Schmitt Industries, Inc.
Annual Report 2013

Plain-text annual report

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 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, 2013or ¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to Commission File Number: 000-23996SCHMITT INDUSTRIES, INC.(Exact name of registrant as specified in its charter) 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:NoneIndicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No xIndicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the 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, 2012, the last business day of the registrant’s most recently completed second fiscal quarter, wasapproximately $6,404,500 based upon the closing price of $3.02 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, 2013, the registrant had 2,990,910 outstanding shares of Common Stock.Documents Incorporated by ReferencePortions of the registrant’s definitive Proxy Statement for its 2013 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, designs, manufactures and sells high precision test and measurement products for two mainbusiness segments: the Balancer Segment and the Measurement Segment. The Company designs, manufactures and sells computer-controlled vibrationdetection, balancing and process control systems for the worldwide machine tool industry, particularly for grinding machines (the Balancer Segment).Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), an Oregon corporation, the Company designs, manufactures and sells laserand white light sensors for distance, dimensional and area measurement for a wide variety of commercial applications, laser-based microroughnessmeasurement products for the semiconductor wafer and hard disk drive industries and for other industrial applications, laser-based surface analysis andmeasurement products for a variety of scientific applications, and ultrasonic measurement products that accurately measure the liquid levels of propane tanksand transmit that data via satellite to a secure web site for display (the Measurement Segment). The Company also provides sales and service for Europe andparts of Asia through its wholly owned subsidiary, Schmitt Europe Limited (SEL), located in Coventry, England and through its sales representative officelocated in Shanghai, China. The Company’s corporate office is located at 2765 N.W. Nicolai Street, Portland, Oregon.“SBS,” “SMS,” “Acuity,” “Xact,” “Lasercheck” and “AccuProfile” are registered trademarks owned by the Company.Balancer SegmentThe Company’s principal product line for this segment is the Schmitt Dynamic Balance System (SBS), which consists of a vibration sensor, a computercontrol unit, and a balance head that is placed either externally on the grinding wheel spindle with the use of a spindle mounted adaptor or internally insidethe spindle bore. The control panel contains up to four slots for additional circuit boards designed for specific functions, such as manual balancing, balancingusing hydro chambers and process monitoring, which involves the detection and analysis of high frequency noise, known as acoustic emission or AE,generated by the grinding process. SBS products are designed as economical yet highly precise measurement and control devices for permanent or Page 2portable installation on grinding machines that can detect and correct imbalance caused by vibration as small as 0.02 microns. Customers can also detect andanalyze the AE signal generated during grinding or wheel dressing to help monitor and improve the grinding process. Customers include both end useroperators as well as manufacturers of grinding machines worldwide for a wide variety of industries that utilize the grinding process, including the automotive,industrial, aerospace, and medical industries where specifications and operating tolerances on machined parts are increasingly precise.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 grinding process. Operating on a principle of mass compensation for wheel imbalance, the balance head contains two movableeccentric weights, each driven by electric motors through a precision gear train. These weights are repositioned to offset any imbalance in a grinding wheel orother application. Imbalance or vibration is picked up by the vibration sensor that feeds the detected signal to the control unit, which filters the signal byrevolutions per minute. The controller then automatically drives the balance head weights in a direction that reduces the amplitude of the vibration signal.The balance cycle is complete when the weights are positioned to achieve the lowest vibration level, as low as 0.02 microns.The SBS System also includes an optional Acoustical Emission Monitoring System (AEMS), which uses proprietary acoustic sensor technology to monitorthe very high frequency AE 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 of the grinding wheel with a new part loaded in the machine. The system can automaticallydetect the initial contact and very quickly report this event to the machine control, stopping the wheel in-feed without operator intervention. Part crashoccurs when a part or fixture is incorrectly loaded into a grinding machine or some abnormal condition occurs. Rapid in-feed of the wheel may then result ina dangerous or expensive crash. The AEMS system allows the CNC control operating system on the machine to monitor the acoustic levels and detect anyunexpected contact when it happens. The system then reports that abnormal contact and instructs the CNC program to stop the grinding process, usuallywithin 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 a variety of languages and inmetric units of measurement, instrument grade calibration, short balance process, measurement of both displacement and/or velocity and minimal operatormaintenance.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 (gear trains, camshafts, crankshafts, valves), bearings (rollerand tapered types), ceramics (precision shaping), electric motors (shafts), pumps (shafts and turbines), aircraft (engine parts such as turbine blades), andgeneral manufacturing. Precision grinding has an established worldwide presence in all industrialized countries and is expanding as a method of materialremoval and part processing. Within the Company’s customer base for the SBS System, there are three major market segments:Machine Tool Builders – These companies design and manufacture a variety of specialty application grinding machines. SBS Systems are distributedto markets throughout the world through machine tool original equipment manufacturers (OEMs), who incorporate the 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.), Drake Page 3Manufacturing (U.S.), Ecotech/SMTW (China/U.S.), Erwin Junker (U.S.), Matrix Machine Tool (UK), Schleifring Group (Germany, China), ShaanxiQinchuan Machinery Development Co. (China), Cinetic Landis Grinding (U.S.), Koyo Machinery (U.S., Japan), Micron Machinery Limited(Japan/U.S.), USACH Technologies (U.S.), Tschudin (U.S.) and Weldon Solutions (U.S.). The Company currently sells its products directly to majormachine builders throughout 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.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, Schaeffler, Caterpillar, Eaton, Emerson Power Transmission, Cummins Engine, Ford Motor Company, GeneralElectric, General Motors, Ingersoll Rand, Komatsu, Sumitomo Heavy Industries, SKF Bearing Industries, Timken, TRW Automotive Components andUniversal Bearing.For the years ended May 31, 2013, May 31, 2012 and May 31, 2011 (Fiscal 2013, 2012 and 2011), net sales of the Company’s balancing products totaled$7.7 million, $9.3 million and $8.0 million, respectively. Net sales of balancing products accounted for 62%, 64% and 70% of the Company’s total sales inFiscal 2013, 2012 and 2011, 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. Competitors primarily come fromGermany and Italy. These competitors produce electromechanical and water balancers and process control products similar to SBS. The Company’s primarycompetitors are Marposs S.p.A., MPM Micro Prazision Marx GmbH and Balance Systems S.r.l.Pricing of the SBS system is intended to maintain the status of the SBS system as the premier product in the industry, offering a combination of best quality,reliability and performance together with superior economic value.Measurement SegmentWithin the Measurement Segment, the Company designs, manufactures and sells laser and white light sensors for distance, dimensional and areameasurement for a wide variety of commercial applications, laser-based microroughness measurement products for the semiconductor wafer and hard diskdrive industries and for other industrial applications, laser-based surface analysis and measurement products for a variety of scientific applications, andultrasonic measurement products that accurately measure the liquid levels of propane tanks and transmit that data via satellite to a secure web site for display.Laser and White Light SensorsThese products include lasers utilizing both triangulation and time-of-flight methods of measurement, and confocal chromatic white light sensors that areused in a wide range of industrial applications including manufacturing, lumber production, steel casting, glass and paper production, medical imaging,crane control and micron-level part and surface inspection and are sold under the Acuity brand. Presently, there are 9 products offered under the Acuitybrand: The AccuRange (AR) 1000, AR2500, AR3000 and AR4000 distance measurement sensors, the AR700, AR500 and AR200 series of triangulating laserdisplacement sensors, the AR CCS Prima, and the AccuProfile (AP) 820 laser line scanner. The Company designs, manufactures and sells the AR200, AR700and AR4000 and designs, manufactures, and distributes the AR500, AR1000, AR2500, AR3000, AR CCS Prima and the AP820, primarily into NorthAmerica. Page 4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, but are not limited to, load confirmation, alignment, lumber positioning, crane monitoring, fill level measurement, velocitymeasurement and laser altimeter.