 was $189,063, $1,070 and $0, respectively. Page 36Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 NOTE 8EARNINGS PER SHAREBasic earnings per share is computed using the weighted average number of shares outstanding. Diluted earnings per share is computed using the weightedaverage number of shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase common stock. The followingtable is a reconciliation of the numerators and denominators of the basic and diluted per share computations for each of the three years in the period endedMay 31: Net loss(Numerator) WeightedAverageShares(Denominator) Per ShareAmount Year ended May 31, 2012 Basic earnings per share Loss available to common stockholders $77,421 2,930,314 $0.03 Effect of dilutive securities stock options — 13,767 Diluted earnings per share Income available to common stockholders $77,421 2,944,081 $0.03 Year ended May 31, 2011 Basic earnings per share Loss available to common stockholders $(205,383) 2,895,042 $(0.07) Effect of dilutive securities stock options — — Diluted earnings per share Loss available to common stockholders $(205,383) 2,895,042 $(0.07) 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) 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 and servicerequirements to be eligible. Participants may contribute up to 15% of their eligible compensation which may be partially matched by the Company. TheCompany may further make either a profit sharing contribution or a discretionary contribution. The Company made matching contributions in conjunctionwith employee contributions to the plan totaling $65,672, $72,151 and $56,532 during Fiscal 2012, 2011 and 2010, respectively. NOTE 10RELATED PARTY TRANSACTIONSEffective June 1, 2004, the Company entered into a contract to provide consulting services to PulverDryer USA, Inc., (“PulverDryer”) pursuant to whichPulverDryer paid the Company $8,000 a month from June 2004 through October 2004. PulverDryer also buys certain products from the Company at normalprevailing rates. The Page 37Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2012, 2011 AND 2010 Company and PulverDryer extended the contract from November 1, 2004 forward at that same monthly fee of $8,000. The contract was terminated inFebruary 2010. Product sales to PulverDryer during the fiscal years ended May 31, 2012, 2011 and 2010 totaled $0, $0 and $1,408, respectively.In connection with the contract, the Board authorized Wayne Case, the Company’s Chief Executive Officer, to provide advisory services to PulverDryer, andpermitted Mr. Case to receive as compensation the total consulting fees paid by PulverDryer from June 2004 through October 2004. From November 2004 toFebruary 2010, Mr. Case received 40% of the ongoing consulting fee from PulverDryer, which percentage was determined by the Compensation Committee.Mr. Case also served on the board of directors of PulverDryer through the termination of the contract. Page 38Report of Independent Registered Public Accounting FirmBoard of Directors and ShareholdersSchmitt Industries, Inc.We have audited the accompanying consolidated balance sheets of Schmitt Industries, Inc. and its subsidiaries as of May 31, 2012 and 2011, and the relatedconsolidated statements of operations, changes in stockholders’ equity and comprehensive income and cash flows for the years ended May 31, 2012, 2011and 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements 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 audits 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 audits 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 audits provide a reasonablebasis for our opinions.In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Schmitt Industries, Inc. as of May 31,2012 and 2011 and the results of its operations and its cash flows for the years ended May 31, 2012, 2011 and 2010 in conformity with accounting principlesgenerally accepted in the United States of America./s/ MOSS-ADAMS LLPPortland, OregonAugust 9, 2012 Page 39Item 9.Changes in and Disagreements with Accountants on Accounting and Financial DisclosureNone. Item 9A.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 submitted underthe Securities Exchange Act of 1934, as amended (Exchange Act), is recorded, processed, summarized and reported within the time periods specified in SECrules and forms. Our disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required tobe disclosed in our reports filed under the Exchange Act is accumulated and communicated to management as appropriate to allow timely decisionsregarding 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 as definedin Exchange Act Rule 13a-15(e) and Rule 15d-15(e). Based on that evaluation, the CEO and CFO have concluded that, as of the end of the period covered bythis report, the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reportsis (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to our management, including the our CEOand CFO, as appropriate, to allow timely decisions regarding required disclosure.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 Rules 13a-15(f) and 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, 2012.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 SEC rules adopted inconformity with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.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, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B.Other InformationNone. Page 40PART IIICertain information required by Part III is included in the Company’s definitive Proxy Statement for its 2012 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 2012 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 2012 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 2012 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 2012 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 2012 Annual Meeting of Shareholders and isincorporated herein by reference. Page 41PART IV Item 15.Exhibits and Financial Statement Schedules (a)Financial Statements: (1)Consolidated Balance Sheets as of May 31, 2012 and 2011 Consolidated Statements of Operations for the years ended May 31, 2012, 2011 and 2010 Consolidated Statements of Cash Flows for the years ended May 31, 2012, 2011 and 2010 Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the years ended May 31, 2012, 2011 and2010 Notes to Consolidated Financial Statements for the years ended May 31, 2012, 2011 and 2010 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 therequired information 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. Page 42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. CaseChairman of the Boardand Chief Executive OfficerDate: August 9, 2012Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrantand in the capacities indicated on August 9, 2012. Signature Title/s/ Wayne A. CaseWayne A. Case Chairman of the Board and Chief Executive Officer (Principal Executive Officer)/s/ James A. FitzhenryJames A. Fitzhenry Director and President/s/ Jeffrey T SiegalJeffrey T Siegal Chief Financial Officer and Treasurer(Principal Financial and Accounting Officer)/s/ Maynard BrownMaynard Brown Director/s/ David M. HudsonDavid M. Hudson Director/s/ Michael J. EllsworthMichael J. Ellsworth Director Page 43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]*10.3 Amendment No. 1 to Loan Agreement between the Company and Bank of America, N.A. dated February 28, 2012.[Form 10-Q for the fiscal quarter ended February 29, 2012, Exhibit 10.1]*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, 2011. 23.1 Consent of Independent Registered Public Accounting Firm. 31.1 Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-OxleyAct of 2002. 31.2 Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-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. Page 44EXHIBIT 21.1SUBSIDIARIES OF SCHMITT INDUSTRIES, INC.AS OF MAY 31, 2012 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 August 9, 2012, relating to theconsolidated financial statements appearing in this Annual Report on Form 10-K of Schmitt Industries, Inc for the year ended May 31, 2012./s/ Moss-Adams LLPPortland, OregonAugust 9, 2012EXHIBIT 31.1CERTIFICATION PURSUANT TO18 U.S. C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Wayne A. Case, certify that:1. I have reviewed this annual report on Form 10-K of Schmitt Industries, Inc.;2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financialcondition, 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 in ExchangeAct 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 registrantand have:(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared;(b) 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 for external purposesin 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 recent fiscalquarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, theregistrant’s internal control over financial reporting; and5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting. Date: August 9, 2012 /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 this report;3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financialcondition, 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 in ExchangeAct 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 registrantand have:(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared;(b) 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 for external purposesin 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 recent fiscalquarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, theregistrant’s internal control over financial reporting; and5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting. Date: August 9, 2012 /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, 2012 as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), we, Wayne A. Case and Jeffrey T Siegal, Chairman of the Board and Chief ExecutiveOfficer and Chief Financial Officer and Treasurer, respectively, of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of theSarbanes-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. CaseWayne A. CaseChairman of the Board and Chief Executive OfficerAugust 9, 2012/s/ Jeffrey T SiegalJeffrey T SiegalChief Financial Officer and TreasurerAugust 9, 2012

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