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 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 a micron. The laser will output 9400 distance readings in a single second. The unit is also verycompact, measuring approximately 80% smaller than its predecessor, the AR600. Model variations permit applications up to 50 inches in range. Applicationsinclude high speed road profiling, product dimensional or thickness measurement, rubber thickness measurement, lumber or plywood thickness measurement,carton dimensioning and product positioning.The AR500 is a compact triangulation laser displacement sensor that provides accurate measurements (+/- 0.15% 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 to100 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, -50M, and -100M have ranges in millimeters thatmatch their model number. The AR200 displacement sensor cannot be overloaded and measures accurately even when a mirror reflects the entire light beamback to the detector.The AR CCS Prima white light confocal-chromatic displacement sensor is the most precise measurement system from Acuity. Using a novel optical principleof measuring the reflected light’s component wavelengths, these confocal sensors measure distance and position to within nanometers. These compact probescan measure to opaque, shiny or even transparent surfaces. Unlike the other Acuity distance sensors, the Prima Confocal systems are comprised of an opticalmeasurement “pen” and a separate controller. This controller houses all of the electronics, light source, etc. Only emitted white light and reflected signals arepassed between the pen and the controller via a thin fiber-optic transmission cable. The Confocal-Chromatic Sensors (CCS) are offered in a variety ofmeasurement ranges and standoff distances, each with a corresponding resolution. The shortest-range models resolve to 5 nanometers of height change.The AP820 is a two-dimensional laser scanner that measures surface height profiles by projecting a beam of visible laser light that creates a line on a targetedsurface. The AP820 is a highly accurate sensor for industrial Page 5surface dimensional and measurement applications. The scanner quickly and accurately generates low-noise 2D or 3D profile scans of objects, surfaces orscenes. The sensor automatically adjusts laser power and detector exposure to compensate for varying surface conditions. Typical scanner applicationsinclude weld gap tracking and weld bead profiling, positional control of objects and surfaces, tire profiling, wheel profiling, surface profiling, 3D profilegeneration and dimensional measurement.Surface Roughness Measurement ProductsThese products use a patented technology using laser light scatterometry to perform rapid, accurate, repeatable, non-destructive and non-contact surfacemeasurement tests that quantify surface micro-roughness. The technology is extremely precise, measuring surface roughness at the molecular (sub-Angstrom)level. Products are sold to manufacturers of hard disk drives, semiconductors, silicon wafers and optical products and industries involved in fabricationprocesses that require precise and reliable measurements.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 Company’s product for the disk industry is the TMS (Texture Measurement System) 2000-RC, an accurate non-contact texture measurement system. Theproduct (used on aluminum 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 be measured tolevels below 0.5 Angstroms. An Angstrom (Å) is a unit of measure equal to 1 hundred-millionth of a centimeter (the point of a needle is one millionAngstroms in diameter).Customers include Hitachi/IBM, Seagate Substrates, Western Digital Showa Denko, MMC and Komag.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, device quality semiconductors and memory devices. This industry demands manufacturingprecision to increase performance and capacity and these products help achieve those goals. Silicon wafers are carefully cut and polished to provide the baseupon which a computer or memory chip is produced. Therefore, chip manufacturing is extremely dependent on the beginning surface roughness of the wafer.Since all silicon wafers exhibit a microscopic level of surface roughness stemming from production techniques such as chemical deposition, grinding,polishing and etching, some method of measuring surface roughness is required. The Company’s wafer measurement products provide a way for customers toquantify and control their manufacturing process. The system provides measurements to less than 0.5 Å.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 and repeatable surface roughness measurements in the 0.025 to 2 micron (<1.0 to80 micro inches) range. Lasercheck provides high-speed in-process measurements in a fraction of a second and is optimized for surface measurements ofground, sanded, polished, hone, super-finished and shot-blasted surfaces.Laser Light-Scatter Surface Measurement ProductsThe Company’s CASI (Complete Angle Scatter Instrument) Scatterometers are sold to companies and institutions involved in scientific research anddevelopment. The CASI Scatterometer uses visible, ultraviolet or infrared laser light as a nondestructive probe to measure surface quality, opticalperformance, smoothness, Page 6appearance, defects and contamination on a wide variety of materials. These products are scientific measurement instruments providing customers withmolecular-level precision in roughness measurement of optical surfaces, diffuse materials, semiconductor wafers, magnetic storage media andprecision-machined surfaces, as well as surfaces affecting the cosmetic appearance of consumer products.The MicroScan system is a portable device consisting of a hand-held control unit, an interchangeable measurement head and a separate charging unit. 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.CompetitionManagement believes the TMS and Lasercheck surface measurement products are two of only a few systems that provide fast, accurate, repeatable non-contact microroughness measurements for a wide variety of commercial customers including computer hard disk and silicon wafer manufacturers. TheCompany believes its surface measurement products are currently the only systems that can provide measurements as low as a few hundredths of an Å withreproducibility +/- 0.2Å or 1% and repeatability of +/-0.1Å. There are differences between our surface measurement products and other optical techniques(which include profilometers, scanning tunneling microscopes, atomic force microscopes or interferometers). These other technologies require theintervention of a skilled operator and perform measurements relatively slowly, whereas our surface measurement products are much simpler and,consequently, can make measurements more rapidly while still maintaining excellent repeatability and accuracy. Stylus profilometers are simpler devicesthat require less skilled operators. However, measurements must be conducted under vibration isolation conditions, 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.Remote Tank Monitoring ProductsThe Company’s newest product line is called the Xact Tank Monitoring System, which provides remote fuel level monitoring of propane tanks, large orsmall, anywhere in the world. Accessing accurate fuel level information is essential to effectively manage inventory, improve delivery efficiency, reduceoperating costs and increase profitability, and justify capital expenditures. The Xact system utilizes an ultrasonic sensor that is applied externally to the tankto calculate the fill level inside the tank with great accuracy (+/- 2% for large tanks, +/- 1% for small tanks). For smaller tanks that are difficult to access orwhere the precise accuracy provided by the ultrasonic sensor is not as important, Xact also offers a sensor that is affixed to the dial of a preinstalled floatgauge (known as a “gauge reader”) which detects the fill level that is reported by the gauge. Float gauges have a Page 7typical accuracy of +/- 8% to 12%. Tank fill data is then transmitted via the Globalstar satellite network to a secure website for display. There is no relianceon phone land lines or cellular networks and therefore no dropped data. The use of satellite telemetry permits monitoring of any tank anywhere in the world.With the Xact system, minimum or maximum alarm or fill levels can be set to automatically notify operators by email anytime a particular tank readingexceeds thresholds or needs refilling. 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.There are three main components to the Xact Tank Monitoring System:Tank SensorThe Xact ultrasonic sensor incorporates patented technology and is externally mounted to the bottom of the propane tank. The sensor produces a smallelectrical pulse, or a “ping,” that travels through the tank’s steel shell, which is reflected off the bottom surface of the liquid stored in the tank in theform of an echo that is detected by the sensor. The time of flight between the “ping” and the echo, which is measured in milliseconds, is then calculatedto determine, based upon additional data regarding tank size and shape, the volume of liquid the tank contains. This information is then remotelytransmitted via a satellite radio transmitter. For smaller tanks that are difficult to access or where the precise accuracy provided by the ultrasonic sensoris not as important, Xact also offers a sensor that is affixed to the dial of a preinstalled float gauge (known as a “gauge reader”) and which detects thefill level that is reported by the gauge and transmits that data by satellite in the same manner as the ultrasonic sensor. Float gauges have a typicalaccuracy range of +/- 8% to 12%.Satellite Radio TransmitterThe Xact radio transmitter is placed on the top of the tank and is connected by cable to the tank sensor or gauge reader. The satellite transmittertransmits the tank data using the GlobalStar satellite network to a GlobalStar ground station and then to the Xact secure website where the tank datais displayed or is automatically directed to a customer’s automated inventory or delivery management system.Xact WebsiteThe Xact website is a secured location providing controlled access to the tank data for each customer’s various tank locations. The tank fill level dataand geometry of the tank are used to calculate and display the precise fill level at predetermined measurement times along with additional informationsuch as temperature, battery status, GPS coordinates and map location, fill levels that trigger email notification and the list of email recipients. Inaddition to the data being displayed on the website, the data can also be automatically directed to a customer’s automated inventory or deliverymanagement system for full automation of the delivery process. Operators can now obtain highly accurate readings and tank information from even themost remote tanks conveniently and cost-effectively using their desktop computer, laptop, tablet or smart phone.BenefitsBenefits of using the Xact Tank Monitoring System include external mounting with no reliance on existing mechanical gauges when using the ultrasonicsensors, tank fill data is sent directly and instantly from the tank to the user via satellite, no reliance on telephone lines or cellular networks and no droppeddata, temperature adjusted readings for accuracy within +/- 2% for large tanks and +/- 1% for smaller tanks when using the ultrasonic sensor, user-set alarmlevels and automatic low tank-level messaging via email or cell phone, the ability to operate in a wide range of operating environments from -40ºC to 60ºC,long battery life, quick and easy installation, secure data transmission via satellite, the ability to integrate directly into delivery scheduling managementsystems and the ability to monitor any tank anywhere in the world. Page 8®®®CustomersCustomers of the Xact Tank Monitoring System include large, regional and local propane distributors, such as Superior Propane (Canada), Suburban Propane(U.S.), AmeriGas (U.S.), Pacific Propane (U.S.) and ThermoGas (Mexico). The Company is focusing its business development efforts on the propane industryin the United States, Canada, Mexico, Central and South America and ultimately intends to expand its business development efforts to include other globalmarkets such as Europe, Africa and India.CompetitionManagement believes that the Xact Tank Monitoring System offers the only ultrasonic sensor specifically designed to provide independent precise tanklevel calculation while most other competitors utilize gauge-reading technology, which reads the tank fill level from a pre-installed float gauge and is lessaccurate. Competitors offer telemetry options based on cellular or closed loop communication networks whereas Xact telemetry is satellite based.Competitors include, but are not limited to, Independent Technologies, Inc. (Wesroc), NasCorp (SkyTracker), WacnGo, Silicon Controls, TankLink,Centeron, TankScan and Enertrack.In Fiscal 2013, 2012 and 2011, net sales of Measurement products totaled $4.7 million, $5.2 million and $3.5 million, respectively, and accounted for 38%,36% and 30% of the Company’s total sales in Fiscal 2013, 2012 and 2011, respectively. See Note 6 to Consolidated Financial Statements.Sales by Geographic AreaIn Fiscal 2013, 2012 and 2011, the Company recorded net sales of its products in the United States, its country of domicile, of $7.4 million, $8.1 million and$5.6 million, respectively. Net sales in the last three fiscal years by geographic areas were: NorthAmerica Europe Asia Others Fiscal 2013 $8,413,970 $1,192,049 $2,499,593 $346,640 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 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 Page 9Company representatives. These individuals operate a display booth featuring an SBS System demonstration 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 factory in Portland, Oregon. Where the Company has distributors,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. Europeandistribution to customers is handled by shipping the product directly from the Company’s Portland headquarters to its European subsidiary in the UnitedKingdom, 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, sales and marketing managersdirect the overall worldwide marketing efforts for surface measurement, laser and white light sensor and remote tank monitoring products. Second, both amarketing manager and a sales manager direct the overall worldwide marketing and sales efforts for distance measurement and dimensional sizing products.Third, the Company uses distributors for international markets for the promotion and sale of surface measurement products in China, Taiwan, Japan andKorea. The Xact product line utilizes two business development personnel, in addition to distributors for selected markets.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. Page 10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.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 trademarks, 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-2000, a dual plane manual balancing system, a control card to control thedressing process of grinding wheels, and a new vibration sensor and internal balancer design. The Company has also introduced several new laser productsunder the Acuity line.During Fiscal 2013, 2012 and 2011, the Company’s research and development expense totaled $573,000, $318,000 and $504,000, respectively.EmployeesAs of July 31, 2013, the Company employed 50 individuals worldwide on a full-time basis. There were also four 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. Page 11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 in the U.S. and Asia, and their impact on levels of capital investment, which have deteriorated significantly in the past and may become depressed, orbe subject to further deterioration. Economic factors that could adversely influence demand for the Company’s products include uncertainty about globaleconomic conditions leading to reduced levels of investment, customers’ and suppliers’ access to credit, unemployment and other macroeconomic factorsaffecting commercial and industrial spending behavior.The past distress in the global 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 a 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 Company’s efforts to accelerate growth of the Xact Tank Monitoring System may not be successfulIn 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 rate of growth of Xact sales has not been as rapid as initially forecasted. The Company’s efforts to accelerate thegrowth of Xact may not be successful, anticipated market demand for the product may not materialize, and additional product or market opportunities maynot be identified and developed and brought to market in a timely and cost-effective manner. Also, the Company may not be able to meet the manufacturingrequirements of large orders in a timely and cost-effective manner. All of this could continue to negatively impact future operating results and result in largeand immediate write-offs of recorded intangible asset balances.New products may not be developed to satisfy changes in consumer demandsThe failure to develop new products or enhance existing products or react to changes in existing technologies, could materially delay development of newproducts, which could result in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design,develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. New product opportunitiesmay not be identified and developed and brought to market in a timely and cost-effective manner. Products or technologies developed by other companiesmay render products or technologies obsolete or noncompetitive, or a fundamental shift in technologies in the product markets could have a material adverseeffect on the Company’s competitive position within historic industries.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 Page 12commercial quantities at low prices to those new markets are important competitive factors. The principal competitive factors in the Company’s markets areproduct features, performance, reliability and price. Many of the Company’s competitors have greater financial, technical, research and development andmarketing resources. No assurance can be given that the Company will be able to compete effectively in the future, and the failure to do so would have amaterial 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.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 management tomake 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.The Company’s existing cash and credit facilities may not be sufficient to fund future growthThe Company had an operating line of credit of $2.0 million and a cash balance of $1.9 million as of May 31, 2013; as of that date, the Company had nooutstanding balance on its line of credit. The Company believes that its existing cash and investments combined with the cash from operating activities willbe sufficient to meet its cash requirements for the near term. However, if sales continue to weaken and the Company is unable to reduce its operating costs ina timely manner, the Company may have to continue to reduce its cash balance or draw on its line of credit, both of which could significantly impact theliquidity or operations of the Company.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. Page 13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.Future success depends in part on attracting and retaining key management and qualified technical and sales personnelFuture success depends on the efforts and continued services of key management, technical and sales personnel. Significant competition exists for suchpersonnel and there is no assurance key technical and sales personnel can be retained or that other highly qualified technical and sales personnel as requiredcan be attracted, assimilated and retained. There is also no guarantee that key employees will not leave and subsequently compete against the Company. Theinability to attract and retain key personnel could adversely impact the business, financial condition and results of operations.Changes in the effective tax rate may have an adverse effect on the Company’s results of operationsThe Company’s future effective tax rate may be adversely affected by a number of factors including: the jurisdictions in which profits are determined 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.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 or challenged by, or licensed to other companies.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 Page 14number of risks, including: the imposition of governmental controls; trade restrictions; difficulty in collecting receivables; changes in tariffs and taxes;difficulties in staffing and managing international operations; political and economic instability; general economic conditions; and fluctuations in foreigncurrencies. No assurances can be given that these factors will not have a material adverse effect on future international sales and operations and,consequently, on business, financial condition and results of operations. Item 1B.Unresolved Staff CommentsNone. Item 2.PropertiesThe Company’s design and assembly facilities and executive offices are located in Portland, Oregon in three company-owned buildings totalingapproximately 40,500 square feet. SEL occupies a 1,080-square foot facility in Coventry, England pursuant to a three-year lease, renewable for an additionalthree-year period, beginning March 29, 2011 with a basic monthly rent of £917 (approximately $1,400 as of May 31, 2013). 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 closing prices of the Company’s Common Stock as reported on the NASDAQ Capital Market for the periodsindicated. 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 Year Ended May 31, 2013 High Low First Quarter $3.75 $3.26 Second Quarter $3.55 $2.90 Third Quarter $3.03 $2.90 Fourth Quarter $3.02 $2.70 As of July 31, 2013, there were 2,990,910 shares of Common Stock outstanding held by approximately 80 holders of record. The number of holders does notinclude individual participants in security position listings; the Company believes that there are more than 900 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, 2013: 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 301,666 $4.06 45,000 Equity compensation plans not approvedby security holders — — — 301,666 $4.06 45,000 Recent Sales of Unregistered SecuritiesNone.Issuer Purchases of Equity SecuritiesNone. Page 16Item 6.Selected Financial DataIn thousands, except per share information Year Ended 5/31/13 5/31/12 5/31/11 5/31/10 5/31/09 Sales $12,452 $14,437 $11,493 $6,806 $9,501 Net Income (Loss) $(540) $77 $(205) $(1,711) $(2,154) Net Income (Loss) Per Share, Basic $(.18) $.03 $(.07) $(.59) $(.75) Weighted Average No. Shares, Basic 2,991 2,930 2,895 2,887 2,870 Net Income (Loss) Per Share, Diluted $(.18) $.03 $(.07) $(.59) $(.75) Weighted Average No. Shares, Diluted 2,991 2,944 2,895 2,887 2,870 Stockholders’ Equity $10,015 $10,484 $10,157 $10,121 $11,718 Total Assets $11,625 $12,026 $11,589 $11,352 $12,624 Long-term Debt (including current portion) $— $— $— $— $— Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsRESULTS OF OPERATIONSOverviewSchmitt Industries, Inc. (the Company), an Oregon corporation, designs, manufactures and sells high precision test and measurement products for two mainbusiness segments: the Balancer Segment and the Measurement Segment. The Company designs, manufactures and sells computer-controlled vibrationdetection, balancing and process control systems for the worldwide machine tool industry, particularly for grinding machines (the Balancer Segment).Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), an Oregon corporation, the Company designs, manufactures and sells laserand white light sensors for distance, dimensional and area measurement for a wide variety of commercial applications, laser-based microroughnessmeasurement products for the semiconductor wafer and hard disk drive industries and for other industrial applications, laser-based surface analysis andmeasurement products for a variety of scientific applications, and ultrasonic measurement products that accurately measure the liquid levels of propane tanksand transmit that data via satellite to a secure web site for display (the Measurement Segment). The Company also provides sales and service for Europe andparts of Asia through its wholly owned subsidiary, Schmitt Europe Limited (SEL), located in Coventry, England and through its sales representative officelocated in Shanghai, China.For the fiscal year ended May 31, 2013 (Fiscal 2013), total sales decreased $2.0 million, or 13.7%, to $12.4 million from $14.4 million in the fiscal yearended May 31, 2012 (Fiscal 2012). Balancer Segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers ofgrinding machines with the target geographic markets in North America, South America, Asia and Europe. Balancer sales decreased $1.6 million, or 16.7%, to$7.7 million in Fiscal 2013 compared to $9.3 million in Fiscal 2012. The Fiscal 2013 decrease in balancer sales is due to lower volumes of shipments intoAsia, primarily China, and also to a lesser extent into North America. The decreases in Asia and North America are due to a reduction in orders as economicgrowth in China has slowed and the uncertainty regarding the U.S. economy continues to have a negative impact on manufacturing in the markets we serve.The Measurement Segment product line consists of laser-based light-scatter, distance measurement and dimensional sizing products and remote tankmonitoring products. Total Measurement sales decreased $434,000, or 8.4%, to $4.7 million in Fiscal 2013 compared to $5.2 million in Fiscal 2011. Thedecrease is primarily due to lower volumes of sales of laser-based surface measurement products.Operating expenses increased $372,000, or 5.9%, to $6.7 million in Fiscal 2013 from $6.3 million in Fiscal 2012. General, administrative and sales expensesincreased $116,000, or 1.9%, in Fiscal 2013 to $6.1 million as compared to $6.0 million in the prior fiscal year. Research and development expensesincreased $255,000, or 80.3%, to $573,000 in Fiscal 2013 from $318,000 in Fiscal 2012. Page 17Net loss was $540,000, or $0.18 per fully diluted share, for the year ended May 31, 2013 as compared to net income of $77,000, or $0.03 per fully dilutedshare, for the year ended May 31, 2012.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 the guidance provided by Accounting Standards Codification Topic 605. For sales to all customers, including manufacturerrepresentatives, distributors or their third-party customers, these criteria are met at the time product is shipped. When other significant obligations remainafter products are delivered, revenue is recognized only after such obligations are fulfilled. In addition, judgments are required in evaluating the creditworthiness of our customers. Credit is not extended to customers and revenue is not recognized until we have determined that collectability is reasonablyassured.Allowance for Doubtful Accounts – The Company maintains credit limits for all customers based upon several factors, including but not limited to financialcondition and stability, payment history, published credit reports and use of credit references. Management performs various analyses to evaluate accountsreceivable balances to ensure recorded amounts reflect estimated net realizable value. This review includes accounts receivable agings, other operating trendsand relevant business conditions, including general economic factors, as they relate to the Company’s domestic and international customers. If these analyseslead management to the conclusion that potential significant accounts are uncollectible, a reserve is provided.Inventories – Inventory is valued at the lower of cost or market with cost determined on the average cost basis. Costs included in inventories consist ofmaterials, labor and manufacturing overhead, which are related to the purchase or production of inventories. Write-downs, when required, are made to reduceexcess inventories to their net realizable values. Such estimates are based on assumptions regarding future demand and market conditions. If actualconditions become less favorable than the assumptions used, an additional inventory write-down may be required.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 – Intangible and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carryingamount of the asset may not be recoverable. Recoverability is determined by comparing the forecasted future undiscounted net cash flows from theoperations to which the assets relate, based on management’s best estimates using the appropriate assumptions and projections at the time, to the carryingamount of the assets. If the carrying value is determined to be in excess of future operating cash flows, the asset is considered impaired and a loss isrecognized equal to the amount by which the carrying amount exceeds the estimated fair value of the assets. Page 18Recently issued accounting pronouncementsRefer to Note 1 of the Notes to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.Discussion of Operating Results Year Ended May 31, 2013 2012 2011 Balancer sales $7,714,122 61.9% $9,265,008 64.2% $8,011,179 69.7% Measurement sales 4,738,130 38.1% 5,172,014 35.8% 3,481,680 30.3% Total sales 12,452,252 100.0% 14,437,022 100.0% 11,492,859 100.0% Cost of sales 6,357,452 51.1% 8,094,386 56.1% 5,887,207 51.2% Gross profit 6,094,800 48.9% 6,342,636 43.9% 5,605,652 48.8% Operating expenses: General, administration and sales 6,083,611 48.9% 5,967,359 41.3% 5,297,083 46.1% Research and development 573,461 4.6% 317,993 2.2% 504,251 4.4% Total operating expenses 6,657,072 53.5% 6,285,352 43.5% 5,801,334 50.5% Operating income (loss) (562,272) (4.5%) 57,284 0.4% (195,682) (1.7%) Other income (expense) 14,106 0.1% 37,260 0.3% (8,042) (0.1%) Income (loss) before income taxes (548,166) (4.4%) 94,544 0.7% (203,724) (1.8%) Provision for income taxes (8,284) (0.1%) 17,123 0.1% 1,659 0.0% Net income (loss) $(539,882) (4.3%) $77,421 0.5% $(205,383) (1.8%) Sales – Sales in the Balancer Segment decreased $1.6 million, or 16.7%, to $7.7 million for Fiscal 2013 compared to $9.3 million for Fiscal 2012. Thisdecrease is primarily due to lower volumes of shipments into Asia, particularly China, and also to a lesser extent to North America. North American salesdecreased $311,000, or 6.7%, in Fiscal 2013 compared to Fiscal 2012. Sales into Asia decreased $1.2 million, or 34.7%, in Fiscal 2013 compared to the prioryear. Sales into Europe increased $34,000, or 3.8%, in Fiscal 2013 compared to Fiscal 2012. Sales in other regions of the world decreased $75,000, or 24.9%,during Fiscal 2013 as compared to the prior year. The decreases in Asia and North America are due to a reduction in orders as economic growth in China hasslowed and the uncertainty regarding the U.S. economy continues to have a negative impact on manufacturing in the markets we serve. The levels of demandfor our Balancer products in any of these geographic markets cannot be forecasted with any certainty given current economic trends and the historicalvolatility experienced in this market.Sales in the Measurement Segment decreased $434,000, or 8.4%, to $4.7 million in Fiscal 2013 compared to $5.2 million in Fiscal 2012. Sales of laser-baseddistance measurement and dimensional-sizing products decreased $380,000, or 10.9%, primarily due to a large sale during the fourth quarter of Fiscal 2012that was not repeated in the fourth quarter of Fiscal 2013. Sales of remote tank monitoring products increased $296,000 to $877,000 during Fiscal 2013 dueto the higher volume of shipments and the developing monitoring revenues associated with unit sales. Sales of laser-based surface measurement productsdecreased $361,000, or 40.8%, primarily due to slowing demand for these products. Future sales of laser-based or ultrasonic measurement products cannot beforecasted with any certainty given the historical volatility experienced in this market.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. This increase isprimarily due to higher unit sales volumes in North America offset by decreases in unit sales volumes in Asia and Europe during the year. North Americansales 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 2012 compared to theprior year. Sales into Europe decreased $14,000, or 1.6%, in Fiscal 2012 compared to Fiscal Page 192011. Sales on other regions of the world increased $187,000, or 162.3%, during Fiscal 2012 as compared to the prior year. The increases in North Americaand other regions of the world are primarily due to higher volumes of shipments as the worldwide automotive and industrial markets in these regionscontinue to recover from the global economic downturn. The decreases in Asia and Europe are due to a reduction in orders as economic growth in China isslowing and the uncertainty regarding the European economy continues to have a negative impact on manufacturing. The levels of demand for our Balancerproducts in any of these geographic markets cannot be forecasted with any certainty given current economic trends and the historical volatility experiencedin 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.Gross margin – Gross margin in Fiscal 2013 increased to 48.9% compared to 43.9% in Fiscal 2012. This increase is primarily due to the impact of lower salesvolumes through the Asian distribution channels, which typically have higher discounts and lower margins, and as a result of the Company’s efforts to reducethe material costs from certain key suppliers and a shift in the product sales mix towards higher margin products. Gross margin in Fiscal 2012 decreased to43.9% compared to 48.8% in Fiscal 2011. This decrease is primarily due to higher inventory reserves associated with an end-of-life SBS balancer product,higher labor and overhead costs related to the increased sales volumes offset by a reduction in inventory component costs.Operating expenses – Operating expenses increased $372,000, or 5.9%, to $6.7 million for Fiscal 2013 compared to $6.3 million in Fiscal 2012. General,administrative and sales expenses increased $116,000, or 1.9%, to $6.1 million in Fiscal 2013 compared to $6.0 million in the prior year. This increase is dueprimarily to higher expenses associated with an international trade show that occurs every two years. Research and development expenses increased$255,000, or 80.3%, to $573,000 in Fiscal 2013 compared to $318,000 in Fiscal 2012. The increase in research and development expense is primarily due tonew product development and product enhancements related to existing product lines.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 salesexpenses increased $670,000, or 12.7%, to $6.0 million in Fiscal 2012 compared to $5.3 million in the prior year. This increase is due primarily to higherpersonnel costs, higher commissions related to the increased sales and higher sales and marketing expenses. Research and development expenses decreased$186,000, or 36.9%, to $318,000 in Fiscal 2012 compared to $504,000 in Fiscal 2011. The decrease in research and development expense is primarily due tolower material costs associated with new product development related to existing product lines.Other income – Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was $1,000,$2,000 and $4,000 in Fiscal 2013, 2012 and 2011, respectively. Interest income has decreased due to lower average cash and investment balances and lowerinterest rates. Foreign currency exchange gain was $13,000 and $18,000 in Fiscal 2013 and 2012, 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. In Fiscal 2012, other income consisted of an $18,000 gain on the sale of fixed assets.Income tax provision – The effective tax rate in Fiscal 2013 was 1.5%. The effective tax rate on consolidated net loss in Fiscal 2013 differs from the federalstatutory tax rate primarily due to changes in the deferred tax valuation allowance and certain expenses not being deductible for income tax reporting offsetby tax credits related to research and experimentation expenses. The effective tax rate in Fiscal 2012 was 18.1%. The effective Page 20tax rate on consolidated net income in Fiscal 2012 differs from the federal statutory tax rate primarily due to the amount of income from foreign jurisdictions,changes in the deferred tax valuation allowance and certain expenses not being deductible for income tax reporting, offset by tax credits related to researchand experimentation expenses. The effective tax rate on consolidated net loss was (0.8)% for Fiscal 2011. The Company’s effective tax rate on consolidatednet loss differs from the federal statutory rate primarily due to the amount of income from foreign jurisdictions, changes in the deferred tax valuationallowance and certain expenses not being deductible for income tax reporting purposes, offset by tax credits related to research and experimentationexpenses.Net income – Net income decreased $617,000 to a net loss of $540,000, or $0.18 per diluted share, for Fiscal 2013 as compared to net income of $77,000, or$0.03 per diluted share, for Fiscal 2012. Net income decreased due primarily to lower sales and related gross profit, higher research and developmentexpenses and higher general, administrative and selling expenses, offset by higher gross margin percentage during Fiscal 2013. 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 Fiscal2011. Net income increased due primarily to higher sales and related gross profit and lower research and development expenses, offset by higher general,administrative and selling expenses and a lower gross margin percentage during Fiscal 2012.LIQUIDITY AND CAPITAL RESOURCESThe Company’s working capital decreased $304,000 to $7.6 million as of May 31, 2013 compared to $7.9 million as of May 31, 2012. Cash and cashequivalents decreased $868,000 from May 31, 2012 to $1.9 million as of May 31, 2013.Cash used in operating activities was $679,000 in Fiscal 2013 as compared to cash provided by operations of $163,000 in Fiscal 2012. The increase in theamount of cash used for operating activities is primarily due to the impact of the Fiscal 2013 net loss and the increase in inventory, offset by the decrease inaccounts receivable.At May 31, 2013, accounts receivable decreased $513,000 to $2.0 million compared to $2.5 million as of May 31, 2012. The decrease in accounts receivableis due to the decrease in sales during Fiscal 2013. Inventories increased $1.1 million to $5.1 million as of May 31, 2013 compared to $4.0 million at May 31,2012 due to the decreases in sales activity coupled with an increase in inventories in our Xact product line. At May 31, 2013, total current liabilitiesincreased $75,000 to $1.6 million as compared to $1.5 million at May 31, 2012. The increase is primarily due to higher accounts payables as compared to theprior year, offset by lower accrual for commissions resulting from the decrease in sales.During the year ended May 31, 2013, net cash used in investing activities was $176,000, which primarily consisted of additions to property and equipmentfor new manufacturing and computer equipment and building improvements.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, 2013), or LIBOR plus 2.0%, (2.19% as of May 31, 2013). The agreement expires on March 1, 2014. There were nooutstanding balances on the line of credit at May 31, 2013 and 2012.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. Page 21QUARTERLY FINANCIAL DATAIn thousands, except per share information (unaudited) 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 2013 Quarter Ended August 31 November 30 February 28 May 31 Sales $3,681 $2,702 $2,796 $3,273 Gross profit $1,874 $1,542 $1,358 $1,321 Net income (loss) $120 $(105) $(191) $(364) Net income (loss) per share, basic $.04 $(.03) $(.06) $(.12) Net income (loss) per share, diluted $.04 $(.03) $(.06) $(.12) Item 7A.Quantitative and Qualitative Disclosures about Market RiskInterest Rate RiskThe Company did not have any derivative financial instruments as of May 31, 2013. 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, 2013. 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 2013, 2012 and 2011, results of operations included gains (losses) on foreign currency translation of $13,000, $18,000 and($10,000), respectively. The foreign exchange gains or losses in Fiscal 2013, 2012 and 2011 are 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, 2013 May 31, 2012 ASSETS Current assets Cash and cash equivalents $1,909,071 $2,776,817 Accounts receivable, net 1,980,685 2,493,889 Inventories 5,054,087 3,975,600 Prepaid expenses 219,492 186,489 Income taxes receivable 48,095 7,780 9,211,430 9,440,575 Property and equipment Land 299,000 299,000 Buildings and improvements 1,805,951 1,723,273 Furniture, fixtures and equipment 1,312,028 1,247,720 Vehicles 121,835 121,835 3,538,814 3,391,828 Less accumulated depreciation (2,203,924) (2,019,692) 1,334,890 1,372,136 Other assets Intangible assets, net 1,078,278 1,213,204 TOTAL ASSETS $11,624,598 $12,025,915 LIABILITIES & STOCKHOLDERS’ EQUITY Current liabilities Accounts payable $918,094 $770,586 Accrued commissions 273,307 335,104 Accrued payroll liabilities 131,772 142,665 Other accrued liabilities 286,307 286,319 Total current liabilities 1,609,480 1,534,674 Long-term liabilities — 7,500 Commitments and contingencies (Note 5) Stockholders’ equity Common stock, no par value, 20,000,000 shares authorized, 2,990,910 shares issued and outstanding at May 31,2013 and 2012 10,369,524 10,279,636 Accumulated other comprehensive loss (331,924) (313,295) Retained earnings (22,482) 517,400 Total stockholders’ equity 10,015,118 10,483,741 TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $11,624,598 $12,025,915 The accompanying notes are an integral part of these consolidated financial statements. Page 23SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS Year Ended May 31, 2013 2012 2011 Net sales $12,452,252 $14,437,022 $11,492,859 Cost of sales 6,357,452 8,094,386 5,887,207 Gross profit 6,094,800 6,342,636 5,605,652 Operating expenses: General, administration and sales 6,083,611 5,967,359 5,297,083 Research and development 573,461 317,993 504,251 Total operating expenses 6,657,072 6,285,352 5,801,334 Operating income (loss) (562,272) 57,284 (195,682) Other income (expense) 14,106 37,260 (8,042) Income (loss) before income taxes (548,166) 94,544 (203,724) Provision for income taxes (8,284) 17,123 1,659 Net income (loss) $(539,882) $77,421 $(205,383) Net income (loss) per common share, basic $(0.18) $0.03 $(0.07) Weighted average number of common shares, basic 2,990,910 2,930,314 2,895,042 Net income (loss) per common share, diluted $(0.18) $0.03 $(0.07) Weighted average number of common shares, diluted 2,990,910 2,944,081 2,895,042 Comprehensive loss Net income (loss) $(539,882) $77,421 $(205,383) Foreign currency translation adjustments (18,629) (86,714) 37,423 Total comprehensive loss $(558,511) $(9,293) $(167,960) 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, 2013 2012 2011 Cash flows relating to operating activities Net income (loss) $(539,882) $77,421 $(205,383) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 347,715 344,553 340,689 (Gain) loss on disposal of property and equipment 0 (18,014) 1,828 Stock based compensation 89,888 199,396 202,603 Tax benefit related to stock options 0 (1,134) (114) (Increase) decrease in: Accounts receivable 510,531 (686,578) (652,700) Inventories (1,082,931) 159,002 (483,802) Prepaid expenses (33,509) (20,529) 26,055 Income taxes receivable (40,315) (7,780) 21,570 Increase (decrease) in: Accounts payable 149,574 (66,729) 169,772 Accrued liabilities and customer deposits (80,183) 185,863 17,980 Income taxes payable 0 (2,073) 2,073 Net cash provided by (used in) operating activities (679,112) 163,398 (559,429) Cash flows relating to investing activities Purchase of property and equipment (175,835) (277,045) (227,620) Proceeds from sale of property and equipment 0 47,180 0 Other long-term assets 291 1,745 4,004 Net cash used in investing activities (175,544) (228,120) (223,616) Cash flows relating to financing activities Common stock issued on exercise of stock options 0 136,330 1,916 Excess tax benefit from stock-based compensation 0 1,134 114 Net cash provided by financing activities 0 137,464 2,030 Effect of foreign exchange translation on cash (13,090) (56,431) (4,465) Increase (decrease) in cash and cash equivalents (867,746) 16,311 (785,480) Cash and cash equivalents, beginning of period 2,776,817 2,760,506 3,545,986 Cash and cash equivalents, end of period $1,909,071 $2,776,817 $2,760,506 Supplemental Disclosure of Cash Flow Information Cash paid (received) during the year for income taxes $39,635 $19,476 $(21,709) The accompanying notes are an integral part of these consolidated financial statements. Page 25SCHMITT INDUSTRIES, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Shares Amount Accumulatedothercomprehensiveloss Retainedearnings Total Balance, May 31, 2010 2,894,802 $9,739,391 $(264,004) $645,362 $10,120,749 Stock options exercised net of related tax benefit of $114 833 1,916 0 0 1,916 Stock based compensation 0 202,603 0 0 202,603 Net loss 0 0 0 (205,383) (205,383) Other comprehensive income 0 0 37,423 0 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 Stock options exercised net of related tax benefit of $1,134 95,275 136,330 0 0 136,330 Stock based compensation 0 199,396 0 0 199,396 Net loss 0 0 0 77,421 77,421 Other comprehensive loss 0 0 (86,714) 0 (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 Stock based compensation 0 89,888 0 0 89,888 Net loss 0 0 0 (539,882) (539,882) Other comprehensive loss 0 0 (18,629) 0 (18,629) Balance, May 31, 2013 2,990,910 $10,369,524 $(331,924) $(22,482) $10,015,118 Comprehensive loss, year ended May 31, 2013 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, 2013, 2012 AND 2011NOTE 1SIGNIFICANT ACCOUNTING POLICIESNature of OperationsSchmitt Industries, Inc. (the “Company”) designs, manufactures, and sells high precision test and measurement products for two main business segments: theBalancer Segment and the Measurement Segment. The Company designs, manufactures, and sells computer-controlled vibration detection, balancing andprocess control systems for the worldwide machine tool industry, particularly for grinding machines (the “Balancer Segment”). Through its wholly ownedsubsidiary, Schmitt Measurement Systems, Inc., the Company designs, manufactures and sells laser and white light sensors for distance, dimensional and areameasurement products for a variety of scientific applications, and ultrasonic measurement products that accurately measure the liquid levels of propane tanksand transmit that data via satellite to a secure web site for display (the “Measurement Segment”).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 financial condition and stability, paymenthistory, published credit reports and use of credit references. Management performs various analyses to evaluate accounts receivable balances to ensurerecorded amounts reflect estimated net realizable value. This review includes using accounts receivable agings, other operating trends and relevant businessconditions, including general economic factors, as they relate to each of the Company’s domestic and international customers. If these analyses leadmanagement to the conclusion that potential significant accounts are uncollectible, a reserve is provided. The allowance for doubtful accounts was $30,576and $26,720 as of May 31, 2013 and 2012, respectively. Page 27Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 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: 2013 2012 Raw materials $2,225,295 $1,638,280 Work-in-process 1,132,534 980,092 Finished goods 1,696,258 1,357,228 $5,054,087 $3,975,600 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 CurrencyFinancial 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, administration and sales, are expensed when the advertising first takes place. Advertising expense was $82,289,$98,093 and $70,411 for the years ended May 31, 2013, 2012 and 2011, 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.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. Page 28Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 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. Management continues to review the level of the valuation allowance on a quarterly basis. There can be no assurance that theCompany’s future operations will produce sufficient earnings so that the deferred tax asset can be fully utilized. The Company currently maintains a fullvaluation allowance against net deferred tax assets.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, 2013 and 2012, amortizable intangible assets were $2,200,883, and accumulated amortization was $1,122,604 and $987,971,respectively. Amortization expense for each of the following years ending May 31 is expected to be as follows: Year ending May 31, 2014 $ 134,635 2015 119,233 2016 111,531 2017 111,531 2018 104,583 Thereafter 496,766 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 undiscounted net cash flows from the operations to which the assetsrelate, based on management’s best estimates using the appropriate assumptions and projections at the time, to the carrying amount of the assets. If thecarrying 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 bywhich the carrying amount exceeds the estimated fair value of the assets. As of May 31, 2013, 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. 13,002, 0 and 66,489 potentially dilutive common shares from outstanding stock options have been excluded from diluted earnings(loss) per share for the years ended May 31, 2013, 2012 and 2011, 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, 2013, 2012 AND 2011 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.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, 2013) or LIBOR plus2.0%, (2.19% as of May 31, 2013). There were no outstanding balances on the line of credit as of May 31, 2013 and 2012.NOTE 3LONG-TERM OBLIGATIONSAs of May 31, 2013, 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 lease expense for the years ended May 31, 2013, 2012 and2011 amounted to $56,721, $75,005 and $56,913, respectively.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, 2014 $ 31,337 2015 17,247 2016 17,247 2017 14,342 2018 0 Thereafter 0 Page 30Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 NOTE 4INCOME TAXESThe provision for income taxes is as follows: Year ended May 31, 2013 2012 2011 Current $(8,284) $17,123 $1,659 Deferred (283,447) (6,753) (3,953) Change in valuation allowance 283,447 6,753 3,953 Total provision for income taxes $(8,284) $17,123 $1,659 Deferred tax assets are comprised of the following components: 2013 2012 Basis difference of assets $311,441 $316,123 Inventory related items 271,790 264,764 Other reserves and liabilities 81,482 95,099 Net operating loss carryforward 752,372 512,101 General business and other credit carryforward 443,190 388,264 Other deferred items, net 1,994 2,471 Gross deferred tax assets 1,862,269 1,578,822 Deferred tax asset valuation allowance (1,862,269) (1,578,822) Net deferred tax asset $0 $0 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 the years ended May 31, 2013, 2012 and 2011, the Company increased its valuation allowance $283,447, $6,753, and $3,953 respectively, as a resultof the write-down of deferred tax assets. The Company has provided a full valuation allowance against all of its deferred tax assets as the recent losses havebeen given more weight than projected future income when determining the need for a valuation allowance.The Company has federal net operating loss carryforwards of approximately $1.6 million which expire in 2030 and 2033 along with the federal generalbusiness and other credit carryforwards. The Company has state net operating loss carryforwards of approximately $2.4 million which expire in 2024, 2025and 2028. Page 31Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 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, 2013 2012 2011 Statutory federal tax rate (34.0)% 34.0% (34.0)% State taxes, net of federal benefit (4.4) 4.4 (4.4) Change in deferred tax valuation allowance 51.7 7.1 23.8 Stock-based compensation 6.3 71.7 33.8 R&E tax credits (17.7) (42.3) (29.4) Effect of foreign income tax rates 1.9 3.2 2.0 Permanent and other differences (5.3) (60.0) 9.0 Effective tax rate (1.5)% 18.1% 0.8% 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 $0 and $7,500 as of May 31, 2013 and 2012,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 May 31, 2013 and 2012.Several tax years are subject to examination by major tax jurisdictions. In the United States, federal tax years for Fiscal 2010 and after are subject toexamination. In the United Kingdom, tax years for Fiscal 2012 and after are subject to examination. In Canada, tax years for Fiscal 2005 and after are subjectto 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, 2013, 2012 and 2011 amounted to $28,797, $40,840 and$22,128, respectively.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 Page 32Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 a five-year earn-out program that ended on May 31, 2013. This additional consideration, if any, would increase the value of the intangible asset recorded inconnection with the acquisition. No additional shares of stock have been issued to former Xtero shareholders as of May 31, 2013.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, 2013 2012 2011 Balancer Measurement Balancer Measurement Balancer Measurement Gross sales $8,546,010 $4,796,620 $10,194,525 $5,231,238 $8,732,900 $3,533,634 Intercompany sales (831,888) (58,490) (929,517) (59,224) (721,721) (51,954) Net sales $7,714,122 $4,738,130 $9,265,008 $5,172,014 $8,011,179 $3,481,680 Operating income (loss) $(63,622) $(498,650) $422,528 $(365,244) $249,657 $(445,339) Depreciation expense $142,288 $70,794 $142,576 $67,342 $123,958 $60,607 Amortization expense $0 $134,633 $0 $134,635 $0 $156,124 Capital expenditures $80,492 $95,343 $129,148 $147,897 $176,578 $51,042 Geographic Information Year Ended May 31, 2013 2012 2011 North America $8,413,970 $9,074,152 $6,037,847 Europe 1,192,049 1,145,449 1,130,480 Asia 2,499,593 3,814,656 3,990,371 Other markets 346,640 402,765 334,161 Total Net Sales $12,452,252 $14,437,022 $11,492,859 Year Ended May 31, 2013 2012 2011 United States Europe United States Europe United States Europe Operating income (loss) $(442,939) $(119,333) $54,265 $3,019 $(84,885) $(110,797) Depreciation expense $213,082 $0 $209,918 $0 $184,565 $0 Amortization expense $134,633 $0 $134,635 $0 $156,124 $0 Capital expenditures $175,835 $0 277,045 $0 $227,620 $0 Page 33Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 Segment and Geographic Assets May 31, 2013 May 31, 2012 Segment assets to total assets Balancer $5,489,976 $4,872,664 Measurement 4,177,456 4,368,654 Corporate assets 1,957,166 2,784,597 Total assets $11,624,598 $12,025,915 Geographic assets to long-lived assets United States $1,334,890 $1,372,136 Europe 0 0 Total assets $1,334,890 $1,372,136 Geographic assets to total assets United States $11,021,901 $11,246,431 Europe 602,697 779,484 Total assets $11,624,598 $12,025,915 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, 2013, 2012 and 2011 includes compensation cost for stock-based awards granted. All outstanding options will expire no later than 2023.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, 2013, 2012 AND 2011 • 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, 2013, 2012 and 2011, 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, 2013 2012 2011Risk-free interest rate 2.5% N/A 3.8%Expected life 4.2 years N/A 4.8 yearsExpected volatility 63.8% N/A 62.4%Stock-Based Compensation Under ASC Topic 718The total stock-based compensation expense recognized under ASC Topic 718 was $89,888, $199,396 and $202,603 during Fiscal 2013, 2012 and 2011,respectively. All stock-based compensation expense has been recorded as general, administration and sales expense in the Consolidated FinancialStatements.As of May 31, 2013, the Company had a total of 301,666 outstanding stock options (254,998 vested and exercisable and 46,668 non-vested) with a weightedaverage exercise price of $4.06. The Company estimates that a total of approximately $51,776 will be recorded as additional stock-based compensationexpense for all options which were outstanding as of May 31, 2013, but which were not yet vested. Page 35Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 Options outstanding and exercisable consist of the following as of May 31, 2013: Outstanding Options Exercisable Options Numberof Shares WeightedAverageExercisePrice WeightedAverageRemainingContractualLife (yrs) Numberof Shares WeightedAverageExercisePrice 41,666 $2.30 1.0 41,666 $2.30 25,000 2.90 9.9 0 N/A 155,000 3.65 8.0 133,332 3.65 5,000 5.80 2.4 5,000 5.80 75,000 6.16 5.0 75,000 6.16 301,666 4.06 6.3 254,998 4.21 Options granted, exercised, canceled and expired under the Company’s stock option plan during the years ended May 31, 2013, 2012 and 2011 aresummarized as follows: Numberof Shares WeightedAverageExercise Price Options outstanding - May 31, 2010 218,609 $3.32 Options granted 170,000 3.65 Options exercised (833) 2.30 Options forfeited/cancelled 0 0.00 Options outstanding - May 31, 2011 387,776 3.47 Options granted 0 0.00 Options exercised (95,275) 1.43 Options forfeited/cancelled (10,835) 3.46 Options outstanding - May 31, 2012 281,666 4.16 Options granted 25,000 2.90 Options exercised 0 0.00 Options forfeited/cancelled (5,000) 3.65 Options outstanding - May 31, 2013 301,666 4.06 The total intrinsic value of both outstanding and exercisable options as of May 31, 2013 and 2012 was $26,875 and $52,083, respectively. The total intrinsicvalue of options exercised during the years ended May 31, 2013, 2012 and 2011 was $0, $189,063 and $1,070, respectively. Page 36Schmitt Industries, Inc.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED MAY 31, 2013, 2012 AND 2011 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 Income/(Loss)(Numerator) WeightedAverageShares(Denominator) Per ShareAmount Year ended May 31, 2013 Basic earnings per share Loss available to common stockholders $(539,882) 2,990,910 $(0.18) Effect of dilutive securities stock options — — Diluted earnings per share Loss available to common stockholders $(539,882) 2,990,910 $(0.18) Year ended May 31, 2012 Basic earnings per share Income 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) 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 $56,633, $65,672 and $72,151 during the years ended May 31, 2013, 2012 and 2011, respectively. Page 37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 (the “Company”) as of May 31, 2013 and2012, and the related consolidated statements of operations and comprehensive loss, stockholders’ equity and cash flows for the years ended May 31, 2013,2012 and 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require thatwe plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. TheCompany is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included considerationof internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose ofexpressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accountingprinciples used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believethat our audits provide a reasonable basis for our opinions.In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of SchmittIndustries, Inc. as of May 31, 2013 and 2012 and the consolidated results of its operations and its cash flows for the years ended May 31, 2013, 2012 and2011 in conformity with accounting principles generally accepted in the United States of America./s/ MOSS-ADAMS LLPPortland, OregonAugust 14, 2013 Page 38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, 2013.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, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B.Other InformationNone. Page 39PART IIICertain information required by Part III is included in the Company’s definitive Proxy Statement for its 2013 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 2013 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 2013 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 2013 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 2013 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 2013 Annual Meeting of Shareholders and isincorporated herein by reference. Page 40PART IV Item 15.Exhibits and Financial Statement Schedules (a)Financial Statements: (1)Consolidated Balance Sheets as of May 31, 2013 and 2012 Consolidated Statements of Operations and Comprehensive Loss for the years ended May 31, 2013, 2012 and 2011 Consolidated Statements of Cash Flows for the years ended May 31, 2013, 2012 and 2011 Consolidated Statements of Stockholders’ Equity for the years ended May 31, 2013, 2012 and 2011 Notes to Consolidated Financial Statements for the years ended May 31, 2013, 2012 and 2011 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 41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/ James A. Fitzhenry James A. FitzhenryPresident and Chief Executive OfficerDate: August 14, 2013Pursuant 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 14, 2013. Signature Title/s/ Wayne A. CaseWayne A. Case Chairman of the Board/s/ James A. FitzhenryJames A. Fitzhenry Director, President and Chief Executive Officer (Principal Executive Officer)/s/ Ann M. FergusonAnn M. Ferguson 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 42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, 2013. 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 43EXHIBIT 21.1SUBSIDIARIES OF SCHMITT INDUSTRIES, INC.AS OF MAY 31, 2013 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 14, 2013, relating to theconsolidated financial statements appearing in this Annual Report on Form 10-K of Schmitt Industries, Inc. for the year ended May 31, 2013./s/ Moss-Adams LLPPortland, OregonAugust 14, 2013EXHIBIT 31.1CERTIFICATION PURSUANT TO18 U.S. C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, James A. Fitzhenry, 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 14, 2013 /s/ James A. Fitzhenry James A. Fitzhenry, President and Chief Executive OfficerEXHIBIT 31.2CERTIFICATION PURSUANT TO18 U.S. C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Ann M. Ferguson, 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 14, 2013 /s/ Ann M. Ferguson Ann M. Ferguson, 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, 2013 as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), we, James A. Fitzhenry and Ann M. Ferguson, President and Chief Executive Officerand Chief Financial Officer and Treasurer, respectively, of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to our knowledge:(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ James A. FitzhenryJames A. FitzhenryPresident and Chief Executive OfficerAugust 14, 2013/s/ Ann M. FergusonAnn M. FergusonChief Financial Officer and TreasurerAugust 14, 2013

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